Seg Funds Revisited: Industry Response to Peregrine and MF Global Collapses

By Joanne Morrison

The collapse of

Peregrine Financial Group

in July, coming on

the heels of MF Global’s

collapse last October,

has galvanized an

industry-wide

self-examination.

20 Futures Industry | www.futuresindustry.com n both cases, the bankruptcy process re- ture Committee on Aug. 1. worked as a county attorney before coming vealed a significant shortfall in customer FIA members are now working with to the Senate. I money, something that had never hap- other segments of the industry on a series CFTC Chairman Gary Gensler testified pened before in the history of the U.S. futures of additional recommendations that will be before both committees and outlined the industry. The two incidents struck a major presented to the Commodity Futures Trad- steps being taken to improve the monitor- blow to confidence in the ability of the in- ing Commission. One important goal is to ing of futures commission merchants and dustry to properly handle customer funds and provide greater transparency into the finan- customer funds held in segregated accounts. raised serious concerns about the effectiveness cial health of futures commission merchants The CFTC chairman explained that the self- of the industry’s self-regulatory system. through the disclosure of key metrics such regulatory organizations are the “front-line” So far, lawmakers in Washington have as capital and leverage. Another important regulators in charge of examining firms and not attempted to legislate a solution. In- recommendation is to build a system that reviewing independent audits while the stead, the initiative for change has come will provide “independent verification” so CFTC’s job is to oversee the examination from within the industry, with a wide range that customers can be confident that the process. Gensler agreed on the importance of ideas being talked about as possible so- money in segregated customer accounts is of getting new protections in place and esti- lutions. These include electronic verifica- actually there. mated that they could be implemented over tion of customer balances, stronger internal While it will take some time to imple- the next few months. “The system clearly controls, the creation of an insurance fund, ment these recommendations, no changes to failed to protect Peregrine’s customers, and I the use of third-party custody accounts, and the laws will be needed. Other proposals will believe we all must do better,” Gensler said. providing customers with more visibility require legislation, however. These include Some lawmakers asked whether the into the handling of customer funds. changes to the bankruptcy code and the cre- CFTC is focusing too much of its attention Although both collapses revealed weak- ation of an insurance fund. Although some and resources on implementing Dodd-Frank nesses in the segregation of customer funds, believe that legislative action could take place regulations. Gensler agreed that his agency is there are important differences in the types before the end of the current session at year- stretched as it moves forward with the large of weaknesses they revealed. At Peregrine, it end, others say that any legislative proposals number of rulemakings mandated by the was a case of misappropriation of funds that are more likely to be taken up next year, after Dodd-Frank Act, but he reassured members went undetected by auditors and regulators the elections have taken place. that the CFTC is also giving serious atten- for years. Russell Wasendorf Sr., the firm’s tion to the customer protection regime. founder, asserted in a note found after his Regulators Under This comment was countered, however, attempted suicide that he had been engaged Fire on Capitol Hill