The Commodity Futures Trading Commission is now in the final leg of its consideration of a package of proposals released for public comment last fall intended to strengthen customer protections. Among other provisions, the proposed rules would require each futures commission merchant to maintain more detailed records and submit more detailed reports regarding the location and investment of customer funds, and to disclose more detailed information regarding the FCM and its affiliates that may be material to a customer’s decision to do business with the FCM.
At a CFTC staff roundtable held on Feb. 5, market participants generally welcomed the proposals as necessary in the wake of the collapse of MF Global and Peregrine Financial Group. Nonetheless, a broad spectrum of participants, including CME Group, sell-side and certain buy-side participants, expressed concern that two of the CFTC’s proposed amendments would adversely affect liquidity, making trading significantly more expensive and less efficient for customers that use the markets to hedge their financial or commercial risks. They warned that the proposals could ultimately restrict customers’ choice of FCMs.
One of the proposals in question would substantially alter the manner in which FCMs calculate their “residual interest” requirement. The other proposal would require an FCM to take a capital charge for customer accounts that are undermargined for more than one business day after a margin call is issued, rather than the three business days now permitted.
Residual Interest Requirement
Commission rules currently require an FCM to hold a portion of its own funds in the customer segregated accounts, i.e., the FCM’s “residual interest,” to assure that no customer’s account becomes undersegregated. A customer’s account is deemed to be undersegregated if the account’s net liquidating equity, calculated as of the close of each business day, is a negative number. A customer’s net liquidating equity is the sum of (i) the customer’s cash and securities on deposit with the FCM, (ii) the net value of the customer’s open options positions, and (iii) the unrealized profit or loss on the customer’s open futures positions.
The proposed amendments would require an FCM to maintain a residual interest in each class of customer funds account—customer segregated account, foreign futures and foreign options secured amount account, and cleared swaps customer account—sufficient to exceed at all times the sum of all customer margin deficits, i.e., the sum of each customer’s margin requirement minus any excess funds that the customer may have on deposit with the FCM.
In its comment letter, FIA cautioned that this requirement would implement “an entirely new interpretation of an FCM’s obligations under the Commodity Exchange Act that would cause a fundamental shift in the manner in which FCMs and their customers have conducted business for a half-century or more and will have a profound impact on the structure of the markets.”
Currently, a significant number of customers do not maintain excess margin with their FCMs. They do not receive, and are not required to meet, a margin call until the day following the date on which the trade has been executed. Requiring customers to hold excess margin with their FCM would substantially alter the established relationships between FCMs and their customers.
At the CFTC roundtable, Michael Dawley, global co-head of futures and derivatives clearing services at Goldman Sachs and chairman of FIA, called the CFTC’s proposed amendments to the residual interest requirement the biggest change to the futures model in his 30-plus-year career in the industry, and urged the CFTC to spend more time considering the consequences. “That means changing an ecosystem that has been in existence for decades,” he told the CFTC staffers at the roundtable. “If we have to go down that path, I would encourage the Commission to spend a lot more time focusing on the unintended consequences. It may be the right decision long-term, but don’t underestimate how big of a deal it is.”
In its comment letter, FIA estimated that FCMs would be required to contribute more than $100 billion into customer segregated accounts to meet this requirement, and warned that this would cause a “tremendous drain on liquidity.” The figures were based on data provided by CME and IntercontinentalExchange. FIA emphasized that this estimate was certainly low, since it did not take into account initial margin requirements for cleared swaps or futures contracts executed on foreign boards of trade.
For their part, end-user groups expressed concern that customers would bear the brunt of the requirement and would be forced to post more collateral with their FCMs. “The FCM is going to be held to the letter of whatever you guys decide,” said Todd Kemp, vice president of marketing and the treasurer at the National Grain and Feed Association. “We fear that some of those costs are going to be driven down to the customer, possibly in the form of pre-margining and intraday margining. That is going to run completely counter to every instinct that our industry has right now. Do we want to send more money to the FCMs? What happens in the event of the next insolvency? You have more funds at risk, more customers at risk.”
However, William Thum, principal and senior derivatives counsel at Vanguard, offered a different perspective, noting that swap market participants have been able to fully segregate their collateral in their bilateral swaps transactions. Thum, whose firm has $2 trillion under management, said: “We strongly feel each customer must stand up for their own trades. If they can’t put the margin up, they shouldn’t trade.”
Thum said the CFTC proposals appropriately shift risk from the customers with excess to customers with deficits. “We agree with this shift, as we don’t want our margin excess used to support other customers in any way. The costs will be appropriately increased as customers will have to pay their own freight as they enter new trades.”
Gerald Corcoran, chairman and chief executive officer of R.J. O’Brien & Associates, responded that it is very seldom that one customer’s excess margin is used to cover the margin of another’s. “I don’t want the perception coming out of this room that all FCMs are running their business on the backs of their customers’ excess,” he said.
