Nuts and Bolts of Account Segregation and Investor Protections
As recent events have cast a negative shadow on the protections of customer segregated funds, certain FCMs are quietly noting how their individual operations work to protect investors. The notion that that funds can "vaporize" or "disappear" regardless of the reported "chaotic" environment has been widely dismissed inside the futures industry. In other words, MF Global funds likely didn't vaporize, but it remains to be seen if required records regarding approval of the transfer of those funds "vaporized."
While noting how a taboo might have been broken by touching the sanctity of segregated funds, one Futures Commission Merchant (FCM) general counsel reflected a concern. "How do you do give clients comfort?" she asks. "The system works and 99.9% of all FCMs do it right. It's a question about making people feel comfortable with something that no one ever thought would happen. It's like someone broke a Taboo. The rules for segregated accounts are solid. Account segregation rules are defined solidly like a road, not to be taken variably like a speed limit for a road."
To understand a general sense of bewilderment in the futures industry is to understand the rules that govern segregated funds. This is because great lengths are taken to clearly denote the special nature of a segregated account.
Clear Guidelines Make Account Title Known to All Participants
Under CFTC guidelines, the FCM must place customer segregated funds in secured depository accounts (such as a bank account) that clearly identify customer fund type, clearly distinguishing between the FCM's own funds.
When trading on a US exchange, funds are placed in what is known as a "4 D segregated account," titled after section 4d(a)(2) of the Commodity Exchange Act under the CFTC, rule 1.20. When trading on a foreign exchange funds are placed in a "30.7 secured amount account," titled after Commission Rule 30.7.
To understand at a macro level, the account titles are not as important as focusing on lengths taken to denote this account is to be given special treatment. The Futures Industry Association (FIA) recently released an FAQ discussing the protection of customer segregated funds, upon which much of this article is based.
In order to initially open this "4 D" or "30.7" account, an FCM establishes a relationship with an authorized depositary such as a bank, and that bank hold customer funds, the FCM is required to obtain an acknowledgement letter from the bank clearly stating that the account in question is specifically designated to hold customer segregated funds. This serves the purpose of highlighting to all involved the legal significance and sanctity of this account, in particular noting the account cannot be co-mingled with the FCM's own funds. Acknowledgement letters are required to be signed and documented, with original files safeguarded at the FCM. But the clear differentiation of account type doesn't end at this legal level.
The very accounts titles are required to have the title acknowledging the special customer segregation designation of the account. Specific title lines must reflect that the account is either a 1.20 rule (4 D) segregated account or a 30.7 foreign secured amount account. This documenting of account type and denoting of the customer segregation funds protection is also written into a legally binding acknowledgement letter between the bank and the FCM.
"Most I know in this industry were doing their job right," noted an FCM legal executive. "I don't understand how (the MF Global situation) could have happened, I'm going to reserve judgment until all the facts are out," said the executive, which might require assuming the facts in the case will be made transparent.
Daily Reporting of Customer Segregation Balances
Commission Rule 1.32 specifies that the FCM is required to prepare a daily segregation report to their regulator. MF Global was regulated by the CMEGroup. When an FCM is regulated by the National Futures Association, the independent regulatory organization, reporting takes place through their online Windjammer system. Thus, it is the author's speculation if the reporting was accurate, a shortfall in segregated funds would be known at the end of each day. (As a sidebar, the CFTC posts the monthly net reported capital requirements of FCMs on their web site.)
Note that the filing of this daily segregation report would reflect inconsistencies in segregated account balances. Thus, if balances were moved from designated customer segregated accounts to non-customer accounts it might have been reflected in the daily reporting. Given this strict daily reporting requirement, it is the author's individual wonderment as to how funds in the MF Global situation without being noticed in this daily reporting requirement? In Congressional testimony regarding MF Global, CMEGroup chairman Terry Duffy clearly identified the falsification of documents being supplied by MF Global to regulators. It is the author's speculation the documents falsified were related to the customer segregation report and the result of a handful of large wire transfers during the week preceding the bankruptcy.
The daily reporting of customer segregation balances is particularly interesting given the apparent three day delay in reporting a $165 million transfer out of segregated funds that occurred between MF Global and JP Morgan as much as 1 week prior to the bankruptcy. The question is: Was this reporting reflected in the daily report? Who initiated the transfer order? When was order confirmation received by top executives? Further, the apparent 1 second approval of the transfer appears highly unusual. Considering past transfers of assets in excess of $100 million, the question might be how common would it be for a 1 second approval process to take place moving millions from customer segregated accounts? At the time of the transfer, who was in the room, who was on the phone and who approved this transfer?
Rehypothecation of Assets
In certain cases, FCMs are allowed the ability to hypothecate and re-hypothecate customer segregated funds for the FCM's investment purposes. This process, also known as "collateral transformation," essentially increases leverage based on the pledged asset. In the US, restrictions under what is known as "Regulation T" require approval to hypothecate assets and leverage usage is limited. In other regulatory jurisdictions, such as London, no "Reg T" restrictions exist and thus leverage can be significantly increased. This is particularly the case when interest rates are low or near zero, as the ability to "lever up" and generate leverage multiples increases without appreciable interest cost.
In the case of MF Global, asset re-hypothecation to London is currently legal - something regulators have yet to address - and allows for significant additional leveraging. According to the FIA customer protections FAQ, such increasing of leverage through rehypothecation requires approval.
"If a customer deposits securities that are permitted to be deposited with a DCO, the FCM nonetheless must be authorized to hypothecate and rehypothecate securities in order to transfer customer securities to a DCO to meet customer margin requirements and to enter into repurchase and reverse repurchase transactions with permitted third-parties. Because customer funds are held in an omnibus account, an FCM must have the authority to hypothecate and re-hypothecate the funds and collateral
Where is this approval? Such asset rehypothecation in European sovereign debt might be considered in some quarters as a "non-traditional" FCM investment method, a concept potentially utilized among FCMs with banking interests. Thus, logic might lead one to believe the trade structure in what is known as "Mr. Corzine's sovereign debt trade" may have been developed and approved by Mr. Corzine and his top echelon. Where is the paper trail establishing this trade, its counterparties and the movement of assets?
Some inside the industry are dismayed at seeing account protections whittle away, their reputation being soiled. But for now they focus on the investigation. "This is so unusual, I'm not sure I can I'm not sure I can get my head around it until the investigation is done," said the General Counsel of one FCM.