by Jill Sommers, the Republican commis- in an elaborate fraud for nearly 20 years, The House and Senate agriculture com- sioner at the CFTC in charge of the MF misleading auditors by forging bank state- mittees both recently held hearings to ex- Global investigation, who said the agency ments and other documents. amine the two failures. At both hearings, could be moving faster. “I do believe that we At MF Global, it was only when the lawmakers questioned how these failures identified many of the enhancements that company was desperately seeking a sale to could have taken place under the watch of we could have made to the futures industry another futures commission merchant that regulators. In the case of MF Global, the six months ago. So the changes that are be- the shortfall in customer funds was discov- primary self-regulatory organization was fore us now are changes that we could have ered. Regulators and bankruptcy liquida- CME Group; in the case of Peregrine, it implemented months ago,” she told the tors are still working to pinpoint exactly was the National Futures Association. In Senate Agriculture Committee on Aug. 1. what led to the shortfall, but according to both cases, the Commodity Futures Trading the bankruptcy trustee, the shortfall was Commission was responsible for ensuring FIA Recommendations driven by a “perfect storm” of weak internal that the self-regulatory organizations were Many of the safeguards that are now be- controls, inadequate systems, disorganized doing their jobs properly. ing adopted by firms and SROs are in line record-keeping, and a desperate need for “The question remains, who’s minding with the initial recommendations released additional funds to meet margin calls on the store? There are some in this town who in February by the FIA’s Futures Markets the firm’s proprietary trades. would argue that we need more regulations, Financial Integrity Task Force. The Futures Industry Association has but the fact remains that new regulations These recommendations called on FCMs been at the forefront of industry responses. mean nothing when regulators are not en- to adopt and document internal control In February, it unveiled a number of specific forcing the existing rules on the books,” said policies and procedures relating to the pro- recommendations for tougher internal con- Representative Frank Lucas (R-Okla.), the tection of customer funds and maintain a trols at firms and increased transparency for chairman of the House Agriculture Com- clear separation of duties among individuals customer and regulators. Many of these safe- mittee, at a July 25 hearing. responsible for compliance with customer guards already have been adopted by the in- Democrats expressed similar views, ex- funds segregation. The recommendations dustry and enforced by new rules, but more pressing bafflement that the CFTC and the also called for enhanced recordkeeping must be done in the wake of the Peregrine NFA missed the fraudulent activity at Per- and reporting, including transmitting daily debacle, according to Walt Lukken, the FIA’s egrine for two decades even though there customer segregation balances. The recom- president and chief executive officer. was a series of red flags at the firm. “You can mendations also require chief financial of- “We have two instances in less than a have all the books with all the laws in them, ficers or other senior officers to authorize in year when segregation was breached and but if you don’t enforce them, sometimes it writing and promptly notify the designated customer funds are missing. That is unac- is worse than not having them at all,” said SRO whenever an FCM seeks to withdraw ceptable,” Lukken told the Senate Agricul- Senator Amy Klobuchar (D-Minn), who more than 25% of its excess funds from the

