For over a hundred years the drum of the futures industry banged to the mantra that client funds had never been embezzled. In less than nine months that mantra has been blown apart with frauds of varying sizes in two large and well known FCMs. The fallout from the frauds will be long and expensive and client segregation will take centre stage. However, as Galen Stops found, there are numerous levels of segregation and many challenges to achieving it.
For the FCM business model to work, clients must have faith in their brokers, and the PFGBest scandal, occurring just nine months after MF Global, has rocked the base of that faith. End-users, FCMs and regulators alike all seem to agree that something must be done to mend a system that failed so dramatically twice in less than a year and help restore confidence in the industry. However, how to do this is the source of much debate.
Inevitably, the spotlight has fallen on the model of client segregated funds used by FCMs and the holy grail of individually segregated accounts right from the FCM to the clearing house. It is a tall order and one in which there is a clear cost/benefit limit.
Questions surrounding the current model of segregation of funds go back further than MF Global. The concept of client segregated funds came under scrutiny in the wake of the Lehman’s collapse, after which large pools of collateral was frozen by administrators.
Prior to that, customers thought, somewhat understandably, that having a segregated account meant that if the firm went down, it would be the firm’s money that was lost while they would quickly get their money back. This proved not to be the case.
While client funds remain segregated, the current FCM model has always allowed for a bit of movement between client’s and the firm’s funds, either for firms to post collateral for clients against their positions or through rehypothication where firms re-use client’s collateral to back other transactions or trades.
In this model the segregation of funds is neither absolute nor thorough, a flaw that has been exposed in recent years. As a result, regulators in both the US and the EU are taking steps to re-structure how FCMs segregate client funds, a move that could have considerable knock-on effects in the industry.
The LSOC model
In the US, the CFTC adopted a new segregation model for cleared swaps in February this year. Termed the “legal segregation with operational commingling”, or the LSOC, model, it allows FCMs and derivatives clearing organisations to operationally commingle funds but stipulates that they must maintain legally segregated customer accounts and that they cannot use a non-defaulting customer’s collateral to cover the losses occasioned by the default of another customer of the firm.
The logic behind this model is that it provides customers with the legal protection but doesn’t force FCMs to endure the additional costs associated with fully segregated individual accounts.
However, the LSOC model is limited in a number of respects. Firstly, it only applies to cleared swaps rather than futures customers, who have suffered the most from the MF Global and PFGBest frauds. Secondly, it doesn’t reduce investment risk, which is the risk that an FCM suffers losses on its legally allowed investment of customer collateral. And thirdly, the LSOC model doesn’t reduce operational risk where a shortfall in segregated funds occurs due to fraud or negligence on behalf of the FCM.
Speaking before the PFG fraud came to light, CFTC Commissioner Scott O’Malia pointed out the LSOC rule would not have protected the customers of MF Global, which were caused by operational failures.
Despite the flaws inherent in the LSOC model, having just one segregation model that is applicable to everyone makes things clearer and easier for both firms and clients, unlike the EU which looks set to have a range of different segregation models, leading to different processes and systems and therefore higher costs.
As well as introducing the LSOC model, the CFTC recently approved a number of new recommendations from the National Futures Association (NFA) that provide additional oversight of an FCM’s segregated accounts in an attempt to boost customer confidence.
Segregation ain’t cheap
European regulators are taking a different approach. The European Markets Infrastructure Regulation, which is due to come into effect next year, states that “a clearing member shall offer its clients at least the choice between omnibus client segregation and individual segregation and inform them of the cost and levels of protection”.
It also requires that if a client chooses to have an individually segregated account then “any margin posted in excess of the client’s requirement shall also be posted to the CCP and distinguished from the margins of other clients or clearing members and shall not be exposed to losses connected to positions recorded in another account”.
It sounds great on paper, but can the industry adopt the individual segregation model?
“A lot of comment in the industry at the moment suggests that’s where we’re headed,” says Hamish Purdey, chief executive of software-as-a-service front to back office provider FFastFill.
