Uncertain futures in evolving financial markets.

• Author: Krug, Anita K.
• Position: III. Uncertain Customer Protection through V. Conclusion, with footnotes, p. 1236-1269

3. UNCERTAIN CUSTOMER PROTECTION

   Both the regulation of securities brokers and the regulation of FCMs rely on specific tools to achieve the goal of procedural regulation, which, again, is to protect assets that customers have deposited with their brokers for purposes of carrying out their financial activities. In each of these regulatory spheres, the tools employed are generally some mixture of operational requirements, bankruptcy rules, and insurance-like compensation. Although the preceding discussion describes the particular combination of tools on which each sphere relies, it does not provide a normative assessment of them.

   That is the task of this Part. It focuses primarily on the regulatory regime governing FCMs, which has received little attention from scholars to date, particularly in comparison to the widespread and extensive focus that securities brokers have received. (138) Critical analysis of FCM regulation is especially important now, moreover, given the ever-growing number of retail investors deploying their assets in the futures markets. (139) Part III.A focuses on the operational requirements governing FCMs, elucidating how, even after having been substantially overhauled in recent years, they harbor weaknesses that present substantial risks to customers, while Part III.B analyzes the deficiencies of the seemingly protective futures-specific bankruptcy rules.

   1. Operational Requirements

      As Part II details, various statutes and CFTC rules that apply to FCMs govern the manner in which FCMs conduct their businesses. (140) Collectively, these provisions aim to ensure the safety of customer deposits by, among other things, specifying where and how the deposits must be maintained and prohibiting the use of other customers' deposited funds to support a defaulting customer's transactions. (141) Operational requirements of some variety are, moreover, necessary, especially considering two recent FCM bankruptcies that produced substantial anguish and losses for FCM customers. (142) After briefly describing these calamitous episodes and summarizing the regulatory reform that they spawned, (143) this Subpart explains why, without more, the requirements presently governing FCMs still are not up to the task of protecting customer assets. (144)

      1. Regulatory Failures and Responses

         As Part II observes, the most important operational requirement governing FCMs requires an FCM to segregate customer assets from the FCM's own assets and to continuously maintain a specified amount of net capital in its own accounts, thereby helping to ensure its financial health. (145) Of course, as Part II also notes, amidst the operational duties that apply to FCMs is an operational right: An FCM may invest its customers' assets in certain types of financial instruments for its own benefit, retaining any profits arising from those investments. (146) The operational requirements constrain this activity, too, however. There are only a limited number of instruments in which FCMs are permitted to invest customer assets, and investments in those instruments are subject to fairly stringent requirements and limitations. (147)

         In evaluating these operational requirements, it is important to keep in mind that, even though FCMs traditionally have been permitted to use customer assets for generating investment-related profit, the futures brokerage business model nonetheless has differed substantially from its securities brokerage counterpart. In the securities arena, firms' business structures contemplate brokers' lending funds and securities to customers and their use of the collateral associated with those loans both for providing services to other customers--namely, lending securities to other customers to facilitate their short sales--and for proprietary investing and trading. (148) Perhaps because securities brokers hold the customer assets that they use in these ways as collateral, the brokers are permitted not only to use the assets somewhat less conservatively than what is permitted by CFTC rule 1.25 for FCMs, but also to repledge them in connection with their own borrowing activities. (149) Accordingly, FCMs' activities historically have not been viewed as creating the same risk for customer assets as the activities that securities brokers pursue. (150) Particularly given this difference, the operational requirements applicable to FCMs may seem sufficient for protecting customer assets, if not overly precautionary.