Futures Industry | September 2012 21 Seg Funds Revisited 28-30 November 2012 Mark Holloway of Goldman Sachs and Alessandro Cocco of JP Morgan participate in a Roundtable Discussion at the CFTC St. Regis Singapore www.futuresindustry.org/asia

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Platinum Sponsors customer segregated accounts in any day. condition of their FCM. Fourth, FIA calls said in a statement. The FIA also released a “frequently asked on FCMs to publicly certify that they are Also in July, the CFTC approved a set questions” document prepared by members in compliance with the initial recommenda- of requirements drafted by the SROs that of the association’s Law and Compliance tions that the FIA issued in February. will tighten internal controls and provide Division. The document was designed to be “Many individual firms have already be- better and more frequent information on Sponsors used by FCMs to help their customers bet- gun to make efforts to implement changes the handling of customer funds. These new ter understand the provisions of the Com- and disclose more information in response safeguards include requiring FCMs to file modity Exchange Act and the rules of the to this crisis of confidence, but this effort daily segregation and secured reports and Commodity Futures Trading Commission must be industry-wide and FIA is commit- bi-monthly reports detailing how customer that relate to customer protections. It con- ted to leading that effort,” Lukken said dur- funds are invested and where they are held, tains 30 questions and answers addressing ing the Chicago speech. performing more frequent spot checks to the basics of segregation, collateral manage- Meanwhile the industry’s SROs are mov- monitor FCM compliance, and requir- ment and investments, capital requirements ing in parallel to implement a broad range ing a principal of an FCM to approve any and other issues. of new rules and requirements. On July disbursement that exceeds 25% of “excess The next step came in July, when FIA’s 17, the SROs unanimously agreed to im- funds,” meaning the firm’s own money in Partners Lukken announced a four-part transparency mediately begin the process of confirming customer accounts. initiative during a speech to members of the the balances of customer segregated bank FIA Chicago division. Lukken said the plan accounts for all FCMs using a web-based Electronic Access to calls for providing regulators with the abil- electronic confirmation process. Addition- Segregated Accounts ity to electronically review and confirm cus- ally, the SRO committee said it would set There is broad agreement among indus- tomer segregated balances at any FCM at rules requiring that all FCMs provide their try representatives that regulators and SROs any time. Second, FIA supports creating an DSRO with direct online access to the bank should have direct electronic access to view automated confirmation process for segre- accounts that hold the FCM’s customer seg- customer segregated funds accounts. Imple- Exhibitors gated funds that will provide regulators with regated and secured funds. menting this idea may be more complicated timely information that customer funds “Any bank depository that fails to pro- than people realize, however. Cinnober • CME Group • CQG, Inc. • Equinix • Eurex • Horizon Software • IntercontinentalExchange are secure. Third, FIA is exploring ways to vide electronic online access will not be con- At a July 26 meeting of the CFTC’s Korea Exchange • Korea Investment & Securities Co., Ltd. • LCH. Clearnet • Newedge Group • Omgeo Pte Ltd • Orc Software create an “information portal” to centrally sidered an acceptable depository for holding Technology Advisory Committee, panel- Phillip Futures Pte Ltd • RTS Realtime Systems • Singapore Exchange • Singapore Mercantile Exchange house information about FCMs so that customer segregated and secured funds, un- ists cautioned that there are technical chal- Thailand Futures Exchange • Tokyo Commodity Exchange (TOCOM) • Tokyo Financial Exchange Inc. customers can better evaluate the financial der the added recommendations,” the NFA lenges in accessing information from certain Tokyo Stock Exchange, Inc. • Trading Technologies International, Inc. • Turkish Derivatives Exchange • ULLINK

