How to Save the Futures Industry

To say the MF Global situation is a mess may be the understatement of the century. What began as an excuse to extol the segregated account’s safeguards against an FCM stock slide as MF Global shares lost 70% of their value in a week rapidly morphed into a full-fledged industry disaster as bankruptcy papers were filed and executives acknowledged a shortfall in those previously sacrosanct accounts.

This admission, in conjunction with the bankruptcy, has caused over $5 Billion of customer funds held by MF Global to be frozen, unable to be accessed or transferred out.  Right on cue, the lawyers have begun to circle, with employees, bondholders, and the customers themselves filing claims for their piece of the $40 Billion in Assets MF Global reportedly had on hand.

What was a very small probability just two weeks ago now looks to be a near certainty – that over 150,000 futures industry customers who held accounts at MF Global will have their money locked up for anywhere between several months to several years. Before a single penny can be distributed, a legal team charging $1,000 an hour will have to go line by line through books that have been described by regulators as a “disaster,” making the potential (and incentive) for a speedy turnaround non-existent. Even then, once the books have been closed on the accounting side, the legal battle royale begins, and if the Sentinel case is any indication, we’ll be waiting for quite a while to run through all the cases,

My firm, Attain Capital, uncomfortable with the direction MF Global was taking, moved all of its accounts from MF Global 2.5 years ago. Even with that foresight, we have had clients close their accounts in the MF Global aftermath because they are worried about the safety of their segregated funds, while many others heatedly question what the industry is going to do to make sure this never happens again.

While the lawyers fight with JP Morgan over who should get what money (how would you feel about being a taxpayer who bailed out the big banks only to have them get priority over your money in bankruptcy?), the rest of the industry needs to be talking about how to salvage our collective business.

Many of you may be feeling lucky you didn’t have exposure to MF Global, or even enjoying an uptick in business because of the MF Global accounts being transferred to you, and that’s understandable. However, that joy becomes short-lived as one realizes that this mess threatens the continued growth of not only your firm, but our entire industry.  Brokers, CTAs, service providers, technology companies, and more will all go out of business because of this – some immediately because they won’t get their most recent payments due from MF Global, and others over the next several months as their business falls due to their client base’s inability to access the funds held at MF Global that they need to trade.

But the biggest threat is to the future. It’s that large investor who would have happily opened a futures account just a month ago, but now chooses not to because he is unsure what would happen to his funds should a bankruptcy occur at his broker of choice.

How do we make sure that such an investor regains confidence in the industry, and chooses to go ahead with that investment? The hollow emails by FCM presidents and owners to their clients saying they care is simply not enough; actual solutions and fixes to the problems which allowed the MF Global mess to happen need to be enacted.

The industry needs to change to protect that which was formerly held most dear – the segregated account. Here is what we propose:

Create a coalition to make all the MF Global customers whole, immediately.

There are billions of dollars of profits between the exchanges, brokerage firms which just received free business from the MF Global demise, and others in the industry.  Someone (ahem… CME)  needs to step up and create a coalition of these industry giants and pony up the money to make each and every one of the MF Global accounts whole, immediately.

If the government didn’t think that MF Global was too big to fail, the industry surely needs to. Do you think the CME put forth their $250 million guarantee or $50 million recovery fund out of the kindness of their hearts? No- they are worried about volumes, and rightfully so. With about $5 Billion worth of customers now unable to trade, the sooner those customers can pump those funds back into the markets, the better for the CME’s bottom line.

How is this supposed to work? We’re not saying this coalition needs to pony up the money and never get repaid. We’re saying they should step in and cover the money until the bankruptcy runs its course and the funds are released.  Why can’t the industry put together a fund which covers the customer segregated funds, and in exchange for making the customer whole, the customer signs over any claim they had to their money in bankruptcy court to the fund?

Think of it more as fronting the money. After all, nearly all agree that it is just 10% or so of the money which is missing.  At worst, the fund would be out the $600 million in missing segregated funds (and that’s only if the trustee is unable to get any of the $41 Billion in MF Global assets to cover that shortfall). The problem here is less about there being no money than it is about the money being frozen up.