         Certainly one might have surmised as much prior to October 31, 2011. On that day, the large FCM (and registered securities broker) MF Global, Inc. was placed in liquidation when its parent company, MF Global Holdings, Ltd., declared bankruptcy. (151) The bankruptcy was later determined to have had a number of causes, all of which could generally be distilled to one factor: the firm's pursuit of high-risk investment activities, centering on European sovereign debt (in the form of bonds). (152) Although MF Global's management believed these instruments to be virtually risk-free, (153) they proved to be virtually the opposite. (154) Putting aside for the moment the cause of the bankruptcy, however, the most notable aspect of the event, and certainly the most disturbing for MF Global's customers, was that, at the point of bankruptcy, the firm's segregated accounts contained insufficient funds to cover customers' legitimate claims. (155) The shortfall, which totaled approximately $1.6 billion, (156) or approximately 27% of customer deposits, (157) was the product of the firm's inappropriate use of customer funds to meet its ever growing liquidity needs as it neared insolvency. (158)

         A mere nine months after MF Global's bankruptcy, another FCM, PFGBest, went bankrupt--an event that similarly revealed a mammoth deficiency of customer assets. (159) Although PFGBest's customer assets were but a fraction of those held by MF Global, PFGBest's bankruptcy was substantially larger in scale than MF Global's, in terms of the percentage of customer assets that were missing from the segregated account. (160) In addition, the cause of PFGBest's shortfall was arguably more troublesome than the inept managerial decisions that stood at the heart of MF Global's downfall. PFGBest's founder had, quite simply, stolen customers' funds, draining the segregated account beginning in the early 1990s and fabricating the quarterly account statements required by the NFA, as PFGBest's designated SRO. (161)

         The effects of these dual bankruptcies were far-reaching. Futures traders and other market participants left the market (at least temporarily), simultaneously reducing market liquidity; (162) firms known as commodity trading advisors, who traded in futures on behalf of their advisory clients, closed their businesses; (163) and farmers who relied on futures trading to hedge against fluctuations in grain prices had insufficient capital to pursue their business activities as a result of having lost the funds they had used to margin their trades. (164) Many affected parties and horrified onlookers blamed the CFTC, as well as the CME and the NFA, which had been, respectively, MF Global's and, as noted, PFGBesfs designated SROs, primarily for having adopted overly lax rules governing FCMs' use of customer funds. (165)

         On that score, there was, in fact, substantial room for improvement. Rule 1.25 at the time permitted FCMs to invest customer assets in a wider range of instruments than what is permitted now, including corporate notes and bonds other than those guaranteed by the US government and interests in sovereign debt (166)--the securities that felled MF Global and that are known to "carr[y] enormous default and liquidity risks." (167) In addition, FCMs that were also regulated securities brokers could engage in "in-house" repurchase transactions, exchanging customer assets for permitted investments that they held in their capacities as securities brokers. (168) Finally, FCMs whose customers traded in non-US futures markets were not obligated to segregate all of those customers' deposits from their own assets. (169) Instead, if the firms chose to use the "alternative method" of segregation for foreign futures trading contained in CFTC rule 30.7, they were required to segregate only the portion of those assets that might be needed to margin the relevant customers' open trades. (170) Any excess amounts that the customers had deposited could be freely commingled with the firm's own assets. (171)

         In late 2011, shortly after MF Global's bankruptcy, the CFTC eliminated several of the permitted investments for customer assets contained in rule 1.25. (172) As Part II points out, customer funds and securities now may be used only for certain types of "safe" investments, including US government bonds and securities, municipal securities, and bonds issued by US government corporations. (173) The agency also eliminated the ability of dually-registered FCMs to enter into in-house repurchase transactions using customer assets, (174) as well as the alternative method of segregating customer assets set forth in rule 30.7. (175)

         Beyond amending existing rules, the CFTC adopted a number of new ones, many of which center on providing information to regulators and customers. (176) These new rules require that FCMs inform regulators if their financial health falters (177) and provide customers with extensive disclosures about the risks associated with holding a futures brokerage account. (178) Another new rule requires FCMs to establish risk management programs targeted at managing risks relating to customer funds. (179) Regardless of their specific content, however, all of the new rules were intended to fortify the procedural regulation of FCMs in order to forestall another fiasco like those wrought by MF Global and PFGBest. (180)

      2. Ongoing Deficiencies

         By themselves, however, these operational rules are not enough. Regardless how limited the range of uses of...