[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]
THE FUTURE OF CFTC: PERSPECTIVES ON CUSTOMER PROTECTIONS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
GENERAL FARM COMMODITIES
AND RISK MANAGEMENT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
__________
OCTOBER 2, 2013
__________
Serial No. 113-8
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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85-418 WASHINGTON : 2014
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COMMITTEE ON AGRICULTURE
FRANK D. LUCAS, Oklahoma, Chairman
BOB GOODLATTE, Virginia, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
STEVE KING, Iowa MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas DAVID SCOTT, Georgia
MIKE ROGERS, Alabama JIM COSTA, California
K. MICHAEL CONAWAY, Texas TIMOTHY J. WALZ, Minnesota
GLENN THOMPSON, Pennsylvania KURT SCHRADER, Oregon
BOB GIBBS, Ohio MARCIA L. FUDGE, Ohio
AUSTIN SCOTT, Georgia JAMES P. McGOVERN, Massachusetts
SCOTT R. TIPTON, Colorado SUZAN K. DelBENE, Washington
ERIC A. ``RICK'' CRAWFORD, Arkansas GLORIA NEGRETE McLEOD, California
MARTHA ROBY, Alabama FILEMON VELA, Texas
SCOTT DesJARLAIS, Tennessee MICHELLE LUJAN GRISHAM, New Mexico
CHRISTOPHER P. GIBSON, New York ANN M. KUSTER, New Hampshire
VICKY HARTZLER, Missouri RICHARD M. NOLAN, Minnesota
REID J. RIBBLE, Wisconsin PETE P. GALLEGO, Texas
KRISTI L. NOEM, South Dakota WILLIAM L. ENYART, Illinois
DAN BENISHEK, Michigan JUAN VARGAS, California
JEFF DENHAM, California CHERI BUSTOS, Illinois
STEPHEN LEE FINCHER, Tennessee SEAN PATRICK MALONEY, New York
DOUG LaMALFA, California JOE COURTNEY, Connecticut
RICHARD HUDSON, North Carolina JOHN GARAMENDI, California
RODNEY DAVIS, Illinois
CHRIS COLLINS, New York
TED S. YOHO, Florida
______
Nicole Scott, Staff Director
Kevin J. Kramp, Chief Counsel
Tamara Hinton, Communications Director
Robert L. Larew, Minority Staff Director
______
Subcommittee on General Farm Commodities and Risk Management
K. MICHAEL CONAWAY, Texas, Chairman
RANDY NEUGEBAUER, Texas DAVID SCOTT, Georgia, Ranking
MIKE ROGERS, Alabama Minority Member
BOB GIBBS, Ohio FILEMON VELA, Texas
AUSTIN SCOTT, Georgia PETE P. GALLEGO, Texas
ERIC A. ``RICK'' CRAWFORD, Arkansas WILLIAM L. ENYART, Illinois
MARTHA ROBY, Alabama JUAN VARGAS, California
CHRISTOPHER P. GIBSON, New York CHERI BUSTOS, Illinois
VICKY HARTZLER, Missouri SEAN PATRICK MALONEY, New York
KRISTI L. NOEM, South Dakota TIMOTHY J. WALZ, Minnesota
DAN BENISHEK, Michigan GLORIA NEGRETE McLEOD, California
DOUG LaMALFA, California JIM COSTA, California
RICHARD HUDSON, North Carolina JOHN GARAMENDI, California
RODNEY DAVIS, Illinois ----
CHRIS COLLINS, New York
(ii)
C O N T E N T S
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Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 1
Prepared statement........................................... 2
Submitted statments on behalf of:
Managed Funds Association................................ 61
State Street Global Exchange............................. 66
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
submitted letter............................................... 61
Scott, Hon. David, a Representative in Congress from Georgia,
opening statement.............................................. 3
Witnesses
Duffy, Hon. Terrence A., Executive Chairman and President, CME
Group, Inc., Chicago, IL....................................... 5
Prepared statement........................................... 6
Submitted questions.......................................... 67
Roth, Daniel J., President and Chief Executive Officer, National
Futures Association, Chicago, IL............................... 8
Prepared statement........................................... 10
Culp, Ph.D., Christopher L., Senior Advisor, Compass Lexecon,
Chicago, IL.................................................... 13
Prepared statement........................................... 15
Submitted questions.......................................... 69
Anderson, Michael J., Regional Sales Manager, The Andersons Inc.,
Union City, TN; on behalf of National Grain and Feed
Association.................................................... 23
Prepared statement........................................... 25
Submitted questions.......................................... 71
Koutoulas, Esq., James L., President and Co-Founder, Commodity
Customer Coalition, Inc., Chicago, IL.......................... 30
Prepared statement........................................... 32
Johnson, Theodore L., President, Frontier Futures, Inc., Cedar
Rapids, IA..................................................... 35
Prepared statement........................................... 37
THE FUTURE OF CFTC: PERSPECTIVES ON CUSTOMER PROTECTIONS
----------
WEDNESDAY, OCTOBER 2, 2013
House of Representatives,
Subcommittee on General Farm Commodities and Risk
Management,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 9 a.m., in Room
1300, Longworth House Office Building, Hon. K. Michael Conaway
[Chairman of the Subcommittee] presiding.
Members present: Representatives Conaway, Neugebauer,
Austin Scott of Georgia, Crawford, Roby, Hartzler, Noem,
Benishek, LaMalfa, Hudson, Davis, Lucas (ex officio), David
Scott of Georgia, Vela, Enyart, Vargas, Walz, Negrete McLeod,
and Costa.
Staff present: Debbie Smith, Jason Goggins, Kevin Kramp,
Mary Nowak, Pete Thomson, Tamara Hinton, John Konya, and C.
Clark Ogilvie.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
The Chairman. Good morning. Well, thank you for joining us
this morning as we continue our series of hearings on the
future of the Commodity Futures Trading Commission. Today's
hearing is focused on how to better protect customers in the
futures marketplace.
I would like to extend a warm welcome to all our witnesses
today, and your participation in today's hearing is invaluable
as we work toward the reauthorization of the Commission and
improving how it operates.
Constituents in Texas and Americans across the nation
depend on well functioning financial markets to manage their
businesses. In an increasingly globalized world, these markets
provide access to financial tools that enable even the smallest
firm to compete in any market. Therein, these markets, in
particular, are essential to agricultural producers and
manufacturers across the country as they use products, such as
interest rate swaps and commodity hedges, to protect themselves
from risk.
Yet, today, there is uncertainty across the commodities
market in the wake of the collapse of two futures commission
merchants, MF Global and PFG Best. In both cases, customers who
thought their funds were held in safe segregated accounts
suffered loss, financial losses. Since the failures of MF
Global and the PFG Best, the futures industry has taken several
important concrete steps to improve the strength of the system
overseeing segregated accounts. Among the most noteworthy of
these changes is the daily electronic monitoring of customer
account balances, a simple step that actually led to uncovering
the fraud occurring at Peregrine Financial. Yet despite these
improvements, no surveillance system is fool proof. There will
always be risks inherent in trusting another person with your
money. Honest people make mistakes, and bad people commit
crimes. As mistakes occur, Members on this Committee must
continue to refine the market surveillance systems, but when
crimes occur, it is essential that our justice system acts
deliberately and decisively to punish those who harm others and
cast doubt on the safety of financial markets.
Our challenge is to put in place systems and processes to
ensure mistakes are caught swiftly and wrongdoing is made
exceptionally difficult. As we do so, we must examine whether
the cost of new regulations outweigh the benefits to the
marketplace. In particular, I know that Members of this
Committee are interested in testimony about the CFTC's proposed
rule on customer protections. Many of the farmers and ranchers
who are supposed to be protected by this rule have expressed
deep skepticism of it, which I share with them, because they
believe the CFTC's proposal would significantly increase their
hedging costs and ultimately limit their ability to manage
their risks.
Improving customer protections in futures markets is a
topic that Members on both sides of the aisle have been eager
to explore for some time.
For many of our constituents, the failure of MF Global and
PFG Best added a new worry to their already overcrowded plate
of concerns. An essential part of our job as lawmakers is to
figure out the best way to restore confidence in investors that
funds will always be safe no matter what happens to other
market participants.
I look forward to the testimony from our witnesses today,
and some good conversation about what the industry has fixed so
far, what problems still remain, and what legislative role this
Committee will play in addressing those issues.
Again, I would like to thank our witnesses for their
willingness to share their expertise with us. As well, I would
like to thank all the Members of the Subcommittee for their
continued diligence in these hearings to reauthorize the CFTC.
We will produce a better legislative product because of our
collective engagement on these issues.
[The prepared statement of Mr. Conaway follows:]
Prepared Statement of Hon. K. Michael Conaway, a Representative in
Congress from Texas
Good morning, thank you all for joining us as we continue our
series of hearings on the future of the Commodity Futures Trading
Commission. Today's hearing is focused on how to better protect
customers of the futures marketplace.
