Regulatory agency the Commodity Futures Trading Commission (CFTC) will shut down an option in US investor protection measures that allowed failed broker MF Global to maximise the client money used to fund its own exposures.
The agency is looking to retire an “alternative method” for calculating client assets that dates back to 1987 and which let MF Global tap US$1.6 billion of supposedly segregated customer funds for proprietary interests – a US$6.3 billion bad bet on European sovereign debt.
Earlier this month, CFTC commissioner Gary Gensler hinted that he intended to close the loophole, and at a conference in London this week Ananda Radhakrishnan, director of the CFTC’s Division of Clearing and Risk, said he anticipated the agency would have a rule published “by the end of the year”.
“You can expect to see a proposed rule formalising the elimination of the alternative method by the end of the year,” he said during a panel discussion at the International Derivatives Expo in London on Tuesday 26 June.
In a report on the downfall and clean-up of MF Global, James W. Giddens – the firm’s liquidation trustee – identified the alternative calculation as the mechanism which allowed the futures commission merchant (FCM) to access a greater amount of client funds.
Under current rules, FCMs are not required to calculate ‘secured’ amounts for customer funds held for trading on foreign exchanges the same way they must calculate ‘segregated’ amounts for customer funds held for trading on US exchanges, explained Giddens.
“Specifically, the rules allow a FCM to calculate the ‘secured’ amount according to one of two methods,” wrote Giddens. He said the first option is the net liquidating value of the net equity of all customer accounts, plus the market value of any securities held in customer accounts. But the alternative method is a risk-based measurement based on margin required, plus or minus the unrealised gain or loss on futures positions, plus long option value, minus short option value.
“In the case of MF Global, reliance on the alternative method in the time period leading up to the liquidation resulted in substantially fewer funds being segregated than under the net liquidating equity method,” wrote Giddens. “This allowed the FCM to believe that it was in regulatory compliance, with hundreds of millions of dollars to spare, even when the amount in segregation was actually in or perilously close to being in deficit. If FCMs were required to compute the secured amount under the net liquidating equity method, it could help ensure that all customer funds are properly segregated at all times and eliminate a difference in treatment among customers of which most customers are unaware.”
Radhakrishnan said the CFTC had already “called firms in and convinced them it was not in their interest” to use the alternative method but was looking to enshrine the behavioural change in law.
However, Radhakrishnan warned that customer protection required more than rule changes in the segregation of funds and market structure.
“Individual segregation and clearing houses [for derivatives] will not work without corresponding changes in the bankruptcy code,” he said.