The way a futures commission merchant manages its capital is a critical factor in determining the profitability of the firm. The futures business is capital intensive with money tied up at exchanges and clearinghouses, global operations requiring significant IT resources, and limited use of customer funds on deposit. James Davison, president and Shaun O’Brien, chief financial officer of Cargill Investor Services, Inc., discuss the role and concerns of the CFO in running a global futures operation with Futures Industry editor-in-chief, Mary Ann Burns.

Burns: What is the scope of the CFO’s responsibility at Cargill?

O’Brien: We have consolidated all of the financial activities of CIS under four key areas: general accounting and regulatory reporting; treasury, credit and risk management; compliance; and business partnering. The general accounting group is responsible for maintaining the financial statements of the firm, calculating the monthly and quarterly closes, reporting our financial statements to our parent and to our DSRO as it relates to preparing 1FR reporting, and tracking our capital spending. The next group, the credit, risk and treasury group, is responsible for doing all of our daily cash settlements with customers, analyzing the credit risk associated with entering into a new exchange and the credit risk associated with our carrying brokers. This group also handles the daily margin call reporting. The third area, compliance, has the responsibility of business risk assessment, along with setting and training our staff in policies and procedures. Now with the USA PATRIOT Act, they also have anti-money laundering responsibilities. Finally, the business partnering group is looking at profitability as it relates to a particular business unit within CIS or a specific customer. They also deal with all of our management information reporting. If we are going to enter into a new product or service, this group will analyze its potential profitability. After we’ve committed to a new product or service, this group will also analyze our results to ensure we’re deriving the most value from that business opportunity. Business partnering is making sure we are not getting ourselves into a new area that we don’t understand from a financial perspective.

All groups are global in nature and are responsible for complying with the different regulatory requirements where CIS operates—U.S., U.K., France and Singapore.

Burns: What area is responsible for risk assessment?

O’Brien: Risk assessment falls under the entire function. Each group has areas of responsibility for managing risk within the company. Accounting monitors internal control, compliance is making sure that we are meeting all rules and regulations and the credit and risk group is keeping an eye on firm risk exposures.

Burns: How does the CFO interact with other business units?

Davison: Shaun’s role is a global one. The CIS Operating Committee, which is essentially the leadership team for CIS globally, is comprised of myself and four senior vice presidents representing the four global functions around which we have structured the firm: accounting, compliance and treasury; IT and operations; global business development; and global human resources. As Shaun has indicated, the CFO’s responsibilities encompass compliance, accounting, treasury, and risk assessment. I want to underline that the risk assessment part of Shaun’s role is applied to three regions—Asia, Europe and North America. All of those regions have different requirements and different complexity of regulation. It’s also important to underline in our industry that the consolidation that you have seen in Europe, for example, has changed the landscape dramatically and it’s important to monitor that on a continual basis. The financial aspect of CIS as a global business and the interpretation of the information that we glean using our own systems is the responsibility of Shaun and his group, which he brings to the CIS Operating Committee. Clearly his financial analysis is an important component. We will make decisions based on the financial input. It’s a key part. That’s the macro role, but in CIS we are organized along a number of different departments that have forecast budgets as well as actual working budgets, which they develop with Shaun’s group. The information and monitoring of that and the understanding of why budgets are being exceeded or not being met is something that all of our businesses globally will work with Shaun’s function. Shaun’s responsibilities are past, present and future.

Burns: Is futures a more capital-intensive business than other businesses with which you’ve been involved?

O’Brien: I would say it’s more capital intensive. We have to capitalize every dollar of new segregated positions that we take in, which is quite different from say a manufacturing firm where it could hypothetically have a one-time fixed capital investment from which it continually grows its business. Every time we grow our business, we have to invest more capital in it to keep pace with the growth. In the past, it wasn’t too painful because we were able to invest those dollars in higher yielding investments, but given the interest-rate environment the country is seeing right now, it’s very difficult to have a reasonable spread off the capital we have in the business today.

Burns: What specific things could be done to improve the futures business in terms of cost of capital?

O’Brien: I’d like to see the U.S., European and Asian regulators develop a standardized global approach to firm capital rules. We are able to control our risk in London, but it takes about one-third of the capital to support that business as it does in the U.S. As a result of Barings, Asia is even more conservative than the U.S. The SGX has mirrored the capitalization rules of the CME, but it has also taken a more conservative approach on top of that which requires a firm to reinvest a certain amount of its P&L every year back into a reserve cushion above and beyond the core capital requirements—until this cushion reaches $5 million.

Burns: So would you hope for something midway between the U.S. and U.K. approach?

O’Brien: If the regulators could get together to brainstorm reasons why the capital rules are so different and come to a joint decision on what is best to protect both the customer and the firm, then somewhere in the middle might be the right answer.