I would like to extend a warm welcome to all of our witnesses
today; your participation in today's hearing is invaluable as we work
toward reauthorizing the Commission and improving how it operates.
My constituents in Texas, and Americans across the nation, depend
on well-functioning financial markets to manage their businesses. In an
increasingly globalized world, these markets provide access to
financial tools that enable even the smallest firm to compete in any
market. Derivatives markets, in particular, are essential to
agricultural producers and manufacturers across the country, as they
use products such as interest rate swaps and commodity hedges to
protect themselves from unknown risks.
Yet today, there is uncertainty across the commodities markets in
the wake of the collapse of two futures commission merchants--MF Global
and PFG Best. In both cases, customers who thought their funds were
held in safe, segregated accounts suffered devastating financial
losses.
Since the failures of MF Global and PFG Best, the futures industry
has taken several important, concrete steps to improve the strength of
the system overseeing segregated accounts. Among the most notable of
these changes is the daily electronic monitoring of customer account
balances--a simple step that actually led to the uncovering of the
fraud occurring at Peregrine Financial.
Yet, despite these improvements, no surveillance system is
foolproof. There will always be risks inherent in trusting another
person with your money--honest people make mistakes and bad people
commit crimes. As mistakes occur, regulators and this Committee must
continue to refine the market surveillance systems. But, when crimes
occur, it is essential that our justice system acts deliberately and
decisively to punish those who harm others and cast doubt on the safety
of financial markets.
Our challenge is to put in place systems and processes that ensure
mistakes are caught swiftly and wrongdoing is made exceptionally
difficult. As we do so, we must examine whether the costs of new
regulations outweigh the benefits to the marketplace.
In particular, I know that Members of this Committee are interested
in testimony about the CFTC's proposed rule on customer protections.
Many of the farmers and ranchers who are supposed to be protected by
this rule have expressed deep skepticism of it--which I share with
them--because they believe the CFTC's proposal could significantly
increase their hedging costs and ultimately limit their ability to
manage risk.
Improving customer protections in futures markets is a topic that
Members on both sides of the aisle have been eager to explore for some
time. For many of our constituents, the failure of MF Global and PFG
Best added a new worry to their already overcrowded plate of concerns.
An essential part of our job as lawmakers is to figure out the best way
to restore confidence that an investor's funds will always be safe, no
matter what happens to other market participants.
I look forward to the testimony from our witnesses today and a good
conversation about what the industry has fixed so far, what problems
still remain, and what legislative role this Committee will play in
addressing those issues.
I'd like to again thank our witness panel for their willingness to
share their expertise with us. As well, I'd like to thank all the
Members of this Subcommittee for their continued diligence in these
hearings to reauthorize the CFTC. We will produce a better legislative
product because of our collective engagement on these issues.
With that, I'll turn it over to my friend and partner in these
issues, Ranking Member Scott, for his opening remarks.
The Chairman. With that, I will turn to my friend and
partner in these issues, Ranking Member David Scott for his
opening remarks. David.
OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
Mr. David Scott of Georgia. Thank you, Chairman Conaway.
As always, I would like to join you and--first, turning on
the mike. First, I would like to join you in warmly welcoming
our distinguished witnesses and guests to our Subcommittee.
Today's hearing is one of the final pieces in our effort to
prepare for the coming Commodities Exchange Act
Reauthorization, and I look forward to a robust exchange of
information regarding the protection of customers of futures
commission merchants.
Of course, protection of market participants is one of the
core functions of the CFTC. Unfortunately, it is in an area in
which we have seen several startling lapses in oversight
recently. Whether it is MF Global, Peregrine Financial, or most
recently, the fines against Vision Financial, which ironically,
absorbed much of the portfolio of Peregrine upon its collapse,
one has to ask questions about the structure of the current
oversight system and its appropriateness for the way the
markets currently operate.
That is not to say that the CFTC isn't working hard. They
are working hard to ensure that customer funds are not
commingled with company funds. However, the CFTC is being asked
to provide oversight for markets that have grown exponentially,
extraordinarily much larger over the last 10 years, and all the
while attempting to implement a very complex and complicated
new financial regulatory regime in Dodd-Frank, without a
sufficient increase in the resources and funds and staff that
they need to be made available to them to do the job. This is
so important. We have to stress the appropriate appropriations
level if we are going to put these demands on the CFTC. If the
markets have grown as they have grown, then we have to grow
their budget to match and make sure they have the resources to
do their job.
And as such, the CFTC has been forced because of a lack of
funds, because of a lack of standing, to become reliant on
self-reporting and third-party auditing. That is not the way to
go, because that only opens up room for error and outright
criminal activity, and that is what we have seen.
And, unfortunately, when we see problems with the futures
commission merchants, it negatively affects their customers and
our constituents, like our farmers, our co-ops, our
corporations, like Delta and Coca-Cola in my district, and
ultimately all of the American people are affected, which is
what brings us here today.
So, Mr. Chairman, again, I thank you for holding this
important hearing. The perspectives of market participants and
the CFTC's work in protecting customers in the FCMs will indeed
be vital as we move forward. We must ensure that whatever
regime the CFTC moves and puts into place works well with all
involved in the market, reducing risk and protecting customer
funds without significantly raising the price of doing
business.
So, our examination here today will help in that respect.
Thank you, I yield back the balance of my time.
The Chairman. I thank the gentleman.
I also recognize that the full Committee Chairman, Mr.
Frank D. Lucas, is with us this morning. And Frank will be
participating in the inquisition of our witnesses shortly.
The chair would request that other Members submit their
opening statements for the record so that witnesses may begin
their testimony and to ensure that there is ample time for
questions.
I would like to welcome our panel of witnesses. I will
introduce all six of them, and then we will start with Mr.
Duffy.
Mr. Duffy is Executive Chairman and President of CME Group
in Chicago, Illinois. We also have Mr. Daniel Roth, President
and CEO with the National Futures Association from Chicago. We
have Dr. Christopher Culp, Senior Advisor, Compass Lexecon from
Chicago, Illinois. We have Michael J. Anderson, Regional Sales
Manager of The Andersons, Inc., Union City, Tennessee, on
behalf of National Grain and Feed Association, and we have
James Koutoulas--is that close, James?
Mr. Koutoulas. Pretty close.
The Chairman. All right, Buddy. Esquire, President and
Cofounder of the Commodity Customer Coalition, Chicago,
Illinois, and Mr. Ted Johnson, the President of Frontier
Futures, Inc., from Cedar Rapids, Iowa.
So, with that, Mr. Duffy, please begin.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
PRESIDENT, CME GROUP, INC., CHICAGO, IL
Mr. Duffy. Thank you. Good morning, Chairman Conaway,
Ranking Member Scott. I want to thank you for the opportunity
to testify regarding customer protection in the futures
industry.
CME, NFA, and others responded to the failures of MF Global
and PFG by enhancing customer protections. These enhancements
include: Daily segregated--segregation reporting by all FCMs;
increased surprise reviews of segregation compliance; bimonthly
reporting on investment of customer funds; periodic electronic
confirmation of customer balances; daily feeds showing balances
of cash and securities for all customer accounts at
depositories; and CEO/CFO sign-offs on significant customer
fund distributions.
The CFTC's proposed rules codify many of these initiatives.
In addition, the CFTC has required gross margining at the
clearinghouse level. This further protects customers from the
kind of losses caused by MF Global and PFG.
Unfortunately, CFTC also has proposed a bad rule. This has
justifiably raised concerns among participants in the
agricultural markets and many Members of Congress. The rule
would require FCMs to ensure that each customer's account is
fully collateralized at all times. The problem is FCMs cannot
accurately calculate customer margin requirements in real-time.
Particularly, this means that--or practically, this means that
customers will be required to double their margin requirements,
or two, FCMs will be required to contribute very large sums as
residual interest on behalf of their customers.
This rule will make the marginally profitable FCM business
unsustainable for many firms that serve the agricultural
community. Further, it may deprive not just FCMs but their
customers' access to futures markets.
The residual interest rule is not necessary to protect
customer funds. It's costs and the negative consequences
outweigh any added protection. This over-collateralized--
collateralization is unwarranted from a risk-management
standpoint. No regulatory risk model assumes that all customers
with margin requirements will fail to meet them.
The proposed ruled would drain liquidity and increase the
cost of hedging financial and commodity risk, especially for
farmers and ranchers using our markets. Unfortunately, the
greatest impact of increased costs would be felt by the smaller
and mid-sized firms that serve them. They may be driven out of
business.
The unintended consequences is that this would actually
increase systemic risk by concentrating risk among fewer firms.
Ironically, the proposal would force customers to place more
collateral with their FCM at the very time they may be trying
to avoid fellow-customer risk or FCM misconduct.
We understand the Commission is considering phasing in the
rule, possibly to mitigate the consequences I just described. A
phase-in does not cure the problem, however. Instead, CME
supports the FIA alternative. This approach would permit an FCM
to calculate its required residual interest as of 6 p.m. on the
first day after the trade date.