The industry simply can’t afford to wait for the bankruptcy to run its course. Every moment of inaction that passes is a moment without those funds coursing through the industry’s veins. Consider that MF Global reported in its Q2 financials that it cleared 575 million contracts over the three months that ended June 30th, 2011.  If  the exchanges are getting $0.25 per contract, without taking action, that’s about $575 million in lost revenues per year. If the brokers who just received the accounts could get $0.25 per contract on the business moved to them, that’s $575 million in new revenue for them (assuming those accounts can get back trading).

There is plenty of money to go around, especially in the name of saving what has been the cornerstone of this industry since its inception- the sanctity of the segregated account. Hell, Attain will even pony up our share. Without taking this step, there is little any of us can do to help our clients feel secure. Industry participants will likely be worried about setting a precedent, but that is, in fact, the whole point. We need to be able to point to this time in our industry’s history and say, “Yes, it was ugly, but the industry stepped in and made the accounts whole.”

If you’re still not on board, why not backstop the coalition fund with a rule granting the ability to increase NFA fees from the current $0.02 per trade to $0.03 to cover any shortfall the fund has to cover? And as a final brushstroke, how about making the coalition member’s investments in the fund count 100% towards their net capital computations, treating it like cash in the bank?

The choice is a known cost in a temporary, defined and shared burden or an unknown cost in an inequitable and unquantifiable loss of business in the long run. How’s that for risk calculation?

Preventative Measures

While this may put out the fires in the short-term, at the end of the day, there’s still much more work to be done. It’s not enough to simply react; we need to be proactive about preventing this from ever occurring again. How? We’re glad you asked.

1. Extend SIPC protection to futures investors. When it came to light that the SIPC was rapidly moving to ensure that all claims to the assets of MF Global were resolved, the initial reaction of many industry participants was to breathe a sigh of relief. However, as many soon found out, SIPC protection is currently only offered to securities customers- meaning only those trading stocks and bonds would be covered, and not our beloved exchange traded futures investors. In our minds, there is zero reason why investors in traditional asset classes should be afforded such protection while investors in the alternative space are not.

As such, we propose that regulations governing the SIPC be amended to ensure protection of futures clients’ holdings as well, with guarantees on the individual account level (the sub-account of the customer segregated account on the FCM’s books) and not just the main overall account level containing all of the customer funds.

The CME and ICE should cut 10% off their marketing budget and put that to lobbying Congress for this protection. This isn’t 1970, when stocks and bonds were the only game in town. If the world turns to the CME to manage risk, the CME needs to turn to Congress to lower the risk of managing that risk.

2. Amend CFTC rule 1-25 to limit segregated funds investment to US Treasuries only. One of the issues that’s gotten a lot of press since the shortfall in funds at MF Global went public is the idea that Corzine might have used those funds to finance his European bets. There’s no proof of this yet, but the concept alone rattled many. The general belief was that FCMs could not, under any circumstances, touch segregated funds.

That’s not true. Under 1-25, FCMs are allowed to gain interest on excess segregated funds through specific investments under explicitly outlined circumstances. There are three limitations that really matter here: preservation of capital, preservation of liquidity, and adherence to risk standards.

Under the rule, FCMs can invest in 6 different vehicles (U.S. treasuries, state bonds, government agencies, commercial paper, corporate notes or bonds, sovereign debt, and money market mutual funds), but, with the exception of U.S. Treasuries or money markets, these vehicles have to have the highest rating possible from one of the NRSROs- or, official ratings agencies. This means that, technically speaking, the allegations flying around that FCMs may legally use segregated funds to invest in high-risk junk bonds are utterly incorrect. That being said, we’re still not satisfied with the requirements.

If we learned anything from 2008, it is that ratings agencies were doling out the highest ratings possible on toxic mortgage-backed securities right up to the point that things blew up. In fact, the rating agencies even downgraded MF Global…wait for it…. after they went bankrupt.  Our trust in their ability to assess risk adequately enough to ensure the preservation of segregated client funds is nil. As such, our recommendation is that 1-25 be amended to prohibit investment of segregated account funds in anything but U.S. Treasuries. While a statement issued today by CFTC Commissioner Scott O’Malia pointed out that we do not know the root cause of the missing funds, and that it’s possible the missing funds have nothing to do with investments permitted under 1-25, in our minds, this changes nothing; this rule needs to be altered regardless of the MF Global investigation’s conclusions.