Individually segregated accounts, where a customer’s assets are ring fenced in their name, provide both transparency and protection. However, individual segregation is operationally very onerous given that it requires every piece of collateral provided by that customer to be tagged by the clearing member and placed in a separate account under that customer’s name. Increased complexity means increased costs and some industry participants are concerned about who will foot the bill.
“When it comes to segregating funds there will be a lot of nice phrases and ideas thrown out around improving risk management but ultimately it is the end-user who pays for it. And it always will be,” claims John McCann, director of Trinity Fund Administration.
Although it is still unclear how individual segregation will be priced, the expectation is that it will not come cheap.
The problem is that the models that are legally clean are operationally intense and the models that are operationally more attractive are legally more complicated, particularly across multiple bankruptcy jurisdictions as in the EU.
Rather than being just individually segregated accounts or omnibus accounts, firms in Europe are anticipating a tiered structure in which different levels of segregation are offered. The cost of each model could be operational, capital related or risk related and each model will trigger a different price structure.
FCMs to struggle
Essentially, firms will have to conduct a cost/benefit analysis of the varying tiers of segregation to work out which is the most economically viable for them. Anthony Belchambers, head of the Futures and Options Association, has voiced a number concerns about this model.
Belchambers argues that regulators and politicians have not thought through the implications of this increase in cost to the industry. He also says that there is a growing tension between public policies that target better risk management while simultaneously stifling growth and making risk management too expensive for some firms.
The risk is that smaller firms will be priced out of the market. McCann warns that the new regulation will have unintended consequences as small and mid-size firms disappear, reducing competition in the market place.
Belchambers adds: “Everyone knows that costs are going to go up in this environment, but they will go up so significantly as to put all these other post-crisis public policy objectives in jeopardy? I think that everyone needs to think very seriously about how much cost they can expect the industry and their customers to bear.”
FCMs are already struggling in the current low interest environment which has forced them to rely on commissions to drive profits. As one industry veteran recently put it: “They’ve got themselves in to trouble by lowering what was a very important element of the transaction, the fee, because they were making it all on the interest. And now the tide has gone out and there are a lot of people swimming naked.”
The cost of capital for an FCM means that an increasing number of them are under pressure and it is inevitable that they will have to re-price their operations to generate profits. The obvious difficulty is that in passing the costs on to the end-user, FCMs could lose clients.
Competition among FCMs is currently intense with participants pushing into new markets for growth. Unless circumstances change dramatically in the near-future, this competition combined with lower profits will lead to a wave of consolidation as smaller FCMs who built their business by reducing their commissions and relying on interest from collateral find their business model increasingly unsustainable.
Is segregation the answer?
Individual segregation isn’t a silver bullet to restore customer confidence and there are a number of technical challenges to achieving it. One area that needs to be addressed is the back-office technology that has historically functioned on a T+1 basis.
The industry has thrown fortunes at the front end to ensure that they have sub-microsecond access to markets but now the operational challenge turns to the middle and back office to ensure that customers can see their collateral positions in real-time.
Another issue that needs to be addressed is whether any of the pricing structures in Europe will lend themselves to substituted compliance with the US. In effect, what will European firms dealing in swaps with a US customer be expected to provide and will any of the pricing structures in Europe be equivalent enough to LSOC to fall under the category of substituted compliance? EU rules would allow firms to exercise the right to provide a less segregated model, but it remains unclear as to whether the CFTC would defer to this.
For all the concern about the cost of individual segregation, it is not something that every customer needs or wants or needs.
“It’s not necessarily more protection, it’s a specific protection against certain tail-risks and it just depends which of those tail risks are actually viable and a concern to the customer based on their activity,” explains a senior figure at a large FCM.
A fund with one-directional trades that incur large margin requirements at clearing is going to want to utilise the long assets in its portfolio and by doing that it’s going to want to make sure that those assets are as secure as possible.
As such, it may not want an omnibus account, where it could be mutualised in the case of a clearer default, or a LSOC account, where there is still some replacement risk and potential technical issues with the return of the inventory. So for them individual segregation may be a worthwhile expenditure.
In contrast a cash-rich hedge fund might not need that level of security and understanding the credit risk they might want to opt out of having their funds in a segregated account.