In its comment letter, CME Group warned that the proposed residual interest requirement will have unintended negative consequences on customers, especially those who use agricultural markets. “We believe that this will be a significant and unnecessary drain on liquidity that will make trading significantly more expensive for customers to hedge financial or commercial risks,” CME wrote. “The liquidity drain will be exacerbated to the extent that the demand for excess margin will increase the costs and limit the activities of market-makers.”
In addition, CME noted that to the extent larger FCMs are able to use their own funds to fulfill the residual interest obligations under the proposed rules, it would result in “significant consolidation” in the FCM community. “Generally, the mid-size and smaller FCMs will not have the capital to cover the residual interest requirement and will have no choice but to require their customers to pre-fund potential margin obligations,” wrote Kim Taylor, president of CME Clearing. In addition, Taylor mentioned at the roundtable that the recent shift to gross margining will greatly reduce fellow customer risk since the entire amount of an FCM’s margin requirement is held at the clearinghouse, rather than netted at the FCM level.
FIA also noted in its comment letter that the proposed amendments are operationally burdensome, if not impossible. The proposals would require FCMs to have the ability to know at all times the status of each customer’s account. “FCM systems currently do not permit at all times calculations, and designing, developing and implementing the changes necessary to permit at all times calculations would be a multiyear project, requiring radical changes to the current processing procedures,” FIA wrote.
The backbone for all applicable data related to customer accounts is the end-of-day batch processing, which occurs overnight following the close of trading each day. Margin and commission processing (including all exchange and clearinghouse fee calculations) take several hours to run. “Intraday runs would be a major drain on technology resources and would cause many other essential systems to slow or fail,” FIA cautioned.
In its comment letter, CME agreed there is currently no system that exists “or could be constructed in the near future” that would enable FCMs to accurately calculate customer margining deficiencies, continuously, on a real-time basis.
FIA and others urged the CFTC to set aside this part of the proposal until all market participants have had an opportunity to fully consider the implications. Alternatively, if the CFTC decides to proceed, FIA recommended applying the requirement only once per day, at the end of the day following the trade date, rather than continuously. “This alternative will achieve the Commission’s regulatory goals without imposing damaging financial and operational burdens on FCMs, and the resulting financial burdens on customers,” FIA said.
Proposed Capital Charge Rules
There is broad concern over the CFTC’s proposal requiring FCMs to take capital charges for accounts that are undermargined one day after a margin call is issued. The current rules require an FCM to take a capital charge to the extent that a minimum margin requirement is outstanding more than three business days after a call has been made.
RJO’s Corcoran highlighted the problem this would cause for small and medium-sized FCMs. He noted that, although many institutional customers can meet this requirement with wire transfers, his firm continues to receive 50,000 checks per year from ranchers, farmers, retail investors and other customers. The cost for these customers to use wire transfers would be far in excess of the commissions they pay his firm, he said. Another solution would be to prepay margin, he noted, but this would mean a substantial increase in the amount of margin deposited by customers at their FCMs.
As a result, smaller FCMs may be forced to have customers pre-fund these calls, many have warned. “Many, if not most, hedgers operate with excess funds regularly moving in and out of their segregated accounts, but this is not typically an automated process,” wrote Diana Klemme, chairman of the of the National Grain and Feed Association’s risk management committee. Klemme, who is a vice president at Grain Service Corp., noted that this likely will result in FCMs requiring clients to pre-fund potential margin calls. “It would be the ultimate irony that rules designed to enhance customer protections in the aftermath of MF Global accomplish the opposite.”
To address these concerns, FIA suggested revising the capital charge for unmet margin requirements so that the capital charge would apply after one business day if the outstanding amount is more than $500,000, and after two business days if the outstanding amount is less than that. FIA asserted that, because an FCM will have met the customer’s margin obligation no later than the business day following trade date, this proposed revision will not endanger other customer funds, while providing limited relief to an important segment of the derivatives markets.
CME questioned the need for this capital charge in light of the proposed residual interest requirement. “If the residual calculation rules are adopted as proposed, the imposition of the charge seems redundant since the segregation account would need to be fully satisfied by the FCM before the time to take the capital charge hit,” CME wrote.
FIA further noted that reducing the number of days to satisfy a margin call increases operational problems because it does not consider delays arising from accounts located in other time zones that cannot settle the same day, or are in other currencies.
FIA Urges CFTC to Take More Time
In light of these concerns and the significant steps that the CFTC, self-regulatory organizations and the industry have all taken to improve greater transparency through daily flows of information, electronic verification of segregated account balances and enhanced and more frequent inspections, FIA urged the CFTC to delay finalizing these rules until prior safeguards have taken effect. “We believe it would be premature to impose additional requirements before fully assessing the impact of the safeguards that have already been adopted,” FIA said.