CFTC passes rules to keep another MF Global from happening
The U.S. Commodity Futures Trading Commission (CFTC) finalized a rule on customer protections Wednesday morning that enhances transparency on how companies use customer funds and compromises on its controversial residual interest provision.
The bulk of the rule strengthens auditing requirements, increases supervision of customer collateral, holds leaders accountable for shortfalls and gives regulators better access to firms’ bank accounts.
The rule is designed to better safeguard segregated customer funds in case their futures commission merchant (FCM) goes bankrupt, like in the case of MF Global or Peregrine Financial Group.
It’s the residual interest provision—a section of commodities law that states one customer’s excess margin can’t be used to cover another’s deficit—that was at the heart of the controversy. CFTC softened the language and phased in the reporting requirements, which the commissioners believe lessen the financial burden of the law. The final rule passed by a vote of three to one.
“I met with a number of producers in my home state of Iowa who actively use the derivatives markets to hedge their risk,” CFTC Commissioner Mark Wetjen said during the hearing. “I listened to and considered their concerns about the residual requirement. Today’s release takes those concerns into account. I believe that their most pressing fears will not be realized because of this rule.”
The final version of the rule dropped the controversial “at all times” language from the residual interest requirement. That language led the futures industry to understand they’d have to keep tabs on customers’ margin balances in real time, something the industry doesn’t have the technology to do.
It could also have forced brokerages and FCMs to require their farmer, rancher and agribusiness customers to pre-fund margin calls, an expensive proposition that some worried would cause hedgers frustrated by their experience with MF Global to walk away from the futures market altogether.
CFTC’s final rule sets a firm time when FCMs must calculate residual interest: 6 p.m. the day after the trade was made. FCMs must comply with that provision in one year.
It also phases in a stricter deadline after five years, moving it up to the first daily settlement, which usually occurs between 7 a.m. and 9 a.m. on the day after the trade. The rule directs CFTC to study the costs and feasibility of moving the calculation to the earlier deadline, and the commissioners have the option of changing the residual interest deadline, once they review the study.
CFTC Commissioner Scott O’Malia disagreed with the structure of the proposed rule and offered an amendment that would do away with the automatic change to the daily settlement time in 2018.
“It lets a future commission make a determination about the best way to proceed after it has collected all the evidence,” he said about his amendment. “In other words, the amendment does not bias a study with outcome that has been previously determined.”
The amendment, which was supported by the National Grain and Feed Association, failed to pass.
CFTC commissioners and staff stuck to a strict interpretation of the Commodity Exchange Act, and see the five-year delay in full implementation as giving time for companies to comply with the law. Many in the industry argued that the rule reinterpreted a statute that’s been in place for more than 40 years.
If the residual interest deadline arrives and individual customers still have outstanding balances, the FCM must cover the difference with its own cash. It cannot look at the total sum of its customers’ balances, and if that’s positive, be considered in compliance, which is what many FCMs have done up to this point.
CFTC staff said repeatedly it was never the statute’s intention to be interpreted this way. There’s never been an enforcement act on that matter, however.
“Sometimes the law leaves lots of latitude for attitude,” CFTC Commissioner Bart Chilton said.
“Sometimes we can mess around with it a little bit. Other times not so much. And on this one, not so much.
“In fairness, we haven’t done as well, if you look at the history, as I think we should have. This rule gets to where we need to be. It comports with the law. It protects customers.”
The phase-in period was also designed to give companies time to beef up their capital, CFTC staff said. However, the changes could still force some of the smaller FCMs, including many that cater to agricultural clients, out of the business.
“The difference is that large FCMs have a much lower cost of capital than small ones,” said Stephen Kane, a CFTC staffer from the office of the chief economist.
A CFTC cost-benefit analysis found the total cost of compliance for all FCMs would be $487 million. Yet it will only cost $70 million to bring the 10 largest FCMs to compliance, a reflection of how expensive it will be for smaller firms to comply.
“The economics may no longer work,” Kane said. “It would be a lot harder for smaller FCMs, and it could force them to become introducing brokers.” Brokerage fees would likely increase for clients at those firms. — Katie Micik, DTN