Now I would like to comment on adopting an insurance
regime. Professor Culp concludes that the only workable
insurance is likely private insurance. This insurance would be
provided through a company owned by participating FCMs. There
seems to be no commercial interest in providing insurance to
individual customers or specific FCMs. He also explains that it
is not feasible to have universal futures insurance mandated by
the government similar to SIPC. Professor Culp points out that
its funding, based on the FCM's gross revenues, would be highly
regressive. Large FCMs would pay a lopsided share while their
customers would likely benefit the least from the $250,000
coverage.
He concludes that the first year of funding, estimated at
$25 million would not grow fast enough to reach the target
level of $2.5 billion, until more that 5 decades later. So,
without a government backstop, the plan would significantly
underfund relative to potential private solutions, and we
certainly would not support imposing the burden on the
taxpayers.
Customer protection is the cornerstone of our industry. We
have strengthened our approach, and we will continually
consider ways to enhance the safety of customer property. At
the same time, we strive to avoid unnecessary cost or change to
market structure.
This will serve customer needs by making certain that we
have deep pools of liquidity that allows customers to mitigate
their risk.
I thank you, Mr. Chairman. I look forward to answering your
questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
President, CME Group, Inc., Chicago, IL
Good morning, Chairman Conaway, and Ranking Member Scott. I am
Terry Duffy, Executive Chairman and President of CME Group.\1\ Thank
you for the opportunity to testify today regarding the protection of
customer property in the futures industry.
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\1\ CME Group Inc. is the holding company for five exchanges, CME,
the Board of Trade of the City of Chicago Inc. (``CBOT''), the New York
Mercantile Exchange, Inc. (``NYMEX''), the Commodity Exchange, Inc.
(``COMEX'') and The Board of Trade of Kansas City Missouri, Inc.
(``KCBT'') (collectively, the ``CME Group Exchanges''). The CME Group
Exchanges offer a wide range of benchmark products across all major
asset classes, including derivatives based on interest rates, equity
indexes, foreign exchange, energy, metals, agricultural commodities,
and alternative investment products. The CME Group Exchanges serve the
hedging, risk management, and trading needs of our global customer base
by facilitating transactions through the CME Group Globex electronic
trading platform, our open outcry trading facilities in New York and
Chicago, and through privately negotiated transactions subject to
exchange rules.
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CME Group Exchanges, the National Futures Association (``NFA'') and
other U.S. exchanges responded to failures at MF Global and Peregrine
Financial Group (``PFG'') by enhancing the protection of customer
property held by futures commission merchants (``FCM''). These
enhancements include:
Daily segregation reporting by all FCMs,
Increased surprise reviews of segregation compliance,
Bi-monthly reporting on investment of customer funds,
Periodic electronic confirmation of customer balances,
Daily feeds showing balances of cash and securities for all
customer accounts at depositories, and
CEO/CFO signoffs on significant customer fund distributions.
These programs and rules mitigate the risk of, and augment the
early detection of, the improper transfer of customer funds and the
improper reporting of customer asset balances, and improve our ability
to check compliance with CFTC requirements for the investment of
customer funds. Our efforts to enhance our monitoring continue today
through the use of an account balance aggregation tool, which
facilitates analysis of all of the firm's customer account balances
across all of its reporting banks. Timely, including daily, access to
this additional information is enabling us to better direct our
regulatory resources at risk-based reviews of customer balances at
clearing members and FCMs and their activity with respect to those
balances.
The CFTC's proposed rules codify many of these initiatives.\2\ In
addition, the CFTC has required gross margining at the clearing house
level. This further protects customers from the kind of losses caused
by MF Global and PFG.
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\2\ NPR dated November 14, 2012 entitled, ``Enhancing Protection
Afforded Customers and Customer Funds held by Futures Commission
Merchants and Derivatives Clearing Organizations.'' 77 FR 67866.
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Residual Interest
CME remains fully committed to protecting customers against the
full range of FCM conduct that may cause customer harm. But it is
important to weigh the costs and consequences of each ``protective''
measure against the benefits to customers. We believe that the CFTC's
proposal respecting the required residual interest that must be
maintained by FCMs in the customer segregated account will adversely
impact customers and fundamentally change the way in which futures
markets operate.\3\ If a proposed ``protective'' measure is so
expensive or its impact on market structure is so severe that customers
cannot effectively use futures markets to mitigate risk or discover
prices, there is no justification for implementing that measure. The
proposal on ``residual interest'' fails this test. It has justifiably
raised concerns among participants in the agricultural markets and many
Members of Congress.
---------------------------------------------------------------------------
\3\ CME Group filed comments to the CFTC's proposed rulemaking by
letter dated February 15, 2013 from Kim Taylor, President, CME
Clearing. (RIN 30-38-AD88).
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The rule would require FCMs to insure that each customer's account
is fully collateralized ``at all times.'' \4\ FCMs cannot accurately
calculate customer initial and variation margin requirements in real
time. Practically, this means that customers will be required to double
their margin requirements or FCMs will be required to contribute very
large sums as ``residual interest'' on behalf of their customers. This
rule will make the marginally profitable FCM business unsustainable for
many firms that serve the agricultural community, and may deprive them
and their customers of access to futures markets.
---------------------------------------------------------------------------
\4\ It would require each FCM to maintain ``at all times'' residual
interest in its customer accounts sufficient to exceed the sum of all
customer margin deficits.
---------------------------------------------------------------------------
The residual interest rule is not necessary to protect customer
funds. Its costs and negative consequences outweigh any added
protection. This over-collateralization is unwarranted from a risk
management standpoint. No regulatory risk model assumes that all
customers with margin requirements will fail promptly to meet them. The
proposed rule will unnecessarily drain liquidity and increase the cost
of hedging financial and commercial risk especially for farmers and
ranchers using our markets. Smaller and mid-sized firms that serve them
will suffer the greatest impact of these increased costs, and may be
driven out of business, leaving farmers and ranchers with fewer FCMs to
facilitate their risk management goals. This will actually increase
systemic risk by concentrating risk among fewer firms. Ironically, the
proposal would force customers to place more collateral with their
FCM--when they may be trying to actively avoid fellow-customer risk or
FCM misconduct.
We understand the Commission is considering phasing in the rule,
possibly to mitigate the consequences I just described. A phase-in does
not cure the problem. Instead, CME supports the FIA alternative--that
would permit an FCM to calculate its required residual interest as of 6
p.m. on the first business day after the trade date.\5\
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\5\ Comment Letter dated February 15, 2013 from Walt Lukken,
President, FIA re: RIN 3038-AD88 Enhancing Protections Afforded
Customers and Customer Funds Held by Futures Commission Merchants and
Derivatives Clearing Organizations, 77 Fed. Reg. 67866 (November 14,
2012).
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Bankruptcy Code
We believe that Congress could further enhance customer protections
through amendments to the Bankruptcy Code. Potential amendments range
from fundamental changes that would facilitate individual segregation
of customer property to narrower revisions that would enhance a
clearinghouse's ability to promptly transfer positions of non-
defaulting customers. While amending the Bankruptcy Code is a
significant undertaking, CME Group believes that modification to the
bankruptcy regime in light of recent experience would benefit customers
and the market as a whole.
Insurance
In the wake of MF Global and PFG, some have advocated establishing
an insurance scheme to further protect futures customers and restore
their confidence in our markets. Like other ``protective measures,'' an
insurance proposal must be analyzed in light of the costs and
potentially limited benefits of such an approach.
To that end, CME Group, the Futures Industry Association (``FIA''),
the Institute for Financial Markets (``IFM'') and NFA engaged Compass
Lexecon to study the costs and benefits of adopting an insurance regime
for the U.S. futures industry.
It's notable that Professor Culp's written testimony concludes that
the only possible workable insurance is likely private insurance
provided through a company owned by FCMs that choose to participate.
There seems to be no commercial interest to provide insurance to
individual customers or on a FCM specific basis.
He also explains that a government-mandated universal futures
insurance, similar to SIPC for securities is not feasible. Professor
Culp points out that its funding--based on an FCM's gross revenues--
would be regressive with large FCMs paying a lop-sided share, while
their customers would likely benefit the least from the $250,000
coverage. He concludes that first year funding estimated at $25 million
could barely cover an average loss caused by a default of small and
medium FCMs.
Without a government backstop, the plan would be significantly
under-funded relative to potential private solutions. And we certainly
would not support imposing this burden on the taxpayers.
Conclusion
Customer protection is the cornerstone of our industry. We've
strengthened our approach, and we will continually consider ways to
enhance the safety of customer property. At the same time, we strive to
avoid unnecessary cost or changes to market structure that would
negatively impact the deep pools of liquidity our customers rely on to
mitigate their risks.
The Chairman. Thank you, Mr. Duffy.
Mr. Roth.
STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, IL
Mr. Roth. Thank you, Mr. Chairman.
I certainly think it is appropriate that the focus of
today's hearing is customer protection issues, and certainly at
NFA, that is what we focus on every day.