22 Futures Industry | www.futuresindustry.com as of August 8, 2012 28-30 November 2012 St. Regis Singapore www.futuresindustry.org/asia

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Sponsors

Partners

Exhibitors Cinnober • CME Group • CQG, Inc. • Equinix • Eurex • Horizon Software • IntercontinentalExchange Korea Exchange • Korea Investment & Securities Co., Ltd. • LCH. Clearnet • Newedge Group • Omgeo Pte Ltd • Orc Software Phillip Futures Pte Ltd • RTS Realtime Systems • Singapore Exchange • Singapore Mercantile Exchange Thailand Futures Exchange • Tokyo Commodity Exchange (TOCOM) • Tokyo Financial Exchange Inc. Tokyo Stock Exchange, Inc. • Trading Technologies International, Inc. • Turkish Derivatives Exchange • ULLINK

as of August 8, 2012 Seg Funds Revisited accounts. Accounts at banks and clearing- holding, the custodial locations where the handle their money. We also will continue houses will be the easiest to access, but there collateral is being held, and a breakdown of to find new ways to provide transparency are challenges in obtaining information how the collateral is being invested. Perkins and contribute to industry solutions.” from custodial accounts, they said. There said that the bank is working on the next are even more challenges with 30.7 secured phase of the project, which will focus on Calls for Insurance accounts holding funds for foreign futures independently validating the balances held While much of the attention has focused and options because they would have to be at clearinghouses as well as more frequent on strengthening existing protections, some verified through foreign affiliates. As a re- updates to the information. He declined to have called for more fundamental reforms, sult, it may take more time to build a tech- go into detail but commented that the bank such as creating an insurance fund that nology solution that will cover these foreign views this effort to provide transparency as a would protect futures customers in case their secured accounts. key feature of Citi’s clearing services. FCM fails. One model is the fund managed Gerry Corcoran, chairman and chief “It’s critically important to have mini- by the Securities Investor Protection Cor- executive officer of R.J. O’Brien & Associ- mum regulatory standards for transparency poration, which guarantees customer se- ates, provided participants with a detailed into the handling of customer funds, but curities investments up to $500,000 in the look at an RJO customer segregated funds we hope the regulators allow ample room event a brokerage firm collapses. statement to illustrate those areas that will James Giddens, the trustee handling the be easier to provide verification of funds as MF Global bankruptcy, has been a strong well as those areas that will take more time proponent of establishing an insurance to implement. Corcoran said that RJO has fund. At the Aug. 1 Senate hearing, he ex- up to 70 different accounts with banks, car- plained that the vast majority of MF Glob- rying brokers and exchanges in the U.S. al’s customers held relatively small accounts and abroad, and he estimated that industry- At a time when and could have been made whole if an in- wide verification would require access to surance fund had been in place. He also more than 1,000 accounts. people are nervous told lawmakers that the process of transfer- Chris Hehmeyer, chairman of the board ring customer accounts out of a failed FCM of the National Futures Association, ex- about too-big- would be much smoother if there were such plained that the NFA plans to build a sys- a fund, since it would eliminate the need to tem that will verify account information to-fail, putting in hold back some funds to cover a shortfall. by the next trading day, commonly known “It’s a cumbersome process even to as T+1. While this will not capture every place government collect funds that demonstrably belong movement of funds in real-time, it should to customers,” Giddens said. “Nothing serve as a sufficient deterrent to fraudsters, guarantees is works quite as it is described when you’re industry representatives told the CFTC. in a bankruptcy.” “It will never be 100% bulletproof, but the something we have Some end-users have supported the in- knowledge that you will be caught at the surance idea. For example, the National end-of-the-day true-up will be a deterrent,” to consider. Grain and Feed Association, a trade group said Chuck Vice, president and chief oper- that represents agricultural interests, has ating officer of IntercontinentalExchange. Walt Lukken, FIA proposed making insurance available on an optional basis for any market participant Individual Firms Take Action for FCMs to differentiate themselves and willing to pay for it. Diana Klemme, an ag- Even as the industry-wide initiatives ultimately compete on transparency,” said ricultural hedging expert who testified on are moving forward, individual firms are Perkins. “There’s a commercial incentive to behalf of the NGFA, told the Senate com- rolling out their own responses to the con- be more transparent than the next guy.” mittee that her clients would be willing to cerns raised by the collapses of MF Global Rosenthal Collins Group is another ex- pay for insurance through a transaction fee. and Peregrine. ample. On July 17, the FCM began posting “My customers would pay for it right now,” One example is Citi. The bank, which op- on its website daily reports describing its in- she told the Senate Agriculture Committee. erates one of the largest FCMs in the world, vestment of customer segregated funds. The details have not been fleshed out, launched a “transparency portal” in July that “RCG is determined to go above and however. Some have suggested that the best gives customers online access to details about beyond what is required of us to provide way forward would be to extend SIPC cov- how their futures and swaps collateral is in- our customers with reassurance that we erage to include futures. Others have called vested and where their funds are being held. are investing their funds wisely,” said Scott for the formation of a separate fund just for The transparency portal is within the bank’s Gordon, the firm’s chief executive officer. futures. Another key issue is funding; there Velocity platform, which provides a single “Unquestionably, the events of the last 10 is no consensus yet on who should pay and point of access to Citi’s research, analytics, months have undermined the confidence how much. execution and post-trade services. of market participants in an industry which Bart Chilton, a Democratic commis- Christopher Perkins, global head of serves a vital role in the global economy. sioner at the CFTC who strongly sup- OTC clearing at Citi, explained that clients While we can’t singlehandedly restore that ports the insurance idea, issued a proposal can now view the total amount of futures confidence, we can do our part to ensure on Aug. 9 with some concrete details. His and cleared OTC collateral that Citi is that customers feel confident in how we proposal calls on Congress to create a SIPC-

