Seg funds aren't sexy but...

Taking a page from the securities side

I really wish these new regulations would solved the seg fund issue and bring back confidence in the industry once and for all, but they won't.  Would they have stopped the MF Global violations? No. Sentinel? No.  Peregrine Financial Group? No. Filing the same reports more often and creating more reports doesn't necessarily stop someone intent on fraud.  Eliminating the Alternative Method was a good new rule, but the proposed capital requirements are going to force more capital requirements on an already marginally profitable industry. With the new capital rules, FCMs are estimated to have to contribute $100 billion into customer accounts, making the futures brokerage business even less profitable. This will ultimately make trading futures more expensive for clients, as FCMs will have no choice and pass on the higher costs. As I said in the beginning, letting regulators solve the seg fund issue would not be business friendly.

Problems with broker-dealer seg funds in the 1980s

Does anyone remember my commentary on April 5, "Five Bankruptcies That Created The Tri-Party Market"? Lombard-Wall, Lion Capital, RTD Securities, E.S.M. Government Securities, and Bevill Bresler & Schulman all collapsed between 1982 and 1985 and their customers suffered serious losses because the firms had under-priced, double-pledged or not pledged securities held in Hold-In-Custody Repo accounts. Sound familiar? That was the last time the securities industry had such a serious problem with seg fund violations and the solution was getting a third party involved - which created the Tri-Party Repo market.

Here's a solution to the current problem

The industry needs to add a third party agent into the seg fund holding process, which would verify and value the securities in the account. The clearing banks don't want additional regulatory responsibility and they certainly don't want to establish millions of Tri-Party-like sub-accounts.  But it still can be done. With available technology and already developed systems, securities held in large omnibus seg fund accounts can be allocated to each customer at the futures broker level, using the same methodologies to allocate collateral into Tri-Party accounts.

Here's how it will work:

  • The futures broker will keep all the collateral in the omnibus seg fund account at the clearing bank, just like it does now.
  • The futures broker allocates the collateral to clients via their trade processing system with minor modifications and the specific securities will appear on the clients' statements.  That way, clients know exactly which securities are theirs.
  • The clearing bank will then make sure the total seg fund collateral that was allocated to clients matches the total in the clearing account and the securities are priced and margined correctly.
  • Like Tri-Party Repo accounts, the broker cannot close its books that night until the clearing bank verifies the collateral is sufficient in the Seg fund accounts.

 This simple solution will give futures clients faith in futures industry again because it will allow clients to know the actual securities in their account and know that a third party has priced and verified that it's there.

*Futures Industry Magazine; "How FCMs are adapting to survive in a difficult market"; March 2013


 A former salesman, trader, trading desk manager, and global business head in fixed-income, securities finance, and securities clearing and settlement, Scott Skryn recently left Newedge, where he worked for over 12 years. For this and other blogs by Scott Skryn, go to his website. You can reach Scott at scott.skyrm@optonline.net

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About the Author
Scott Skrym

Scott Skyrm is a former salesman, trader, trading desk manager, and global business head in fixed-income, securities finance, and securities clearing and settlement. He recently left Newedge, where he worked for over 12 years. Prior to Newedge, he managed the repo desk at ING Barings, worked summers at Shearson Lehman/American Express and started his full-time career at The Bank of Tokyo. His first book, “The Money Noose,” was just  releasted. It's a tale about MF Global's fall from grace.

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