Q&A
Inside The Futures World
Want to find out how the futures markets really work? DeCarley Trading senior
analyst and broker Carley Garner responds to your questions about today’s
futures markets. To submit a question, post your question at https://Message-Boards.Traders.com.
Answers will be posted there, and selected questions will appear in a future
issue of S&C. Visit Garner at www.DeCarleyTrading.com.
Her books Currency Trading In The Forex And Futures
Markets; Commodity Options; and A Trader’s
First Book On Commodities, are available from FT
Press.
CUSTOMER-SEGREGATED FUNDS
What exactly are customer-segregated funds in relation to futures trading accounts?
Until the autumn of 2011, more specifically the collapse of MF Global, few outside of the futures industry were aware of the term “customer-segregated funds.” The failure of PFG to uphold the sanctity of customer-segregated funds in the summer of 2012 catapulted the phrase into daily usage in national media outlets, and maybe even the homes of many Americans.
Customer-segregated funds are exactly what the name implies; they are monetary deposits made by clients that are segregated from the assets of the brokerage firm. When a client opens a trading account with a futures commission merchant (FCM), which is a term for a brokerage firm registered with the Commodities Futures Trading Commission (CFTC), he is writing a check payable to the FCM for deposit in a bank account that holds client funds but not the brokerage firm’s funds. Or if funding by wire, funds are sent directly into an account under the name of the FCM titled “customer-segregated account.”
The CFTC requires brokerage firms (FCMs) to hold customer margin deposits in segregated accounts as a safeguard against a brokerage firm bankruptcy. In theory, if the FCM suffers financial trouble and files for bankruptcy, any client funds on deposit will be unaffected. In fact, in such a case it is common practice for the funds and open positions to simply be transferred to an alternative FCM, leaving the insolvent FCM to deal with its issues.
Simply put, the math isn’t quite as easy as we might think…The CFTC requires that FCMs report the status of their customer-segregated funds on a monthly basis. With the data collected, they publish a monthly report on the financial data of each FCM. Events leading up to, and subsequent to, the PFG debacle was a painful reminder that data portrayed on the report might not always be verified. As you may be aware, the top executive at PFG was reporting false customer-segregated funds figures to the CFTC and using falsified bank statements to fool regulators into assuming the reported data was accurate.
Within the report, clients, employees, and brokers can find information such as the total value of customer-segregated deposits, the amount the brokerage firm must have in the customer-segregated funds account to be compliant, and any excess or deficiency in the account.
You might be wondering why an FCM would have more in their customer-segregated funds account than their customers have on deposit, but the truth is cash inflows and outflows are constantly taking place as clients deposit and withdraw funds, buy and sell options and futures contracts, and pay brokerage fees.
Simply put, the math isn’t quite as easy as we might think — so instead of there being a black & white figure, there is quite a bit of gray. Nonetheless, the regulations in place that require brokerage firms to segregate customer funds from their own worked flawlessly to protect client funds for decades before MF Global and PFG pilfered customer-segregated funds accounts.
The failure of MF Global and PFG to avoid the comingling of firm and client money reminded us that rules are only as good as their followers — and enforcers. Both FCMs displayed a disregard to compliance stipulations intended to protect the customers who enabled their longstanding success as brokerage firms. Regrettably, industry regulators weren’t able to detect the violations until after it was too late.
As painful as back-to-back system failures were for clients, employees, and brokers of both MF Global and PFG, there might be some long-term good that comes of it. For instance, in the aftermath of these events, the NFA has been provided electronic access to the bank accounts of FCMs enabling verification of customer-segregated funds balances in real time and on a frequent basis. There has also been a proposed insurance fund discussed within the CFTC that would provide deposit insurance to commodity traders up to $250,000. This insurance fund would be similar to the banking system’s FDIC deposit insurance and eliminates the risk of unforeseen events such as a bank insolvency or a brokerage failure to comply with segregation rules.
The violation of customer-segregated funds regulations is rare, despite the recent hiccup in its track record. Even without new safety nets in place to avoid another calamity of this sort, it would likely not happen again anytime soon. Nevertheless, for those of us whose livelihood depends on a properly functioning marketplace in which we can be confident, positive changes in oversight are welcomed with open arms!