Futures Industry Debates Solution to Protect Customer Segregated Accounts

As the futures industry debates different ways to safeguard customer segregated funds, regulators and industry leaders are under the gun to come up with a solution to win back the trust of customers whose funds were pillaged in two high-profile breaches.

Last week, the CFTC’s Technology Advisory Committee (TAC) met with industry leaders in Washington D.C. to identify and explore technological issues and possible solutions to verify the daily balances in customer segregated accounts.

CFTC Commissioner Scott O’ Malia called for an urgent, technical solution that can verify customer balances held by the FCM, custodial banks and the clearinghouse.

Clearly, regulators are in the line of fire since they’ve failed to detect the disappearance of customer segregated funds in two major fiascos —the October 2011 bankruptcy of MF Global in which $1.6 billion in customer segregated funds went missing, followed by revelations earlier this month that Peregrine Financial Group had committed extensive fraud resulting in shortfalls of more than $200 million in segregated customer funds.

One of the proposals is to have regulators verify the location and status of funds held in customer segregated accounts at futures commission merchants (FCM)s. However, in his speech, Commissioner O’Malia said the reforms currently under consideration “fail to close the existing regulatory gap that allows firms to self-report the status, balance and location of the customer funds.”

O’Malia called for the industry to develop a technology solution that can verify customer balances held by the FCM, custodial banks and the clearing house. “This system must be fully automated to draw feeds directly from the relevant entities to compare the balances. If balances do not match, then an automated alert should be sent to both the appropriate self-regulatory organization (SRO) and the Commission.”

But if the method is too onerous, then regulators will fail to monitor the rules they’ve codified. The question is how to bring technology into the equation?

At the CFTC meeting, Gerald Corcoran, chairman and CEO of R.J. O’ Brien, drew on his background as a CPA and former CFO of the firm, to bring some reality to the meeting. Corcoran illustrated which areas will be easier to provide verification of funds across the industry versus those areas that are more complex and will take longer for regulations to implement.

Showing a financial statement of the RJOs customer segregated funds, Corcoran illustrated how RJO has up to 70 different accounts with banks, carrying brokers and exchanges in the U.S. and abroad. Extrapolating this across the industry of 116 registered FCMs, Corcoran told regulators they would probably be looking at over 1,000 accounts in their verification efforts.

Despite the complexity of verification, Corcoran advised regulators, “Let’s not wait until everything is perfect,” suggesting that the current proposals to offer “read-only” access to cash accounts be implemented immediately. While Corcoran voiced confidence that technology exists to provide real time access into all accounts, he said that cash accounts were a good place to start since most fraud has taken place in the cash domain.

But CME Group, operator of the Chicago Mercantile Exchange, which was the front-line regulator of MF Global, who relied on the balances reported by MF Global, is calling for more radical action. CME wants all customer money to be held at either clearinghouses or other depositories so as to prevent it from being misused by brokers as a result of management transgressions.

It will be interesting to see which solution ultimately emerges, but in the meantime, the urgent call for technology as the best way to monitor real-time cash balances in segregated accounts, cannot come soon enough to restore trust from futures customers. After all, you can get real time bank balances on an iPhone, why not in futures accounts?