And as both the Chairman and Ranking Member pointed out in
their opening statements, over the last 2 years, the failures,
first at MF Global and then at Peregrine, certainly highlighted
the need to strengthen the overall regulatory structure, and
over the last 2 years, that is exactly what we have been
working on. We have worked very closely with the CFTC and with
the CME and with the entire industry. And just as Mr. Duffy
reviewed, we have implemented--developed and implemented a wide
range of regulatory enhancements that are described in my
written testimony. And they are all important. They are all
significant, but if I could focus your attention on one, it
would be one that Mr. Duffy mentioned as well, and that is the
daily confirmation of segregated balances.
So, for years and years, we have required FCMs to issue
daily reports with either the NFA or CME regarding the amount
of customer funds that they are holding. And then what we would
do is, among other things, we would confirm those balances
reported by the FCMs. We confirm those balances to outside
sources, to the banks holding those funds as part of the annual
examination process.
Well, clearly, that wasn't good enough. We had to find a
better way to do this, and that is exactly what we have done.
We have partnered with the CME, and together we developed this
system that provides for the daily confirmation of segregated
balances so that we receive reports from over 2,000 bank
accounts confirming the balances that those banks are holding
for customer segregated funds, and then we perform an automated
comparison between the reports from the FCM and the reports
from the bank to identify any sort of suspicious discrepancies.
So that daily confirmation process, along with all the
other regulatory enhancements that we have made, clearly make
the regulatory structure now significantly stronger than it was
2 years ago. And we are very gratified, really, that so many of
the changes that we developed were incorporated into the CFTC's
rule proposal, and we support so much of what is in the CFTC's
rule proposal.
But as Mr. Duffy mentioned, there are other aspects of that
rule that are very, very troubling. And let me just add a few
points with respect to residual interest. What the Commission
basically is proposing would require every FCM to assume that
every customer is going to default on every margin call, and
then there--make sure that they always have enough funds on
hand to cover that possibility.
Well, let me make four quick points. Number one, this rule
proposal on residual interest has absolutely nothing to do with
either MF Global or Peregrine. Neither one of those cases had
anything to do with customers not meeting margin calls.
Number two, this is first time in its 39 year history that
the Commission has taken this position, that somehow the Act
requires FCMs to assume that all customers will default on all
margin calls. They have never taken that position before.
Number three, there is underlying assumption under this
rule that all customers meet their margin calls with wire
transfers and that nobody writes checks anymore, and that
assumption is just not right, particularly in the ag sector,
where the--both ag end-users and the FCMs that service them
regularly accept checks as margin payment.
And fourth, just as Mr. Duffy mentioned, this proposal
could have a devastating impact on both end-users and the FCMs
that service the ag industry.
Like Terry said, either the customers have to put up a lot
more money or the FCMs have to put up a lot more money or both,
and the net effect is that, you are going to have fewer farmers
using the futures markets to hedge their risk and fewer FCMs to
service those customers. It is a bad idea and it shouldn't go
forward.
Finally, Mr. Chairman, let me just mention the Griffin
Trading case again. I have testified about it before. Over 30
years ago, the CFTC adopted a rule which provides that if an
FCM bankruptcy proceeding, that if there is a shortfall in
customer segregated funds, the term customer property includes
all of the assets of the FCM until the customers have been made
whole, and I think that is a really good rule. It has been on
the books a long time. It gives customer the--customers the
priority and the protection they deserve.
But several years ago, a Federal district court cast some
doubt about the validity of that rule. They issued a decision,
which was later vacated, which questioned the Commission's
authority to adopt that rule that they did.
Well, I think we have to address that and we have to
eliminate that doubt. We have to eliminate that cloud of
uncertainty. And I don't think that requires us to amend the
Bankruptcy Code. And I don't think that requires us to have
FCMs run around and get a multitude of subordination agreements
from various creditors. Section 20 of the Act deals with FCM
bankruptcy proceedings. I think we can amend section 20 of the
Commodity Exchange Act to make very clear the Commission's
authority to adopt the rule that it adopted, and we would be
happy to work with staff to develop that language.
Mr. Chairman, thank you very much for the opportunity to
testify, and I look forward to answering any questions.
[The prepared statement of Mr. Roth follows:]
Prepared Statement of Daniel J. Roth, President and Chief Executive
Officer, National Futures Association, Chicago, IL
Chairman Conaway, Ranking Member Scott, Members of the Committee,
thank you for the opportunity to testify at this important hearing. My
name is Daniel Roth and I am the President of National Futures
Association. As Congress begins the reauthorization process, customer
protection issues should be front and center in everybody's mind.
Customer protection is the heart and soul of what we do at NFA, and for
years the futures industry had an impeccable reputation for
safeguarding customer funds. Since Congress last considered
reauthorization, though, that reputation has taken a serious hit. First
at MF Global and then at PFG, customers suffered very real harm from
shortfalls in customer segregated funds, the kind of harm that all
regulators seek to prevent. Clearly, dramatic improvements had to be
made. In the wake of MF Global and PFG, NFA has worked very closely
with the CME, other self-regulatory organizations and the CFTC to bring
about those improvements. In my testimony today I would like to
describe some of the improvements that have already been made, discuss
the CFTC's proposed customer protection rules and suggest changes to
the Commodity Exchange Act that would strengthen customer protections
in any FCM bankruptcy proceeding.
Regulatory Improvements
Daily Confirmation of Segregated Account Balances
For years, NFA and other SROs confirmed FCM reports regarding the
customer segregated funds held by the FCM through traditional paper
confirmations mailed to the banks holding those funds. These
confirmations were done as part of the annual examination process. In
early 2012 NFA began confirming bank balances electronically through an
e-confirm process. That change led to the discovery of the fraud at
PFG, but e-confirms were still done as part of the annual examination.
We had to find a better way and we did.
We partnered with the CME and developed a process by which NFA and
the CME confirm all balances in all customer segregated bank accounts
on a daily basis. FCMs file daily reports with NFA and the CME,
reflecting the amount of customer funds the FCM is holding. Through a
third-party vendor, NFA and CME get daily reports from banks for the
over 2,000 customer segregated bank accounts maintained by FCMs. We
then perform an automated comparison of the reports from the FCMs and
the reports from the banks to identify any suspicious discrepancies. In
short, Mr. Chairman, the process by which we monitor FCMs for
segregated fund compliance is now far ahead of where it was just 1 year
ago.
We have recently expanded this system to also obtain daily
confirmations from clearing firms and will expand it again by the end
of the year to include clearinghouses as well.
FCM Transparency
One of the lessons we learned from MF Global is that customers
should not have to study the footnotes to an FCM financial statement to
find out how their segregated funds are invested or other financial
information about their FCMs. We had to make it easier for customers to
do their due diligence on financial information regarding FCMs. For
years, NFA required FCMs to file certain basic financial information
with NFA, and that information is now posted on NFA's website for
customer review. The information includes data on the FCM's capital
requirement, excess capital, segregated funds requirement, excess
segregated funds and how the firm invests customer segregated funds.
This information is displayed for each FCM and includes historical
information in addition to the most current data. The display of FCM
financial information on NFA's website began in November 2012 and so
far these web pages have received over 25,000 hits.
MF Global Rule
All FCMs maintain excess segregated funds. These are funds
deposited by the FCM into customer segregated accounts to act as a
buffer in the event of customer defaults. Because these funds belong to
the FCM, the FCM is free to withdraw the excess funds, but after MF
Global, NFA and the CME adopted rules to ensure notice to regulators
and accountability within the firm. Now all FCMs must provide
regulators with immediate notification if they draw down their excess
segregated funds by 25% in any given day. Such withdrawals must be
approved by the CEO, CFO or a financial principal of the firm and the
principal must certify that the firm remains in compliance with
segregation requirements. This rule became effective on September 1,
2012.
FCM Internal Controls
NFA, CME and other SROs developed more specific and stringent
standards for the internal controls that FCMs must follow to monitor
their own compliance with regulatory requirements. In May 2013, NFA's
Board approved an interpretive notice that contains specific guidance
and identifies the required standards in areas such as separation of
duties; procedures for complying with customer segregated funds
requirements; establishing appropriate risk management and trading
practices; restrictions on access to communication and information
systems; and monitoring for capital compliance. NFA submitted the
interpretive notice to the CFTC on May 22, 2013, for its review and
approval.
Review of NFA Examination Procedures
NFA's Special Committee for the Protection of Customer Funds--
consisting of all public directors--commissioned an independent review
of NFA's examination procedures in light of the PFG fraud. The study
was conducted by a team from the Berkeley Research Group (``BRG'') that
included former SEC personnel who conducted that regulator's review of
the SEC's practices after the Madoff fraud. BRG's report was completed
in January 2013. The report stated that ``NFA's audits were conducted
in a competent manner and the auditors dutifully implemented the
appropriate modules that were required.'' The report, however, also
included a number of recommendations designed to improve the operations
of NFA's regulatory examinations in the areas of hiring, training,
supervision, examination process, risk management, and continuing
education. All of the recommendations of the BRG report have been
addressed and, as a result, NFA has:
Revised and beefed up its examination modules regarding
segregated funds, capital compliance, internal controls and the
exam planning process;
Made staffing changes so that experienced managers and
directors spend more time in the field for every examination;
Increased its recruiting and hiring of more experienced
examiners; and
Made further improvements to its training programs.