3.  Establish regulation under which language must be added to all creditor agreements for any registered FCM in which those creditors agree to the assignment of the customer segregated accounts as the primary lien holder on all assets of the company. Under current provisions, segregated accounts are given what is, in our minds, inadequate protection during the bankruptcy process. True, their accounts cannot be tapped to meet outstanding financial obligations of the bankrupted FCM, but there’s also no guarantee of those funds being made whole in the event of a shortfall, nor protection from a too big to fail bank like JP Morgan sending in armies of attorneys arguing that their claim should take precedence over the customers.  While clients may, after a pro-rata distribution, file a claim with the Trustee in an attempt to get their missing money back, it appears that there are back door methods for big creditors like JP Morgan Chase and those who held MF Global bonds to get in front of the customers in the claims process. As TheStreet summarized:

“The group of customers, led by James Koutalas, chief executive of a Chicago-based commodities trading firm, are taking issue with a lien and other protections offered to JPMorgan in exchange for a $8 million loan the bank extended to MF on the first day of its bankruptcy, according to the report. That would allow JPMorgan the right to some assets over other creditors.”

In our minds, segregated account holders should absolutely come first in the claims process. Unlike the creditors and bold holders, who knowingly accepted the risk of default when they handed over their money, MF Global clients were paying MF Global to hold their funds- not lose them. With this in mind, we believe that the law must designate segregated accounts as the primary creditor if an FCM goes belly up, ensuring that, should there be a shortfall in client segregated funds, available assets of the bankrupt FCM will be tapped to make those accounts whole before any other creditor gets their day in court.

You can be sure that the big creditors would take an immediate and very big interest in insuring that any FCM they lend money to has the adequate procedures and safeguards in place to protect customer funds knowing that they are second in line behind said customer funds. If you can’t rely on morality to protect the funds, rely on greed and the invisible hand of those who would stand to lose money should the customer segregated funds be breached.

4. Establish regulation outlining standard operating procedures in the wake of an FCM bankruptcy. Part of the reason that the MF Global situation has been so chaotic was the result of poor planning. Positions were stuck in limbo. There was no infrastructure for facilitating an orderly transfer of accounts, which led to an ad-hoc distribution among arbitrarily selected FCMs without the transfer of legal documents- including those necessary for a CTA to trade on behalf of a client. Without any stipulations regarding timeframe, the process was drawn out to the detriment of all parties involved. Add to that a failure to effectively communicate what was going on to the clients involved, and it’s no wonder the situation turned into the nightmare it did.

In the wake of both the Refco and Sentinel scandals, one would think that remedies would already have been put into place for such administrative Bermuda Triangles, but unfortunately, that did not occur. In order to prevent such a disorderly dissemination from occurring again, we suggest that new regulations be developed; outlining exactly what is to happen in the event of an FCM going bankrupt. The old plan seemed to be, wait for a suitor to step up and take on all of the accounts. That clearly worked out wonderfully this time around. Coming up with standard operating procedures outlining the immediate impact on open positions, where the client funds are to be transferred to and within what timeframe, and so forth would help avoid the confusion we’ve seen to date.

A Call to Action

We are not about to claim that we have all the answers. Have we researched these subjects? Yes. Have we consulted with others in the industry? Absolutely. Does that mean that the solutions proposed here are perfect? NO.

But someone needs to start the dialog. The CME has made a nice first step with its $250 million guarantee to the trustee. The efforts of Koutoulas and Roe to provide a voice for the clients in the bankruptcy proceedings are certainly admirable. But at the end of the day, we all know that there is a long road ahead of us. Laws need to be changed and rules rewritten.  The industry needs to step up and reclaim its image. At the end of the day, perception is all that matters. If this situation is not resolved effectively, every CTA, FCM, CPO, Commodity Broker, Introducing Broker and Exchange will lose a sizable amount of business. There’s no getting around it. People aren’t going to invest in something where they don’t feel secure.

Make no mistake- these are extraordinary times we face, and they require an extraordinary communal effort to be survived. Despite the challenges on the horizon, we have no doubt that, in one way or another, this industry will rise to the occasion.  Because as important as it may be to understand what’s transpired and what’s at risk here, what comes next matters even more.       