Burns: Why is it more expensive to manage a futures business in the U.S.?

Davison: The cost of doing business in the U.S. is higher than in Europe because of regulatory capital requirements.

O’Brien: In the U.S., we are putting capital up for our segregated balances. In London, we’re taking our capital charges differently—such as when our customer doesn’t meet a margin call. We have basic fixed capital requirements that we have to meet in the U.K. for being a member, but one of the biggest capital hits comes as a result of specific customer risk—i.e. a customer not meeting its margin call.

Burns: Is the U.S. the only jurisdiction that allows FCMs to use risk-based capital?

O’Brien: I really wouldn’t view the U.S. approach as truly “risk-based.” The eight percent capital computation model doesn’t reflect the differences in the type of customer or individual risk associated with a customer. I would view the FSA’s approach to its capital requirements as “riskbased.” A firm is only required to put up additional capital based on the risk associated with customers—i.e. in the case of not meeting a margin call, foreign exchange exposure, a large customer exposure, etc. As CIS is only regulated in the U.S., U.K., France and Singapore, I’m not familiar with the regulations outside of these countries.

Burns: How are capital requirements different in the U.K.?

O’Brien: The FSA uses a prudential approach to regulation and aims to ensure that a firm maintains a certain level of minimum capital. For investment firms (non banks) there is a primary and secondary requirement. For investment businesses, these include two elements: initial capital and financial resource requirements. Initial capital is the basic amount of capital required by any firm to undertake investment business activities. It’s determined by a brokerage firm’s business activity. For a brokerage firm such as CIS-—a firm that does not take proprietary trading positions—-the capital requirements are much less than a firm that trades for its own account. In addition, the additional capital requirements depend upon the firm and its customer position risk. A risky firm or risky customers drive more capital. For example, assets held that represent foreign currency exposure, large customer concentrations (exposure that exceeds 10 percent of the firm’s basic capital requirement), customers that do not meet margin calls, etc. would require more.

In comparing this to the U.S., we have capital requirements to satisfy all segregated customer accounts. In the U.K., there’s the equivalent of segregation but you don’t take a fixed rate charge on each dollar of customer assets that you carry. It’s capitalized in a way that you would have your firm minimum, as I indicated before, and then you would increase capital based on the activities of a customer. If, for example, a customer doesn’t make a margin call on time, the firm will be hit dollar-for-dollar in capital charges until the customer settles its deficit balance. These capital charges could be astronomical—especially if you have a poorly controlled customer base. It’s a tremendous incentive for a firm to have good customers and good controls.

Also, when you’re dealing with a purely electronic market, you can manage your risk better when you’re trading electronically. You have more real-time information that allows you to manage your risk almost real-time versus the traditional markets where you may not see a customer’s position until the end of the day.

Davison: The controls that are enforced by the FSA lead to lower capital requirements. It’s not about managing customer risk or position risk to a fixed number, but how the regulatory environment decides that the business should be capitalized.

O’Brien: There are areas that drive capital usage other than customer positions. One of the things that has to be considered is that the European market is ahead of us as it relates to just one platform—-all electronic-—whereas in the U.S., we’re still managing the costs of the traditional marketplace in addition to electronic. In addition, there are significant IT investments that a firm needs to make in order to meet customer and exchange requirements.

Burns: So IT demands also make futures an unnecessarily capital intensive business in the U.S.?

O’Brien: Probably no more than other businesses, but it’s important to note that investments in IT are a cost of capital, although it’s different from the type of capital which we’ve discussed here. There are a lot of investments we have to make just to interface with our exchanges and keep pace with changes in their systems. When we do make significant IT investments, we don’t see any type of reduced costs coming back to us…whether it be a reduction in membership fees or a reduction in cost per trade, or a head count reduction. The improved efficiencies seem to be going outside the FCM back to the exchanges. The FCMs don’t reap the benefits.

Davison: The cost of maintaining competitiveness in a very competitive environment is again one of the barriers of entry for other participants, but our biggest spend for the foreseeable future is going to continue to be investment in IT infrastructure and the need to make sure our systems and work processes are maintained. Think of it this way: every 12 or 18 months is a generational change in PCs and laptops. Consequently, maintaining the electronic infrastructure that is required on a global basis is a very, very significant expenditure. We have close to 180 staff globally who are involved in our e-infrastructure and IT. It’s a very significant part of our global workforce.

Burns: What are the benefits of risk-based capital and where is it currently being used?

O’Brien: The advantage is that you don’t have to capitalize the excess cash that you’re holding for your customer. Under the capitalization rules of segregation, a firm is required to have capital equal to four percent of its customer segregated balances—regardless of the risk position. If a customer left excess cash and didn’t trade this excess cash, a firm would still have to hold capital equal to four percent. Under risk-based capital, a firm’s capital is based on the risk presented by the positions its customers hold and not the balances you hold on behalf of customers. Therefore, a customer can put up additional assets, but the firm doesn’t have to put up additional capital to support these positions—provided they do not represent a trading risk. The shift to risk-based capital was a way to recognize that not all of the assets a customer has at a firm are risk positions.