Certified Fraud Examiner Training
At the end of the day, the examinations performed by SROs in the
futures industry are not about crossing ``T''s and dotting ``I''s--they
are about detecting violations of SRO rules--including anti-fraud
rules. That is why we have greatly expanded our use of the training
programs of the Association of Certified Fraud Examiners. Becoming
certified as a fraud examiner involves extensive training, testing and
continuing education requirements. In the last year over half of our
staff has obtained the certification and we are now requiring all of
our compliance staff to obtain that certification.
Strengthening Customer Protections in FCM Bankruptcy Proceedings
Both the PFG and MF Global bankruptcies highlighted the need for
greater customer protections to not only guard against the loss of
customer funds but also in the event of an FCM's insolvency. As
discussed above, NFA has made and continues to implement changes to
enhance the safety of customer segregated funds and guard against a
shortfall in customer funds in the event of any future FCM failures.
NFA believes, however, that Congress should consider a statutory
change to strengthen customer protections and priorities in the event
of a future FCM bankruptcy. Over 30 years ago the CFTC adopted rules
regarding FCM bankruptcies. Among other things, those rules provided
that if there was a shortfall in customer segregated funds, the term
``customer funds'' would include all assets of the FCM until customers
had been made whole. Several years ago, a district court decision cast
doubt on the validity of the CFTC's rule. That decision was
subsequently vacated but a cloud of doubt lingers. Congress can and
should remove that doubt about the priority customers should received
if there is a shortfall in segregated funds and can do so by amending
Section 20 of the Act. Section 20 gives the CFTC authority to adopt
regulations regarding commodity brokers that are debtors under Chapter
7 of Title 11 of the United States Code. We would suggest an amendment
to clarify the CFTC's authority to adopt the rule that it did. We
believe there is a broad base of industry support for this approach and
would be happy to work with Congress on specific proposed language.
CFTC's Proposed Customer Protection Rules
NFA worked closely with the CFTC staff in developing many of the
regulatory improvements described above. The Commission also proposed
its own changes to customer protection rules in a 107 page Federal
Register release last year. Certain parts of the Commission's proposals
have provoked strong opposition both from the industry and from end-
users of the markets, particularly in the agricultural sector. As
described below, NFA shares many of the concerns raised by others, but
we fully support many of the Commission's proposals. For example, the
Commission's proposed rules would:
Require SROs to expand their testing of FCM internal
controls and develop more sophisticated measures of the risks
posed by each FCM;
Require that FCM certified annual financial reports and
reports from the chief compliance officer be filed within 60
days of the firm's fiscal year end;
Require that an FCM that is undercapitalized provide
immediate notice to the Commission and its DSRO; and
Require each FCM to establish a risk management program
designed to monitor and manage the risks associated with the
FCM's activities.
Other provisions of the Commission's proposals, however, raise
serious concerns, particularly with regard to the so-called ``residual
interest'' issue. FCMs have always maintained an amount of its own
capital in customer segregated accounts to act as a buffer for
customers who fail to meet their margin obligations in a timely manner.
This amount is often referred to as the FCM's ``residual interest'' in
the segregated account. The Commission has now proposed that all FCMs
must maintain at all times a residual interest sufficient to exceed the
sum of all margin deficits that the customers in each account class
have. Essentially, FCMs would have to assume that every customer will
default on every margin call and maintain capital in the segregated
account to cover that possibility.
Several points need to be made on this proposal. First, it has
absolutely nothing to do with the problems encountered at either MF
Global or PFG. Neither of those cases had anything to do with customers
failing to meet margin calls. Second, this is the first time in the
Commission's 39 year history that it has ever taken the position that
the Act requires FCMs to assume that all customers will default on all
margin calls. Third, the underlying assumption that in this day and age
no customers meet margin calls by writing checks is wrong. Agricultural
hedgers frequently meet their margin calls with checks. Fourth, the
impact of this proposal could be devastating for both agricultural end-
users and the relative handful of FCMs that service those customers.
Customers will have to post much more margin funds with their FCMs or
the FCMs will have to maintain much more capital in their business.
Either way, there will be fewer customers using futures markets to
hedge and fewer FCMs handling their accounts. This proposal does not
just fix something that is not broken, it threatens to do real harm to
a longstanding system that has worked well for both customers and the
markets.
The Commission has also proposed new requirements for SROs, most of
which we support. However, the Commission's proposals blur important
distinctions between the annual examinations of FCMs performed by CPAs
and those performed by SROs. Each year an FCM must have a certified
financial audit performed by a CPA. The CPA issues a report expressing
an opinion with respect to the FCM's financial statements or issues an
Accountant's Report on Material Inadequacies. The SRO examination, on
the other hand, focuses on FCM compliance with the rules of the CFTC
and the SRO. Certainly, there are areas of overlap between the two
examinations but there are also marked differences in focus and
purpose. The Commission proposes that an SRO apply Generally Accepted
Auditing Standards to every aspect of its FCM examination, not just in
those areas where the SRO and CPA exams overlap. This is overbroad and
will add unnecessary costs and burdens to the examination process.
Customer Account Insurance Study
The failures of MF Global and PFG have generated renewed calls for
some form of customer account insurance. Abstract discussions of this
question do not help answer the two key questions: what type of
insurance would be available and what would it cost. To answer those
questions NFA joined with FIA, CME and the Institute for Financial
Markets to sponsor the study being conducted by Dr. Christopher Culp,
who is also a witness at today's hearing. Dr. Culp is awaiting pricing
proposals from London reinsurance companies that would be part of a
private sector solution.
Dr. Culp's research on this issue has been thorough and methodical.
Based on his data, we would agree with his preliminary conclusions that
for the vast majority of customers at the larger FCMs various forms of
customer account insurance would be of little or no interest and that,
given the size of these larger customers, the cost of a mandatory
insurance program for all customers of all FCMs would be cost
prohibitive, whether sponsored by the government or by the private
sector. Dr. Culp's research thus far, though, indicates that for
smaller FCMs with customers who maintain smaller balances there may be
a voluntary private sector solution. Ultimately, the viability of that
option will depend on the price quotes for reinsurance and on the
demand for the product among smaller FCMs and their customers. We look
forward to Dr. Culp's final report.
Conclusion
Detecting and combating fraud is central to our mission. No system
of regulation can ever completely eliminate fraud, but we must always
strive for that goal. The process of refining and improving regulatory
protections is ongoing and the initiatives outlined above do not mark
the end of our efforts. We look forward to working with Congress, the
CFTC, SROs and the industry to ensure that customers have justified
confidence in the integrity of the U.S. futures markets.
The Chairman. Thank you, Mr. Roth.
Dr. Culp.
STATEMENT OF CHRISTOPHER L. CULP, Ph.D. SENIOR ADVISOR, COMPASS
LEXECON, CHICAGO, IL
Dr. Culp. Excuse me, Chairman Conaway, Ranking Member
Scott, other Members of the Committee, thank you very much for
the opportunity to appear here today.
In December 2012, Compass Lexecon was engaged by CME,
Futures Industry Association, NFA, and the Institute for
Financial Markets to conduct an analysis of the potential
benefits and costs of a customer asset protection insurance
scheme of some kind that would apply to customers of U.S.
futures commission merchants. I was the director and am the
director of the study, and I am pleased to give you a progress
report today on where we stand with the study, as well as offer
some preliminary conclusions based on what the data and our
discussions with market participants have thus far
demonstrated.
Just to be clear, the risk that we are contemplating would
be potentially covered by customer asset insurance is the risk
that an FCM failure would result in losses of customer assets
if the FCM is undersegregated when it fails. In other words,
the customer assets actually at the FCM are below the
liabilities to customers of the FCM. That can occur for two
reasons. One would be the misfeasance or malfeasance, as
occurred, for example with MF Global and Peregrine. Another
concern of some market participants is that so-called fellow-
customer risk could impose undersegregation related losses.
Fellow-customer risk occurs when one or more customers of the
FCM face significant losses, miss a margin call, and that
results in a deficiency in customer funds, that, in turn,
results in asset losses for the other non-defaulting customers.
When evaluating the potential benefits of any kind of
customer insurance regime, you have to keep in mind two things:
The insurance doesn't exist in isolation, so the benefit of
insurance has to be considered both with respect to the cost
and to the probability that the underlying risk event will
actually occur. I am not here to discuss these various other
enhanced protections that have occurred since MF Global, but
these protections that the other panelists are all discussing
are relevant because, to the extent these additional
protections are working to reduce the risk that there is an
undersegregation at the time of an FCM failure, the value of
insurance becomes potentially less with respect to its
potential cost.