Sincerely,

JEFF MALEC
CAIA  |  CEO, FOUNDING PARTNER
ATTAIN CAPITAL MANAGEMENT, LLC.

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Comments

  1. Very well written that hits the target on the head. I hope they are listening. Every minute that passes is a ticking time bomb for the managed futures industry.

  2. Eduardo Frid says:

    Extraordinary work, I cant beleive that customers havent got 100% of their money back. After hearing for 15 years that “you are safe in a segregated futures account”, I have been selling that to my customers for years and now I dont have an answer to those who ask me whats going on, I suppose they all feel just like I do, confused angry and betrayed, if confidence was scarse after 2008 this is the icing on the cake, not only they should be made whole, new rules should be made and change to protect first and most the customer, but once and for all get this crooks out of the street and into Jail. Nor I or my customers where MFG clients but the image that this hasnt been solved quickly nor orderly and that there is no timeframe to when it will if it ever does we as an industry are doomed, I have been trying to keep up with this issue and doing what I can to help those in need but the worst part of it is that nobody know where to turn to.

    Eduardo Frid CTA
    EF Financial Services

  3. Jeff,

    You are right on. We appauled you and everyone there at Attain. We have discussed here about the great foresight that you and your firm had 2 years ago. We listened, observed and watched your business model grow and develop accordingly.

    Now we have had another monkey wrench thrown at us here in the industry.

    You are right in that we can collect survive these events; that we can grow together and collectively; and that in the end we will have even better products and services for clients, for the industry, and for the longevity of the markets.

    Please keep us informed, and keep up with the cheerleading and coaching as to what we can proactively do to make this industry even more respected in time.

    Craig Kendall,
    President
    Financial Commodity Investments, (FCI)

  4. Marcus Custance says:

    Jeff
    A well written article as always; but the fact that accounts have been frozen for so long, positions expired, options exercised, deliverable contracts given notice and goodness knows what else it is a complete mess. The industry needed to act much sooner to transfer all customer accounts out to other FCM’s.
    In my opinion there is only one solution that will solve this and unfortunately that is a giant FCM run by the exchange; so that customers know full well their funds will be secure. In this scenario the exchange holds all the client funds and current FCMs just become FTMs (Futures Transaction Merchants). You have a back-to-back type accounting system and the FTM never has their hands on any client funds.
    There are some risks in this scenario, particularly of transaction cost manipulation and there may be a new admin cost, similarly a single deposit holder is not ideal but may be the only solution. The industry is clearly at risk given the shambolic handling of MF affair and if a solution is not found soon will lead to a certain demise in business.
    Marcus

  5. While I am not a fan of goverment solutions typically this is an ideal situation for the US Treasury take on. The worlds trust in the US futures system, the jobs and tax revenue at stake make it easily justified for the US Treasury to become the entity to “front” the money so client funds can be released immediately. It is in our national interest far more than saving an individual bank which they do regularly. This fiasco is risking the future that an entire industry that the US dominates going offshore to a place that creates a better system for protecting customer assets. The Treasury Department’s failure to act already shows the bias that still exits against the futures markets in our country. If something similar happened that put the equities business at risk they would have already stepped in?

    So immediately the US Treasury Department should step in a clean up this mess by providing the 600 or whatever million. They will get repaid if assets are available when it’s all sorted out including first dips on criminal penalties if applicable. I don’t believe it’s a good idea for independent companies to create a consortium to do this themselves as its difficult to include all the beneficiaries of the futures business and their respective percentages as well as it set a precedence for action on the next fraud we can’t yet comprehend which may be larger and that private consortium can’t cover.

    Once that is done the next step is too create an insurance like FDIC or SPIC specifically for the futures markets in the US ( to try and provide a competitive advantage for doing business in the US and perhaps strengthening the US business because of this fiasco over time). This insurance would be funded by a NFA like fee of some amount to be determined based on the gross size of the protection available.

    Secondly as you point out there needs to be a more rapid and simple process for moving accounts and the associates legal agreements associated with those accounts so that customer trading is not be interrupted and no financial harm comes to customers if a similar situation were to occur. While as others have requested a central goverment administered exchange is not a good idea as it would get bogged down with politics.