“I think that individual segregation will go some way to restoring customer confidence, but whether it’s the entire answer, I’m not so sure,” says Ffastfill’s Purdey.
Finding additional protection
To address the fallout of the violation of customer funds that occurred at MF Global and PFGBest, the CME Group sent out a letter to all of its customers detailing the new requirements from the CFTC. In the letter executive chairman and president, Terrence A. Duffy, and CEO, Phupinder Gill, said the current system in which customer funds are held at the firm level “must be re-evaluated”.
They went on to outline a model whereby clearing houses or other depositories hold all customer segregated funds while returning any interest earned on that money back to the FCMs. This, they said, would increase protections while preserving the operating model for the vast majority of firms who respect and comply with the rules.
This echoes the calls made by Philip McBride Johnson in an article for FOW in the wake of the MF Global scandal for the creation of an independent, single-purpose central repository to hold customer funds. Clearing houses are investing in facilities that would enable greater levels of segregation with Eurex Clearing planning to offer full individual segregation for client clearing when it goes live later this year.
Nicola Breateau, head of the Newedge Group, has also publically argued in favour of creating a new entity to ensure customer funds are safe. Breateau wants an independent authority that would require brokers to submit information about how much customer money they hold through daily submissions and how much customer money they have deposited in their accounts.
Although these remain possible solutions, there remain questions about how much appetite there is in the industry for yet more complexity in terms of oversight and regulation and such a change in the structure of the industry would take some time to implement.
Discussing possible protections that could be implemented in addition to the Emir regulation, Belchambers suggested the possibility of insuring the risk of having an omnibus account. Such an insurance policy would, in theory, cover the time lag in payout in the event of a default. This would allow firms the advantage of having a lower tier of segregation whilst maintaining a high level of protection in terms of expedited payout.
Belchambers says that it isn’t clear if such a policy would be economically effective but revealed that the FOA is talking to a number of insurance companies about the model.
Custodian banks could benefit
One probable beneficiary from the scandals at MF Global and PFGBest, and the subsequent demand for more transparency and protection around customer assets, are the custodian banks that have set up as FCMs, such as Wells Fargo amongst others. These firms could leverage their existing models of segregated accounts and apply it to their FCM business.
BNY Mellon, for example, has offered a segregated account service for non-cleared transactions for a number of years now. Using a tripartite structure the bank is able to put the margin posted by its clients into a segregated account that the bank has oversight of as the custodian.
If such a model could be applied to cleared transactions then the custodian banks could enjoy a significant shift of flow into their businesses from customers that have lost confidence in the traditional FCM model.
Mark Higgins, managing director of business development for EMEA at BNY Mellon, agrees that the firm’s segregation service is likely to see an influx of new clients in 2013 although he attributes this to the new regulation more than anything else.
“The requirement for segregated accounts and structures are likely to expand into new sectors where institutions that didn’t previously use collateral management services at all or previously just moved variation margin now have to post initial margin that requires segregation and legal ringfencing,” he explains.
FCMs have two issues that they need to deal with: the perception and the reality. The reality is that risk management is top of most firm’s agendas but that it is also expensive. The more risk adverse firms get the more costs they will incur and it is the nature of the beast that these costs will be passed down onto the end-users. As such, it seems inevitable that some fairly major re-structuring will be needed by the industry and the costs involved in this are likely to see some smaller FCMs consolidate or disappear.
But as the industry grapples with how this re-structuring will be done, the more pressing issue is one of perception. Derivatives volumes are down at nearly all of the major US and European exchanges and investor confidence is low. The last thing the industry needed was for more customer funds to go missing at a well-established FCM. The industry needs to convince customers that their money is safe and they need to do it quickly.
FCM Rosenthal Collins has started providing daily updates on investments of customer’s money, while Citibank has recently rolled out a new platform that allows its clients to see where their assets are at any given time (not their individual assets but rather the Citibank segregated client account).
These initiatives to increase transparency are a good start to assuaging customer fears, but FCMs need to start thinking about what the post-Emir and Dodd-Frank landscape holds for them and this must be a landscape in which the transparent protection and segregation of client funds is at the centre of their business. Those who offer that will have a great commercial advantage.