A significant objective of our study has been to try to
estimate or quantify the cost of alternative insurance
scenarios. Specifically, we considered four scenarios. Three
private scenarios. First, direct provision of customer
insurance by primary insurance companies. Second, direct
provision of customer insurance to FCMs, on FCM-by-FCM basis.
The third scenario is an industry risk retention group in which
a group of FCMs collectively capitalize an insurance company
that provides insurance to the customers of the participating
FCMs. Those FCMs would retain and bear some of the first loss
exposure in the event that there is an FCM failure, but
reinsurance would then provide the primary source of capital on
top of that first loss layer.
The final scenario we considered is a mandated, government
mandated universal SIPC-like structure, in which every customer
of U.S. futures commission merchant would receive up to
$250,000 in insurance coverage. In return, that coverage would
be funded by a SIPC-like investor protection fund for futures
that is paid for by, under the current proposal, 0.5 percent of
the previous year's gross annual revenues from futures of each
and every U.S. FCM on a mandatory basis, and that would be a
target funding level for the fund of $2.5 billion.
To facilitate the analysis of the three private scenarios,
we have engaged for the better part of a year in a
comprehensive data collection and analysis and empirical
exercise, in which case we obtained customer level data from
FCMs. We contacted a number of FCMs and received responses from
six, two large, two medium, two small. We consider these
broadly representative. We then worked with CME Group to
conduct stress tests of this information and data so that we
could examine what kind of customer assets might be at risk if
an FCM happened to file during catastrophic market conditions.
We then showed summary analyses from those results to about
ten potential interested insurance and reinsurance companies.
All of them remain interested at this point. We do not have
quotes or indicative cost estimates from any of them, but we
are awaiting those and will provide them with the final study
to this Committee when it is completed.
We can, however, offer several preliminary observations.
First, as Mr. Duffy mentioned, we received no indication of
interest in the direct provision of the FCM level or customer
level insurance from insurance market participants. We have,
however, received interest in the reinsurance aspect for a
voluntary opt-in risk retention group. Our analysis also
suggests that a government mandated universal coverage scheme
could potentially suffer from significant drawbacks and
concerns, one of which is that the vast bulk of the benefit of
retail-oriented kind of investor protection fund would accrue
benefits to the customers that are not bearing a proportional
amount of the cost.
For example, in 2012, the average amount of assets on
deposit at small and medium FCMs was about $100,000 in our data
sample, as compared to about $25 million at large FCMs, and yet
the large FCMs would be responsible for bearing a
disproportionate amount of the cost. In addition, the fund
would accrue money over time very slowly at about $25 million a
year, using 2012 numbers, and it would virtually necessitate a
government backstop to close the gap to the $2.5 billion
funding level.
Finally, it would crowd out and discourage innovative
market solutions, like the retention group, and it would
essentially freeze a mandated structure in place and complicate
the ability of voluntary solutions to close the gap. And I will
be happy to cover any additional materials you have during the
questions. Thank you for your time.
[The prepared statement of Dr. Culp follows:]
Prepared Statement of Christopher L. Culp, Ph.D., Senior Advisor,
Compass Lexecon, Chicago, IL
Chairman Conaway, Ranking Member Scott, and other Members of the
Committee, thank you for inviting me to appear today. My name is
Christopher Culp. I am a Senior Advisor with Compass Lexecon (a
consulting firm that applies the principles of economic analysis to
legal and regulatory issues), an Adjunct Professor of Finance at The
University of Chicago's Booth School of Business (where I have taught
MBA courses since 1998 on subjects including derivatives and
insurance), and a Professor for Insurance at the University of Bern in
Switzerland. I have a Ph.D. in finance, have authored four books and
coedited two books on derivatives, insurance, structured finance, and
risk management, have published numerous articles on those same topics,
and have provided consulting services in these areas for the last 19
years.
In December 2012, Compass Lexecon was engaged by the CME Group
(``CME''), Futures Industry Association (``FIA''), Institute for
Financial Markets (``IFM''), and National Futures Association (``NFA'')
(collectively, the ``Sponsors'') to conduct a study of how customer
asset protection insurance (``CAPI'') might work in the U.S. futures
industry and to evaluate the economic benefits and costs of alternative
CAPI approaches (the ``Study''). Before I give you a report on our
progress, I begin by providing some background and context for the
Study.
Background
The U.S. futures industry has been in the business of providing
risk-management products and solutions to customers since the mid-19th
Century. Typical futures customers include commercial entities like
grain elevators, cooperative associations of farmers, non-financial
multinationals, asset managers, commodity pool operators, proprietary
trading firms, and retail traders. Many of these futures market
customers use futures and options to manage the risks that they face in
their primary businesses in order to stabilize their costs and insulate
themselves from swings in market prices that could give rise to
catastrophic losses.
Futures customers execute their transactions through futures
commission merchants (``FCMs''). Those transactions are cleared by
central counterparties (``CCPs'') like CME. CCPs function as the
counterparty of record for all futures transactions and guarantee the
performance on all trades. CCPs manage their risk exposures to trading
counterparties in part by limiting their direct credit exposures only
to ``clearing members.'' Although all futures customers execute their
transactions through FCMs, only some FCMs are CCP clearing members. Any
trades executed by non-clearing FCMs must be guaranteed by a clearing
FCM.
In order to provide trustworthy and safe risk-management solutions
to customers, FCMs and CCPs must manage their own risks, preserve the
integrity of the marketplace, and offer a risk-management solution in
which market participants have confidence. In that regard, the U.S.
futures industry has a long track record of successfully navigating a
wide variety of market disruptions and high-profile defaults like
Drexel Burnham Lambert, Refco, and Lehman Brothers.\1\ The
effectiveness of the futures trading risk-management system is largely
attributable to several guiding principles that have been in place
since the turn of the 19th century.
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\1\ All of these firms failed for reasons unrelated to their U.S.
futures businesses, and their customer funds remained properly
segregated at all times.
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The first guiding risk-management principle in futures markets is
that all trading participants must post a performance bond before
entering into a new position and must maintain a required minimum
margin amount throughout the life of an open trade. These minimum
``initial margin'' requirements are generally set to cover 99 percent
of potential price changes over the time the CCP expects it would take
to close out or hedge a losing position, which, for most products, is a
day or less. Customers must deposit margin with their FCM(s), non-
clearing FCMs must deposit margin with their clearing FCMs, and
clearing FCMs must deposit margin with CCPs. Customer margin required
by FCMs must be at least equal to and is usually higher than margin
required by CCPs from FCMs.
The second guiding risk-management principle is that all open
positions are marked to market twice daily. Depending on the direction
of market movements, the process of marking open positions to market
may create an obligation for customers to provide additional margin to
FCMs or CCPs or may result in a credit to customers for their trading
profits. Customers with gains may withdraw their profits daily. As a
practical matter, however, many customers and non-clearing FCMs choose
instead to leave their profits on deposit in order to maintain excess
assets above margin requirements as a buffer to avoid the risk of being
under-margined in the future, to reduce the hassle and cost of frequent
funds transfers, or because they lack the operational capabilities to
engage in daily account sweeps.
In the event that a clearing FCM cannot cover its payment
obligations to a CCP, the defaulting FCM's margin and other eligible
financial assets are used by the CCP to cover any losses resulting from
the liquidation of the defaulting FCM's open positions and the
liquidation or transfer of the FCM's customer positions. Any additional
losses are absorbed by other financial safeguards, such as the
mutualized clearing default guaranty funds maintained by CCPs. No FCM
default to date has ever resulted in any losses to a U.S. CCP's
clearing default fund.
A third risk-management principle underlying U.S. futures markets
is the protection of customer assets held by FCMs, which include assets
on deposit to satisfy customer margin requirements and any excess
assets. Since 1974, Commodity Futures Trading Commission (``CFTC'')
regulations (and Commodity Exchange Authority regulations before that)
have required FCMs to segregate customer assets from FCMs' own funds
and to recognize those segregated assets as the customers' property.
Although customer assets are segregated from an FCM's assets, most
customer assets are legally and operationally commingled in customer
pools or omnibus accounts--one for customers trading futures and
options on U.S. exchanges (i.e., segregated or 4d accounts), and
another for customers trading on foreign boards of trade (i.e.,
foreign-secured or 30.7 accounts).\2\ For both types of customer
pools, FCMs must maintain sufficient funds to cover all of their
customer obligations. In other words, assets in an FCM's customer pools
must equal or exceed the customer liabilities in those pools. When that
does not occur in either or both pools of customer funds, the FCM is
said to be ``under-segregated.''
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\2\ Customer assets on deposit to support cleared over-the-counter
derivatives are subject to a different segregation regime in which
customer collateral is legally segregated but operationally commingled.
---------------------------------------------------------------------------
One of the main benefits that segregation requirements provide is
to make it easier for CCPs to manage the defaults of clearing FCMs that
fail as a result of losses in their house trading accounts or for
reasons unrelated to their futures trading activity. In those
situations, the customer accounts \3\ of the defaulting FCM can be
transferred very quickly to non-defaulting FCMs or liquidated with no
resulting loss to customers, and no significant ongoing disruption to
customers' trading activities. This approach has worked well in
practice over time.