    The risk of customers losing money with an FCM blow up has always been real and I am surprised with so many industry professionals seeming weren’t aware of that? This situation provides an excellent opportunity to correct the flaws in the system and improve it.

    While exactly what happened here is not yet known I am also puzzled with all the blame being put upon the CFTC 1.25 and 1.29 regulations. From what I can tell this situation happened because MF Global or another entity misappropriated segregated customer funds when there was a margin deficiency that resulted form losses in MF’s proprietary trading which was highly leveraged. The issue isn’t that segregated customer funds were invested in repos as there was plenty of additional segregated customer funds available to meet any margin call and hold the repos to maturity where a profit was locked in? The scenario of MF investing clients segregated funds directly in leveraged repos makes no sense either the losses would have been higher or those margin call would have been met. However whether MF missapropriated the funds as a last ditch to save the company hoping a Euro bailout would return the markets to normal or if another entity siezed client segregated funds as collateral although less likely is still possible. The fact that it has been reported that there were efforts made by MF to conceal things makes me believe the issue was the former which is highly illegal.

    Either way it looks to me like this happened due to fraudulent and illegal actions and criminal charges should be vigorously pursued and if proven guilty Maddoff type of sentences should be handed down.

    To me there isn’t anything really wrong with the present system assuming people running these place behave ethically. However, since executives playing roulette with other peoples money for their own benefit and violating regulations in these illegal acts appears
    to have become a regular occourance that additional safeguards could and should be implemented.

  6. Jeff,
    You make excellent points. I’m enclosing an e-mail I have circulated to regulatory agencies and associations.
    —————————–

    MF Global’s collapse has serious ramifications.

    There are three fundamental issues to address:

    (i) Safeguarding of segregated customer accounts
    (ii) Tightening CFTC Rule 1.25 to ban certain transactions funded from segregated accounts; moving all gross risks on-balance sheet; and full disclosure of investment risks in FCM customer disclosure documentation
    (iii) The ethical approach would seem to be prompt and full return of cash/collateral to all Hedgers (e.g. Farmers/Producers) and Small Traders first, before creditors, remaining customers or the Trustee. For the purpose of disclosure neither I nor my firm suffered a direct financial loss. As such I will leave those directly affected to argue the merits of (iii)

    Background

    (i) Safeguarding of Segregated Customer Accounts

    – This is a founding principal of the Brokerage and Banking industry. Currently the SIPC does not insure Futures/Commodity accounts
    – If customer account segregation is at risk who will trust dealing with any brokerage, FCM, bank or custodian?
    – CFTC audits were clearly high level e.g. believing the net numbers they are shown instead of checking the funds are actually there and the numbers make sense. In that case how can we be sure that Global Custodians, who custody equities, bonds and cash are not repeating the same methods as outlined below? The major custodians all offer securities lending and financing programs. BNY Mellon faced numerous lawsuits earlier this year from Pension Funds accusing them of executing foreign exchange transactions at the worst prices of the day; Morgan Stanley was recently fined for excessive spreads. This is the not the same as mishandling segregated accounts, but once trust fades what is left?
    – What is needed is deeper audits, a cap on leverage, perhaps separation of brokerage from prop trading and prevention of dangerous practices across brokerages, custodians and banks. Future safeguards regarding FCM segregated accounts must be applied equally across all industry including banks and custodians., otherwise the financial system is at risk of collapse

    (ii) Tightening CFTC Rule 1.25 and Repo 105

    Accounting Laws: Repo 105
    – Repo 105 refers to giving at least $105 in collateral per $100 of cash borrowed
    – Repos involve the transfer of assets/collateral (e.g. sovereign debt) to another party, in return for cash, for a fixed period of time => secured financing; and reverse repos, the subsequent reversal: receiving back the assets/collateral and returning the cash plus interest for borrowed cash. During the transaction MF Global or Lehmans continue receiving coupon interest on the collateral, which is higher than interest charged to borrow the cash. They would also profit from any rise in asset value
    – US Accounting does not prevent these trades from being booked as ‘off-balance sheet’. Instead repos are booked as ‘’sales’’ implying assets are sold while the receipt of cash is not recorded on the balance sheet. First as coupons are received this is not a ‘’true sale”. Second, cash can be used to pay off other liabilities. Thus both assets and liabilities decrease, so the balance sheet shows reduced leverage. This ‘’technique’’ has been used since 2001 and is particularly in play before reporting periods/regulatory checks
    – Issues: if the collateral value falls (e.g. sovereign debt/default risk increases), counterparties require more margin/collateral which creates both solvency and liquidity risks
    – Post-Lehmans these trades/issues were investigated yet nothing changed!
    – I urge these transactions to be brought on balance sheet and with each leg shown gross so that all risks can be fully assessed

