I still believe in the futures industry segregated funds model.  In fact as strange as it may seem, my own experience, or that of my former firm with Refco and MF Global, has only strengthened my belief in the structure and wisdom of the model.  However, there is a flaw to the model which has weakened faith in the futures markets and the model.  That flaw is the lack of stewardship from our regulators and bankers and the lack of what I will call a customer fund dislocation scheme.

Recently we received the news that MF Global customers in the US would receive 100% of their funds back.  Several years ago, a fund The Price Group represented had over $200 million stolen from it by Refco right before Refco went bankrupt.  Through the diligence of Tom Price, all those funds and more were returned to customers.

All it took to get the money back was time, application of the laws and a waste of customer goodwill.  A customer fund dislocation scheme for the industry could have benefited both the Refco and MF Global bankruptcies.  Instead, the industry has squandered its hard earned reputation for customer fund safety and we are paying the price for that lack of stewardship.

The Peregrine Financial Group case continues to go on and I believe there will be a recovery of significant assets from the custodian bank, which I believe was derelict in its regulatory responsibilities.  A customer fund dislocation scheme would have helped here too.

Our banks are highly regulated entities.  Our futures commission merchants are as well.  There are laws, rules and regulations about how customer funds are supposed to be handled.  The catch is that we must have able and active brokers, bankers and regulators to apply and monitor these laws and regulations.  

The MF Global, Refco and Peregrine bankruptcies all featured significant regulatory stewardship failures, which allowed illegal acts or problems to go on longer than they should.

Take the Refco situation.  Refco got a major boost to its plans to go public when it received an investment from a shrewd private equity investor, Thomas H. Lee.  Lee and his firm do extensive due diligence on Refco, but do not find the “hide the debit” scheme.  As Refco went public it underwent millions of dollars in due diligence by one of the country’s leading accounting firms, but the firm did not uncover the scheme.

Where it should have been caught was during any of the hundreds of audits by the regulators at the CME Group, the NFA or the CFTC over the preceding years.  The regulators should have discovered these large regular movements of capital during their routine or surprise audits.  That was the best opportunity, despite the millions spent for due diligence by Thomas H. Lee and the Refco for the IPO.

In the MF Global case, regulators were in the offices of MF Global all week long the week prior to the firm declaring bankruptcy.  It was only over the weekend when Interactive Brokers was conducting its due diligence on MF Global ahead of a potential purchase that the customer shortfall was discovered.  It was the regulators, not Interactive Brokers, that should have uncovered the problems.  In fact, there was a regulatory failure at FINRA when MF Global changed its risk profile and business plan as a result.  MF Global should have reported to FINRA their new highly leveraged foreign fixed income trading scheme, which would have alerted investors and clients about the new risks months before their demise.  

Lastly, the Peregrine issue should never have happened if the NFA and US Bank had not been fooled by a third rate fraud.  The lax application of regulations and the lack of double-checking key audit components led to this problem going on for years.  US Bank, as the holder of segregated funds for Peregrine, should have found this issue.  The NFA should have found this issue.  It was not for a lack of rules or regulations.  The model works, but it needs diligent, intelligent and up-to-date application to live up to its intent.

We can push for more talented and well trained regulators.  But even they can be fooled sometimes.  Acknowledging that not all fraud can be prevented from happening, we need to address the negative impact on the industry from the fraud that does occur.  We need to address the negative impact from the customers who feel as though the system failed them and  having their money stolen right out from under them.

When the MF Global bankruptcy occurred, I convened a group of industry representatives from all aspects of the futures industry in order to discuss a potential solution to the negative impact on the customers.  I championed something that had been proposed by Attain Capital Management’s Jeff Malec, now an NFA Board Member, and suggested in the 1980s in a study after the Volume Investors failure.  There were other insurance ideas suggested too from John Roe, James Koutoulas and Steve Hurst.

I championed the idea of “forward insurance.”  Think of this insurance as a “customer fund dislocation scheme.”  What I was proposing was that the futures industry set up a structure to raise the funds necessary to make customers of failed futures brokers whole.  The industry, through this structure or entity then steps into the customer’s place in the bankruptcy proceedings.  The customers have their funds to continue to hedge and trade.  And, the industry goes about applying the laws, processes and regulations to get the money returned.

In the meantime, I suggested applying a transaction fee to pay the interest on the borrowed funds and to pay off any shortfall in recovered funds, should there be one.

In both the Refco case and the MF Global case, this solution would have worked.  The customers would have received their money quickly, and the industry would have recovered all the funds it paid to customers.  In fact, the industry would even have had a rainy day fund left over to help for future failures.  The downside would be a slightly higher transaction fee on some trades for period of time.

Industry friends I have asked would they take this outcome, with the higher transaction fee for the short time until the funds were fully recovered and customers with all their funds ASAP, or the markets we have today, they chose the first.

You see, I believe in the strength of the laws and the regulations that protect customer funds.  Many of the new regulations may improve some of those protections theoretically, but if we don’t have the regulators or bankers trained and able to apply them properly, then we will see more problems in the future.  

I think the price we should pay for greater customer protection, from criminals as well as ineffective bankers or regulators, is a customer fund dislocation scheme in the form of forwarding insurance.  I still believe in the futures industry segregation model and the laws behind it. I think the futures industry ought to believe it in too.  And in that belief, set up this customer fund dislocation scheme.

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