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\3\ I henceforth use the term ``customer accounts'' to refer
collectively to both segregated 4d and foreign-secured 30.7
accounts.
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Customer Assets at Risk
U.S. futures CCPs have a solid track record of managing FCM
defaults with regard to the risk exposures of non-defaulting clearing
members and mutualized CCP default funds. Nevertheless, customers have
in the past several years experienced major losses arising from
defaults of individual FCMs. Such losses can occur for two different
reasons.
First, customer losses can arise if an FCM defaults as a result of
misfeasance or malfeasance (e.g., fraud, embezzlement, misappropriation
of customer funds, and operational failures). Prior to 2007, such
losses were generally small. For example, a study of customer asset
risk conducted by NFA in 1986 found that between 1938 and 1985, less
than $10 million of customer assets were lost as a result of defaults
by FCMs that were under-segregated.\4\ The failures of MF Global in
October 2011 and Peregrine Financial Group in July 2012, however,
involved substantial amounts of under-segregation losses realized by
the customers of those firms.\5\ In particular, the failure of MF
Global has heightened customers' awareness of their exposure to under-
segregation risk. Those concerns were a significant reason that the
Sponsors commissioned the Study.
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\4\ National Futures Association, Customer Account Protection Study
(November 20, 1986).
\5\ The failure of Sentinel Management Group in August 2007 also
involved losses of customer funds. Sentinel, however, was not a
traditional FCM but rather was registered as a FCM so that it could
hold other FCMs' customer funds. Sentinel thus was more similar in its
operations to an investment company than a FCM.
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Second, futures customers are exposed to ``fellow-customer risk.''
If one or more customers of an FCM incur significant losses and fail to
honor their margin calls, a shortfall in customer segregated funds may
result, in which case non-defaulting customers may not receive all of
their funds back. Such fellow-customer losses arise when several
situations occur at the same time: (i) one or more customers of the FCM
must experience losses in excess of the margin they have already
deposited--i.e., market conditions must be so severe that the resulting
losses exceed the target 99 percent coverage level underpinning initial
margin requirements; (ii) some of those customers with large losses
must be financially unable to honor their resulting payment obligations
to the FCM; and (iii) the FCM must lack the financial resources to
cover the defaulting customer payment(s), thereby forcing the FCM into
default. The simultaneous occurrence of all three of these situations
is highly unlikely.
In more than a century of U.S. futures trading, only one situation
has arisen in which customers actually lost money as a result of
fellow-customer risk exposures. In December 1998, a customer of Griffin
Trading entered into positions on Eurex that generated a $10 million
loss overnight. Griffin transferred funds to its clearing FCM from its
foreign-secured customer accounts to cover the customer's losses. But
those losses grew larger later the same day, and, when Griffin could
not cover the margin calls arising from those additional losses, it
filed for bankruptcy. As a result, Griffin's non-defaulting customers
experienced losses resulting from Griffin's inability to cover the
losses of its defaulting customer.\6\ All of the fellow-customer losses
at Griffin arose from its foreign-secured customer accounts (i.e.,
customer assets related to trading on foreign boards of trade). The
U.S. futures customer segregated accounts were transferred intact, and
no Griffin customer trading only U.S. futures experienced any fellow-
customer losses.
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\6\ See, e.g., In Re: Griffin Trading Company, 245 B.R. 291 (Bankr.
N.D. Ill. 2000), and In Re: Griffin Trading Company (7th Federal
District, Northern Illinois), No. 10-3607 (June 25, 2012).
---------------------------------------------------------------------------
A handful of other situations have occurred in which a failure of
one or more customers of an FCM to meet margin calls has resulted in
the FCM's under-segregation and forced it into default. Other than
Griffin Trading, however, none of these other defaults resulted in
actual fellow-customer losses. For example, three customers failed to
meet a total of $26 million in margin calls made by Volume Investors
Corp. (``Volume'') in 1985. Volume could not cover the payment
obligation and thus defaulted to its CCP, The Commodities Exchange
(``COMEX''). As a result of other assets held by Volume, recoveries by
Volume's receiver from the original defaulting customers, and a payment
by Volume's chief executive, none of the non-defaulting customers of
Volume realized any losses.\7\
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\7\ CFTC, Release 2586-86, Docket #85-25 (July 29, 1986), at http:/
/www.nfa.futures.org/BasicNet/Case.aspx?entityid=0002121&case=85-
25&contrib=CFTC.
---------------------------------------------------------------------------
Nevertheless, fellow-customer risk remains a concern amongst many
futures trading customers. Such concerns persist in part because
customers do not feel that they can monitor the risk to which they are
exposed through their fellow-customers' trading activities. Customers
are, of course, free to choose their FCM(s) based on reputation and
their customer risk monitoring capabilities. As a practical matter,
however, only very large customers tend to do so.
Customer Asset Protection Insurance
Following the customer asset losses at MF Global and Peregrine,
market participants and the CFTC have implemented numerous changes in
how customer assets are protected. I am not here to discuss those
changes today, but I do urge the Committee to take them into account
when considering the issue that I am here to discuss today (i.e.,
CAPI).\8\ The net value of CAPI depends on the other protections in
place to reduce the risk of customer asset losses. To the extent those
other safeguards are working properly, insurable customer asset losses
should be extremely rare occurrences, which, all else equal, reduces
the value of CAPI.
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\8\ Our Study will include an Appendix that summarizes the recent
changes in detail.
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The benefit and value of CAPI--like any other form of insurance--
must be carefully weighed against its costs. In general, the price or
premium that insurance companies charge policy holders in a competitive
marketplace is the sum of (i) the average amount of claims the insurer
expects to pay, (ii) the cost to the insurer of providing the coverage
(including the cost of any reinsurance), and (iii) the insurer's profit
margin. As such, a typical purchaser of virtually any kind of insurance
should expect to lose money on average. Even if the customer's actual
losses and claims payments are exactly equal to the customer's expected
loss, the customer still has to pay the total premium, which, as noted,
includes provisions to cover the insurer's costs, the cost of
reinsurance, and the like.
That insurance purchasers have an expectation of losing money does
not mean insurance has no value to purchasers. The policy limit, after
all, is much higher than the expected or average claim. Insurance
purchasers thus are willing to incur relatively small costs (i.e.,
premium based on expected or average losses) in states of the world
when an insured loss has not occurred in order to eliminate or reduce
much larger potential losses in states of the world when an insured
loss has occurred. The value of CAPI to customers thus depends both on
the cost of the coverage and the amount of coverage relative to
expected or average losses.
Another important determinant of the value of insurance is the
amount of the deductible, or what insurers call the ``first-loss
retention.'' Insurance and reinsurance companies consider a first-loss
retention of critical importance because it helps align the risk-
management incentives of the policy holder with the insurance provider.
Because the insurance company cannot perfectly observe the risk-
management decisions and activities of policy holders, the first-loss
retention gives policy holders an incentive to manage their own risks
in order to avoid high-frequency, low-severity losses below the
deductible. Naturally, the lower the first-loss retention, the higher
is the policy premium.
In the context of CAPI, the first-loss retention is a challenge
because the potential customer beneficiaries of CAPI do not directly
control the process by which under-segregation and fellow-customer risk
are managed. Forcing customers to bear the first-loss through a
deductible is highly unlikely to influence the risk-management
decisions of the FCMs that actually monitor and control those risks.\9\
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\9\ True, the existence of CAPI with no customer deductible will
make customers indifferent about the risk-management practices of their
FCMs, but, as I noted earlier, that is essentially already the case
even in the absence of CAPI.
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The Insurance Scenarios
After Compass Lexecon was engaged by the Sponsors in December 2012,
we first worked with the Sponsors to articulate several different CAPI
scenarios that could then be shown to various insurance and reinsurance
industry participants for the purpose of estimating the costs of
privately provided CAPI under those different scenarios.\10\ We
articulated three private, voluntary, opt-in CAPI scenarios, and we
also have considered a fourth scenario involving mandated, universal
CAPI coverage.
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\10\ We realize that possibilities for CAPI exist beyond the
scenarios we defined. Nevertheless, we had to define several specific
scenarios in order to facilitate consistent comparisons of costs
provided by (re-)insurers. Otherwise, too many specific solutions might
have been proposed that would have rendered cost comparisons
impossible.
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The first private, market-based CAPI scenario we defined is CAPI
provided directly by primary insurance carriers to individual futures
customers. Yet, no insurance market participant with whom we have
spoken has expressed any interest in underwriting CAPI directly to end
customers because customers seem unlikely to agree to a deductible,
which is incompatible with virtually all traditional insurance markets.
In addition, a customer-level deductible would not serve its usual
purpose in mitigating moral hazard.\11\ Insurers also indicated that,
apart from the deductible issue, direct customer-by-customer CAPI
likely would be very costly to administer and underwrite, which would
lead to higher premiums than many futures customers might be willing to
pay.