Burns: CFTC Rule 1.25 expanded the list of permissible investments for customer funds considerably. What else could be done either in the U.S. or abroad that would help FCMs manage their capital requirements without harming the safety and soundness of the system?

O’Brien: Rule 1.25 was a great change because it allowed us to invest in a wider range of investment vehicles. I think it should remain conservative because in the event of large market volatility or a large customer default, it’s intended to make sure your firm is liquid. I don’t see how you could get more aggressive with those investments and still maintain the liquidity that we have in the industry today. On the other hand, given that we are investing significant dollars, it would be nice to see a larger spread than we see today. The investment vehicles that are Triple-A rated or the money market mutual funds or the highly liquid investment vehicles that are used just don’t return a whole lot. For customers that are holding excess assets at a firm, even those that are under segregation should have the ability to invest in potentially higher yielding instruments than the regulations allow today.

Burns: Does opting out of segregation offer any relief for FCMs?

O’Brien: An institutional client can opt out of segregation, but I don’t know why he would want to unless we could invest his cash into something more aggressive. CIS would be exposed to more risk from a specific customer and we would have to have stronger risk management controls in place to make sure this institutional client couldn’t bring us down.

Burns: How do you decide whether to join an exchange and the capital obligations that go along with that versus establishing a carrying broker relationship?

O’Brien: Our business partnering group of financial analysts would assess demand for any new exchange or membership that we would purchase. We would work with our sales and marketing groups to understand the needs of the customer and the reason for wanting to make an investment into a new market or a new exchange. Then it would go through our credit and risk group where they would analyze the risk associated with the exchange. It also would go before our Risk Committee. Depending on whether we are changing a carrying broker or actually making an investment decision as it relates to a sizable capital investment for membership, that would go through the CIS Operating Committee for final approval as well. Once that happens, compliance would get involved with actually filling out the paperwork, making the initial membership application and outlining the necessary policies and procedures.

Burns: Does the cost of belonging to an exchange vary dramatically around the world?

O’Brien: Yes. It really depends on the country. For example, IDEM, the derivatives arm of the Italian exchange, has a $30 million capital requirement to become a member. The minimum requirement for becoming a general clearing member of Eurex is $125 million in capital.

Burns: Can you meet these requirements with a bank guarantee?

O’Brien: In the case of Eurex, you can do part with a bank guarantee and part has to be true regulatory capital in your business. You have to show a minimum requirement of $25 million and you can make up the rest in either bank guarantees or net worth of your parent.

Davison: We’re going through a period where what used to be off-balance sheet and didn’t affect the parent is changing quite dramatically. The idea of being able to capitalize or give guarantees with regard to your parent if you are a subsidiary has changed.

O’Brien: This is quite new, but FASB just came out with a new rule requiring companies that are not consolidated into that of the parent financial statement to disclose the use of parent guarantees. CIS is a consolidated company so it would be a footnote on Cargill’s financial statement. But for some firms that may become an issue if a non-consolidated company now has to disclose parent guarantees on their balance sheet as a liability. It could have an impact on the financial statements of a brokerage firm that relies on parent guarantees in the course of its business.

Burns: How does Cargill, the parent, view the cost of running a futures operation?

Davison: Like all Cargill businesses, we have capital from the company that we use and we have certain financial returns that we have to meet. We have a commitment to make “x” amount of return on the capital that we use and if we fail to make that type of return, then we would want to understand why that is occurring and whether it is a permanent phenomena or a short-term event.

Burns: How does the increase in futures volume translate into a return on capital?

Davison: Our business has become significantly more competitive in the 30 years since Cargill Investor Services was established. The downside of this competitiveness is that it is harder to make an adequate return on capital—not impossible, but harder. In addition, there are barriers of entry to our business (i.e. increased capital), which has led to the consolidation that we’ve seen. Consolidation continues-—we’re getting down to very few global players. Certainly a contributing factor in consolidation is that the business is more competitive from the perspective of the efficient use of capital. Specific to this article, the cost of being in this business globally has increased—especially considering the multiple regulatory regimes globally. Therefore, it is arguably a less attractive business than it was historically.

Burns: What’s the downside of having fewer global players?

Davison: The classic answer is that you wouldn’t want to get to the point where there isn’t enough competition. The concentration of risk would be a concern. Ultimately, when you see capital markets with very few players that develop problems, the effect of systematic risk clearly increases. It’s a question of the risk not being diversified across the customer base.

Mary Ann Burns is senior vice president of communications for the Futures Industry Association and editor-in-chief of Futures Industry magazine.