Tue, Sep 23, 2014
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Futures Intelligence

Guest Article: How to Save the Futures and Options Industry

Friday, December 02, 2011


Jeff Malec

Guest Article: How to Save the Futures and Options Industry
By Jeff Malec, Attain Capital

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.       

Risk Disclosure:

MANAGED FUTURES IS NOT APPROPRIATE FOR ALL INVESTORS.  IT CAN INVOLVE VOLATILITY AND RISK OF LOSS.

While this article is written with balance and accuracy in mind, the content is designed for sophisticated qualified eligible persons.  It is not appropriate for all individuals. 
Qualified eligible person as defined under the (CFTC) Regulation 4.7., because they are: Registered investment company; Bank; Insurance company; Employee benefit plan with >$5,000,000; Private business development company Organization described in Sec. 501(c)(3) of the Internal Revenue Code with >$5,000,000 in assets; Corporation, trust, partnership with >$5,000,000 not formed to invest in exempt pool; Person with net worth >$1,000,000; Person with net income >$200,000 each of last 2 yrs. or >$300,000 when combined with spouse; Pool, trust separate account, collective trust with >$5,000,000 in assets;  User also confirms they meet the following Portfolio Requirement: Own securities with a market value >$2,000,000; Have had on deposit at FCM, in last 6 months, >$200,000 in margin and option premiums; Have combination of securities and FCM deposits. The percentages of required amounts must = 100%.

Opinions:

User represents themself to be a sophisticated investor who understands volatility, risk and reward potential.  User recognizes information presented is not a recommendation to invest, but rather a generic opinion, which may not have considered all risk factors.

User recognizes this web site and related communication substantially represent the opinions of the author and are not reflective of the opinions of any exchange, regulatory body, trading firm or brokerage firm. The opinions of the author may not be appropriate for all investors and there is no warrantee relative to the accuracy or completeness of same.  The author may have conflicts of interest, a disclosure of which is available upon request.

RISK DISCLOSURE

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. YOU COULD LOOSE ALL OF YOUR INVESTMENT OR MORE THAN YOU INITIALLY INVEST. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS.

THE DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF THE PRINCIPAL RISK FACTORS AND EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE COMMODITY TRADING ADVISOR ("CTA"). THE REGULATIONS OF THE COMMODITY FUTURES TRADING COMMISSION ("CFTC") REQUIRE THAT PROSPECTIVE CUSTOMERS OF A CTA RECEIVE A DISCLOSURE DOCUMENT WHEN THEY ARE SOLICITED TO ENTER INTO AN AGREEMENT WHEREBY THE CTA WILL DIRECT OR GUIDE THE CLIENT'S COMMODITY INTEREST TRADING AND THAT CERTAIN RISK FACTORS BE HIGHLIGHTED. THIS DOCUMENT IS READILY ACCESSIBLE AT THIS SITE. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL OF THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. THEREFORE, YOU SHOULD PROCEED DIRECTLY TO THE DISCLOSURE DOCUMENT AND STUDY IT CAREFULLY TO DETERMINE WHETHER SUCH TRADING IS APPROPRIATE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION.

YOU ARE ENCOURAGED TO ACCESS THE DISCLOSURE DOCUMENT. YOU WILL NOT INCUR ANY ADDITIONAL CHARGES BY ACCESSING THE DISCLOSURE DOCUMENT. YOU MAY ALSO REQUEST DELIVERY OF A HARD COPY OF THE DISCLOSURE DOCUMENT, WHICH WILL ALSO BE PROVIDED TO YOU AT NO ADDITIONAL COST.

MUCH OF THE DATA CONTAINED IN THIS REPORT IS TAKEN FROM SOURCES WHICH COULD DEPEND ON THE CTA TO SELF REPORT THEIR INFORMATION AND OR PERFORMANCE. AS SUCH, WHILE THE INFORMATION IN THIS REPORT AND REGARDING ALL CTA COMMUNICATION IS BELIEVED TO BE RELIABLE AND ACCURATE, PUBLISHER CAN MAKE NO GUARANTEE RELATIVE TO SAME. THE AUTHOR IS A REGISTERED ASSOCIATED PERSON WITH THE NATIONAL FUTURES ASSOCIATION.

No part of this publication or website may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher.



 
This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing


  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. SEC charges 19 investment firms and one trader for breach of Rule 105[more]

    Benedicte Gravrand, Opalesque Geneva: The Securities and Exchange Commission (SEC) started a push to enhance the enforcement of Rule 105 of Regulation M last year to uncover hedge funds and private equity firms that have illegally participated in an offering of a stock after short selling it duri

  2. Fund managers, bullish on Europe, anticipate monetary policy separation of Fed and ECB[more]

    Komfie Manalo, Opalesque Asia: At least 202 fund managers with $556bn of assets under management said that while the European Central Bank (ECB) has eased its monetary policy that sent sentiments towards Europe to pick up, the Fed is expected to hike its rate in the spring of 2015. Investor

  3. Institutions - North Carolina workers call on state pension to dump up to $6bn in hedge funds, UK pension fund criticizes hedge fund fees[more]

    North Carolina workers call on state pension to dump up to $6bn in hedge funds From Forbes.com: The State Employees Association of North Carolina this afternoon called on state Treasurer Janet Cowell to withdraw all investments in hedge funds, which appear to amount to approximately $6 b

  4. News Briefs - Limited partners of investment managers may be subject to self-employment taxes, Just one week left until NYC's Rocktoberfest[more]

    Limited partners of investment managers may be subject to self-employment taxes On September 5, 2014, the Internal Revenue Service (“IRS”) issued Chief Counsel Advice 201436049, concluding that members of an investment manager were subject to self-employment taxes with respect to their e

  5. Institutions - Adviser's faith in hedge funds unshaken by CalPERS' move Advisers weigh in on CalPERS’ decision, Gina Raimondo sees no reason to follow California’s lead, exit hedge funds, Danish pension funds step up 'alternative investments'[more]

    Adviser's faith in hedge funds unshaken by CalPERS' move From WSJ.com: Financial advisers who use hedge funds in their clients' portfolios say they aren't rethinking that approach after a huge California pension fund announced plans to exit the hedge-fund market. The decision by the Cali