    CFTC: Rule 1.25 and related rules
    – This rule enables Futures Commission Merchants (FCMs), such as MF Global, to use segregated customer funds for ‘investment’ purposes; the FCMs have no obligation to disclose these investments, profits are not shared with their customers and in the event of serious shortfalls/investment losses – their final option is bankruptcy
    – Investments are meant to be restricted to liquid instruments, such as treasuries, which can be exchanged for cash quickly without any material change in value
    – Around 2004 the CFTC relaxed the rules to include repo/reverse repo investments and permitted internal repos. In 2010 the CFTC proposed tightening rules, including banning internal repos, preventing Foreign Sovereign Debt being used in repos and considered setting a 1% haircut; pressure from the Futures industry won the day and the post-Lehman proposals were watered down.
    – Heightened European Sovereign risk has been fact since May 2010 so it cannot be argued that the situation just arose. Not only were risky trades made, this was facilitated by using cash and assets from segregated customer funds. Even a loose interpretation of ‘investing in liquid instruments whose material value should not change’ cannot be made.
    – The regulators must have known the intent of 1.25 was not being met or should have known
    – I strongly urge the tightening up of this rule to ban using segregated customer accounts to fund risky investments; to force FCMs to provide full disclosure to customers with segregated assets and let the customer sign off on whether and in which instruments the FCM might invest using their funds; if the customer refuses the account will incur higher running costs but let customers make this choice

    Sara Statman
    President and Chief Investment Officer
    Statman Advisors

  7. I will not invest in the US futures market again, and I’m considering pulling my clients’ funds from all US regulated investments. Why would I trade in the US when I can trade in Singapore, for example, where I know there is an actual regulatory regime and enforcement in place?
    Everyone who voted in the “De-Regulate Everything” crowd (you know who you are), well your chickens have come home to roost.
    Banking and all of financial services NEED actual regulation, not toothless organizations asleep at the switch, defunded by paid-for politicians.
    Madoff? Bear? AIG? Refco? MF Global? Hello? Anyone home?

Trackbacks

  1. […] This article was written by Attain Capital, a US-registered CTA back in November of 2011 in the dire….  It only came to our attention via reading Attain’s more recently penned article about the Peregrine Financial debacle.  In the former, there was systematic and cultural failure to put clients first, in the latter it seems to be a case of blatant stealing.  Either way, if the National Futures Association (NFA) really is and wants to be what they state they are, (“NFA strives every day to safeguard market integrity, protect investors and help our Members meet their regulatory responsibilities. – per NFA website), then the NFA needs to seriously rethink a lot of their policies and procedures.  And the CFTC is the entity who can at least get the attention of the Senators and congressmen who can change the rules and change the funding for the CFTC.  The CFTC needs to start thinking like a consumer advocate which would benefit both the end clients of the Futures industry and would benefit the industry participants.  We think that the Attain Capital article has a lot of good starting points for the industry. This entry was posted in News. Bookmark the permalink. Comments are closed, but you can leave a trackback: Trackback URL. « More Media/Commentary Hide Content Skyline Above: New York City var _gaq = _gaq || []; _gaq.push(['_setAccount', 'UA-25940309-1']); _gaq.push(['_trackPageview']); (function() { var ga = document.createElement('script'); ga.type = 'text/javascript'; ga.async = true; ga.src = ('https:' == document.location.protocol ? 'https://ssl' : 'http://www') + '.google-analytics.com/ga.js'; var s = document.getElementsByTagName('script')[0]; s.parentNode.insertBefore(ga, s); })(); […]

  2. […] we originally penned our white paper, How to Save the Futures Industry, we had no idea that we would be staring down the same deficiencies less than a year later. Today […]

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