In the aftermath of the MF Global disaster, the futures industry immediately recognized the need to restore confidence by implementing greater protections for commodity customers. The Commodity Customer Coalition (CCC) was formed to advance customer claims. The Futures Industry Association (FIA) studied the situation and made “Initial Recommendations for Customer Funds Protection” in February 2012. The National Futures Association (NFA) and CME Group adopted many of the recommendations that the FIA offered. They required Futures Commission Merchants (FCMs) to file daily segregation statements, regularly report on customer funds, and set limitations on the withdrawal of the firm’s residual interest in the segregated account.
On Oct. 30, 2013, the Commodity Futures Trading Commission (CFTC) took up where the NFA and CME left off and adopted a new rule: “Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations.” This 604 page rule is wide ranging and comprehensive. With some slight modifications, the CFTC included the rules drafted by CME and NFA, but they went much further. The new rules not only cover the handling of customer funds, but they mandate the adoption of comprehensive risk management programs, internal monitoring and controls and required disclosures to customers.
This article cannot reduce to a few pages what the CFTC spent 604 pages discussing, but will attempt to highlight many of the rules that are scheduled to be implemented in 2014.
The rules that are of direct concern to customers are those that address the handling of customer funds (see “Categories of customer funds,” below). If customer funds are properly “segregated” from the FCM’s funds, then customers should be protected from the liabilities of the FCM. Over time the segregation regime has generally worked well; however, as we learned from MF Global and Peregrine Financial Group (PFG), the segregation process does not always function as it was designed.
An FCM cannot commingle (without prior approval) the funds in one category with those of another, and must keep the funds in an approved depository. The FCM must caption the account at each depository with a description of the type of funds being held, and the FCM must obtain an acknowledgement from the depository that it will hold the funds for the benefit of the customers, not the FCM. The investment of customer funds is limited to U.S. government or government guaranteed obligations, the general obligations of the States or bank or money market deposits. The CFTC removed sovereign debt and intercompany transactions from the approved list of investment as it was outsized bets on sovereign debt that contributed to the MF Global bankruptcy.
The segregated (or secured, or cleared swaps) account is the sum total of money or other property deposited by or for customers or earned by customers from their trading activities. The FCM adds to (or tops off) the segregated account by adding their own funds to provide a cushion in the event a given customer loses more than he has deposited. The FCM addition is called the “residual interest” in the account.
The new rules require an FCM to set a targeted amount for the residual interest based on the past history of customer trading activity, customer balances and customer losses as well as market conditions and liquidity needs. The residual interest target may be a fixed dollar amount or a percentage of the segregated account. On a daily basis each FCM must report their segregated funds calculation and their residual interest to the CFTC and their Designated Self-Regulatory Organization (DSRO). A similar calculation is made and reported for secured funds and cleared swap customer funds.
Limit on withdrawals
The residual interest is the cushion protecting against a shortage in the segregated account as any shortage could put the FCM in jeopardy. Under the new rules, FCMs are prohibited from withdrawing more than 25% of their residual interest without the pre-approval of a senior officer and proper notice of the withdrawal to the CFTC and their DSRO. After a 25% withdrawal, any further withdrawals are prohibited until a new segregation statement has been filed. FCMs are permitted to make withdrawals to or for the benefit of customers without restriction.