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.
Customer funds
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.
Segregated account
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.
Residual interest rule
The most contentious of the new rules is known as the “Residual Interest” rule (which isn’t really a new rule but a reinterpretation of an existing rule). Traditionally it has been industry practice to allow customers up to three days to meet a margin call. The CFTC has reinterpreted the rules to require that the FCM meet all customer margin calls from its own residual interest rather than from other customer’s funds. Most FCMs felt that this would present a capital and liquidity issue for themselves and an undue burden on customers who may be called on to pre-fund margins. The current rule remains in place until November. Beginning Nov. 14, 2014 the CFTC will allow a one-day grace period before requiring the FCM to reduce its residual interest to the extent that any customer account balance is under the required margin. In the absence of a rule change, the grace period will be eliminated in 2018 and the FCMs will have to reduce their residual interest as of the close of business on the day the margin deficit arose.
Risk disclosures
The CFTC has always required that prospective customers be given a generic “risk disclosure.” The new rules require the distribution of a risk disclosure that has been entirely revamped. The newly revised risk disclosures make it clear that the risks to a customer’s account go well beyond market risk. The purpose is to advise potential customers of the issues that came to the surface in the MF Global bankruptcy. The new risk disclosures include a warning that customer funds are not insured, not protected by the Securities Investors Protection Corporation (SIPC) or Exchange Guaranty funds, and that fellow customer risks still exist (see “revised risk disclosure,” below).
Beginning in July 2014, each FCM must also make available a firm specific risk disclosure document. The firm specific disclosure must include sufficient information about the FCM’s business, operations, risk profile, affiliates and any other information that would be material to a customer’s decision to entrust funds to that FCM. Also included in the firm specific disclosure document is information about the FCM, its principals, business activities and litigation. The FCM must include information about its capital, proprietary trading, concentration of customers and history of write offs.
Web postings
Beginning July 2014, each FCM must post detailed financial information on its web site (see “Web postings,” below). The idea being that a customer can make an intelligent choice among FCMs if given sufficient information. The web site postings include information on customer funds, firm capital and monthly financial statements. There will also be links to the FCM financial data posted on the CFTC and NFA websites.
Risk policy
FCMs have been required to file a Chief Compliance Officer report annually. That report is intended to highlight material deficiencies that have been detected by the FCM over the previous year. The new rules require that each FCM draft and adopt a written risk policy that covers the full spectrum of risks faced by an FCM. Typically FCMs were most concerned about trading risks, but the new rules require a consideration of legal, technological, currency, liquidity, capital and operational risks, to name just a few. FCM’s must submit their new risk policies to the CFTC and create “risk exposure reports” that are presented to the firm’s senior management and directors quarterly. The risk exposure reports must then be submitted to the CFTC. The goal is to obtain an early warning on issues before they develop into serious problems.
Notices
FCMs have always been required to notify the CFTC and their DSROs in the event that they encountered any capital or segregated account issues. The new rules require the filing of immediate notice when an FCM experiences any material adverse impact to its creditworthiness or its liquidity. An FCM must give notice within 24 hours whenever there is a material change in its operations or risk profile, including changes of personnel, lines of business or clearing arrangements. An FCM must also give notice if it becomes the subject of a formal investigation conducted by a regulator. The CFTC does not want to be taken by surprise in the event that another MF Global or PFG should occur.
Training
The customer protection rules require annual training of all finance, treasury, operations, regulatory, compliance, settlement, and other relevant officers and employees regarding the handling of customer funds, procedures for reporting suspected breaches of the policies and procedures and the consequences of failing to comply with the segregation requirements of the Act and regulations. The training requirement cuts across many departments and many disciplines so that every employee who might have knowledge of a possible issue will need to be educated on what, when and how to report an issue to the compliance department.
Conclusion
The protection of customers and the safeguarding of their funds is a fundamental component of the CFTC’s regulatory framework. Confidence in the entire financial system was shaken in the 2008 meltdown, and confidence in the futures industry was severely damaged by the MF Global and PFG disasters. Something had to be done to assuage customer concern. These new rules are undoubtedly detailed and well intentioned and may well serve to prevent another FCM failure. These rules, however, are extremely complex and will be very costly to implement. For some FCMs this may be a burden that they can’t or won’t be able to bear. The Residual Interest rule in particular will stress the capital and liquidity of the smaller FCMs that service farmers and retail customers. These customers may be better informed in selecting an FCM, but the result may be fewer FCMs for these customers to choose from.
Marc Nagel is a compliance consultant with 35 years experience in the futures industry. He is an attorney and CPA and serves as an advisor to Exchange Analytics, the leading provider of training to the futures and derivatives industry. He can be reached at mn@marcnagel.com or at www.marcnagel.com.