24 Futures Industry | www.futuresindustry.com like insurance fund called the Futures Inves- that no customer has ever lost a penny as willing to pay the necessary costs, and has tor and Customer Protection Corporation the result of a clearing member default.” suggested launching a “pilot program” to with up to $2.5 billion in assets. The fund- Whatever the approach, the cost of fund- test the idea. ing would come from a fee paid by FCMs ing such a scheme will be a critical issue. The Another proposal under discussion equivalent to 0.5% of annual gross revenues cost will depend on many issues, including is tri-party custody. In this model, cus- from their futures business. Coverage of loss the structure of the fund, the cost of ad- tomer funds would be held by a custodial would be limited to $250,000 in futures ministration, and the amount of coverage. bank rather than the FCM, and the FCM liquidation value and cash. Equally important is the source of funding; would have access to these funds only for “By drawing on an existing blueprint, the options include transaction fees, mem- the purpose of meeting margin obligations. the creation of FICPC would be a relatively ber firm assessments, and private insurance. Proponents of this model say that it would simple task for legislators and FICPC ad- Terry Duffy, executive chairman and provide greater protection from fraud or ministrators,” Chilton said. “This would help president of CME Group, warned that the misuse by the FCM, but customers are less remedy the present crisis of confidence in the SIPC model, which depends on funding sure. At the CFTC staff roundtable on Aug. futures markets in the wake of the fall of Per- from securities dealers, would not work as 9, several customer representatives pointed egrine Financial Group and MF Global.” well in the futures market. “We do not have out that in the event of a shortfall in the The agency’s chairman is more cautious, a payment-for-order-flow model in the fu- customer funds, customers who opted for however. While not rejecting the insurance tures industry. We have a central limit, tri-party custody would still be subject to a idea, Gensler has stressed initiatives that can open, transparent book for all to see. And pro-rata distribution of any losses. The only be put into effect without requiring changes I think that’s a completely big, huge dif- way to fully protect against loss would be to to the law. “I think we need to focus in on ference when you talk about who’s going make the use of tri-party custody accounts our rules and ensure … the self-regulatory to fund these type of insurance programs,” mandatory across all customers, they said. function works better,” he told the Senate Duffy said. Agriculture Committee on Aug. 1. FIA’s Lukken suggested that the next step Stay Focused on the Basics Gensler also is wary of the potential should be an in-depth analysis of the prac- At an Aug. 9 roundtable discussion held costs, saying that the costs and benefits tical aspects of establishing an insurance by CFTC staff, customer representatives of establishing an insurance fund would fund. “There are serious costs that may go urged the industry to stay focused on the have to be weighed before the idea could with these insurance programs that we have basics—ensuring that customer money is be implemented. to consider. Coverage, actuarial soundness exactly where it is supposed to be. That re- An alternative approach would be to and also potentially, a lot of these insurance quires not only new rules and regulations create an industry-funded “liquidity facil- programs have a government guarantee be- but also a higher standard for checking to ity” that would focus on covering shortfalls hind them,” he told the Senate committee. make sure that those rules and regulations in customer property and ensuring that “At a time when people are nervous about are actually followed. customer accounts are transferred quickly too-big-to-fail, putting in place government “While it’s very important to focus on to other brokers. This proposal has been guarantees is something we have to seri- the process and that the rules being im- put forward by the Commodity Customer ously consider.” posed by the regulatory bodies (as well as Coalition, a group formed after the col- the self-denominated rules by each entity) lapse of MF Global to represent custom- Alternatives to Segregation are being followed, I think given what we’ve ers of the failed FCM. The facility in effect Instead of establishing an insurance seen as well as the expectation by end-users, would “step into the shoes” of the failed fund, CME has raised the possibility of is that the standard of care has to be confirm’s customers, enter the bankruptcy having customer funds held at the clear- siderably higher in terms of ensuring that proceedings in their place, and pursue inghouse rather than the FCM. Recogniz- the money is where it’s supposed to be,” said their claims for recovery of missing funds. ing that this would remove a key source of William De Leon, global head of portfolio In this way the facility would recover revenues for FCMs, CME has emphasized risk management at PIMCO. whatever funds were used to support the that it will protect the FCM business model While there are many questions that customer account transfer process. by collecting the interest on the customer still remain about potential new safe- In testimony before the Senate Agricul- funds and passing that to the FCMs. CME guards, industry representatives and regu- ture Committee on Aug. 1, John Roe, an has not yet disclosed how this model will lators have vowed to continue working to introducing broker and co-founder of the work, however. help restore confidence. CCC, explained that there is a Canadian Another option under discussion is “full “There is no easy solution—no magic model for this idea. When MF Global col- segregation,” meaning that each customer’s bullet—that will bring back the trust lost in lapsed, the Canadian Investor Protection positions and collateral would be held in a these past weeks. Instead, it’s going to take Fund provided a 20% guarantee on the cus- separate account, rather than pooled with a lot of hard work across the whole industry tomer property at the firm’s Canadian sub- other customers. The CFTC considered this to implement a host of improvements as to sidiary. That covered a 20% shortfall in the idea when it designed the account structure how FCMs conduct their business and how customer accounts and cleared the way for for cleared swaps, and rejected it in favor of their conduct is examined and audited by the transfer of more than 7,000 accounts of the “legally separated operationally com- the regulators,” said Lukken. MF Global Canada to new brokers. As a re- mingled” model. Nevertheless, the NGFA ...... sult, he told the committee, “Canada’s com- has proposed allowing full segregation as a Joanne Morrison is the deputy editor of modity customers can still make the claim voluntary option, available to any customer Futures Industry.

Futures Industry | September 2012 25