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\11\ If there is an alternative solution that does not expose FCMs
to first-loss risks, we would recommend skepticism and suspicion for
the aforementioned reasons.
---------------------------------------------------------------------------
In the second scenario, FCMs could attempt to procure insurance on
a one-off, FCM-by-FCM basis. For example, if a sole FCM wishes to
provide $250,000 of CAPI to all of its 1,000 customers, the FCM would
want to buy a total of $250 million in insurance with its customers as
the named beneficiaries. Suppose an insurer agreed to provide $200
million in coverage in excess of a $50 million first-loss retention or
deductible. The CAPI only would be triggered when the FCM fails,
however, in which case the FCM would not have unencumbered access to
the funds it would need to pay the first $50 million in customer CAPI
claims. So, for this scheme to work, the FCM would have to pre-fund the
$50 million deductible in a manner that insulates those funds from the
general assets of the bankrupt estate so that the $50 million is
available solely to fund the first $50 million in CAPI payments (with
the insurance covering the next $200 million in CAPI claims). It is
possible to do this (e.g., through the use of captives or protected
cell companies), but most insurance market participants with whom we
spoke viewed such alternatives as cumbersome, unlikely to be profitable
on an FCM-by-FCM basis, and, hence, unattractive.\12\
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\12\ This does not preclude the possibility that some insurers and
FCMs eventually could structure such a CAPI program. For purposes of
the Study, however, interest in this scenario was too limited for us to
get any meaningful feedback from insurers on costs and pricing.
---------------------------------------------------------------------------
Our third scenario is an industry risk retention group (``RRG'') in
which a licensed primary insurance company is capitalized and owned by
FCMs that wish to participate. Customers of the participating FCMs
would be eligible for CAPI coverage that would be provided directly by
the RRG. The participating FCMs would contribute capital that, together
with CAPI premiums paid by customers, would fund a first-loss retention
for the aggregate risk exposure of all customers across all
participating FCMs arising from under-segregation or fellow-customer
risk. The RRG would then purchase reinsurance for any CAPI payments in
excess of the RRG's first-loss retention.
For example, a RRG might be formed by five or six FCMs to provide
CAPI coverage to all customers of those participating FCMs. If the
expected or average loss of the RRG based on the under-segregation and
fellow-customer risks of the participating FCMs is $50 million, the
participating FCMs would be required to deposit sufficient capital such
that the paid-in capital plus premiums received from customers for
their CAPI coverage would total $50 million. The RRG then could secure
about $250 million of reinsurance in excess of the first-loss layer of
$50 million. Customers of the participating FCMs thus would have up to
$300 million available to cover under-segregation or fellow-customer
losses. The first $50 million of customer claims would be paid out of
the RRG's assets (including FCM-contributed capital and customer-paid
premiums), and the next $250 million would be paid by the reinsurers of
the RRG. Such a structure could also involve sub-limits for customers
based on their size--e.g., small customers would be covered for losses
up to $50,000, whereas large customers would have claims limited to
payments of up to $500,000.
In addition to providing CAPI protection to customers, the RRG
provides a mechanism by which customers could be reimbursed for some or
all of their indemnified losses very quickly even if their actual
assets were frozen in the defaulted FCM's bankruptcy estate. For
example, the RRG could obtain a line of credit to cover some or all of
the payments owed to customers of a defaulting participating FCM that
would be secured by the RRG's capital and the reinsurance receivable.
Customers would thus receive a very rapid payment, and the eventual
reinsurance payment to the RRG would be used to pay down the line of
credit.
The industry RRG scenario is very similar in many important
respects to the proposal put forth by the Commodities Customer
Coalition (``CCC''), a nonprofit organization formed in response to the
bankruptcy of MF Global.\13\ There are a few exceptions, however,
between the RRG proposal we presented to reinsurers and the CCC
proposal. For example, the RRG scenario we are reviewing with
reinsurers is based solely on FCMs as owners, capital providers, and
absorbents of losses in the first-loss layer. The CCC proposal, by
contrast, contemplates that the RRG would also be owned and capitalized
by commodity trading advisors, commodity pool operators, and
introducing brokers.
---------------------------------------------------------------------------
\13\ See J. Roe, ``Commodity Insurance Corporation: A Proposal for
a Captive Insurance Company Servicing Customers of Introducing Brokers,
Commodity Trading Advisors and Commodity Pools,'' Presentation of the
CCC (December 17, 2012) http://commoditycustomercoalition.org/ccc-plan-
for-private-commodity-customer-insurance/ (last visited September 25,
2013).
---------------------------------------------------------------------------
Progress of the Study
In order to provide (re-)insurers with sufficient information for
them to respond with meaningful indicative premium quotations for the
three private, voluntary opt-in CAPI scenarios, we undertook a
comprehensive empirical analysis of customer assets exposed to under-
segregation or fellow-customer risk. Although aggregate data on
customer assets reported on an FCM-by-FCM basis was readily available
through the CFTC and the two Designated Self-Regulatory Organizations
(``DSROs'')--i.e., CME and NFA, both of which are Sponsors of this
Study--these data alone are not sufficient because FCM-level data only
reveal total customer assets of the FCM and do not indicate customer-
specific assets at risk. So, in February 2013, we contacted ten U.S.
FCMs (ranging from very large banking institutions to smaller,
specialized FCMs) and asked them to provide customer-level position and
asset data for each month-end in 2012.\14\ Of those ten FCMs, six (the
``Contributing FCMs'') provided usable data.
---------------------------------------------------------------------------
\14\ We limited our request to 2012 both because recent regulatory
changes make earlier time periods less representative of the market,
going forward, and because of the demanding nature of our data request
on the voluntary FCM contributors.
---------------------------------------------------------------------------
The six Contributing FCMs that responded to our request are broadly
representative of the U.S. futures industry. Two of the FCMs were
``Large FCMs'' with $5 billion or more in customer assets and $1
billion or more in Adjusted Net Capital at year-end 2012. Another two
of the Contributing FCMs were ``Small FCMs'' with less than $1 billion
in customer assets and less than $100 million in Adjusted Net Capital
at year-end 2012. The other two FCMs were ``Medium FCMs'' with between
$1 and $5 billion in customer assets and between $100 million and $1
billion of Adjusted Net Capital. We completed our collection and
preparation for subsequent analyses of the data that we received from
the six Contributing FCMs in June 2013.
To analyze assets at risk as a result of under-segregation arising
from misfeasance or malfeasance, the above data alone was sufficient.
Under-segregation losses arising from fraud, embezzlement, unauthorized
conversions of customer funds, and the like, after all, need not and
historically have not occurred on days when markets themselves are
experiencing catastrophic price volatility. Fellow-customer losses, by
contrast, are more likely to occur in highly stressed market conditions
that cause market prices to exceed the price movements used to compute
initial margin requirements.
So, to analyze and quantify potential fellow-customer losses, we
worked with the Clearing division of CME to perform stressed
simulations of potential fellow-customer losses using a model similar
to the one used by CME Clearing to measure its exposure to potential
defaults by clearing FCMs. Specifically, we assumed that the prices of
all futures contracts change by an amount that averages the worst 0.1%
of all historical price changes dating back generally to 1987.\15\ To
be conservative in our analysis, we assumed that all products within
each commodity type experienced losses at the same time, and then
ranked the losses of all customers at each Contributing FCM and
calculated the ``hole'' in customer funds that resulted from a failure
to meet a margin call by all customers from the 98th largest net margin
payment obligation up to the 99.5th largest net margin payment
obligation. Finally, we assumed that defaulting FCMs contributed none
of their own financial resources to cover the unmet customer payment
obligations, another conservative assumption.\16\ We completed our
stressed analyses of potential fellow-customer losses in late August
2013. The completed Study will summarize and present all of the
relevant loss estimates that were computed for under-segregation and
fellow-customer risk.
---------------------------------------------------------------------------
\15\ For more recently listed products, we used data back to the
inception of the products or the first date on which the data was
clean. For some older products (e.g., gold and some interest rate
products), we use historical data back to the early 1980s.
\16\ We adopted the assumption that FCMs contribute nothing to
cover losses arising from customer defaults purely for conservatism and
not because it is realistic.
---------------------------------------------------------------------------
We then provided various loss exposure analyses to ten potential
CAPI
(re-)insurers. We also have participated in various meetings and calls
with the potential CAPI (re-)insurers since providing our loss exposure
analyses. Most of the (re-)insurers have expressed interest exclusively
in the industry RRG scenario and have not indicated any intention to
provide us with indicative pricing for the first (CAPI provided
directly to customers) or second (CAPI provided to individual FCMs)
scenarios. As of today, we are waiting for indicative premium
quotations from the interested (re-)insurers regarding the cost of
providing CAPI coverage. When we have that information, we will provide
the completed Study to this Committee.
Mandatory CAPI Coverage
The fourth scenario we analyzed involves the mandatory and
universal CAPI coverage of U.S. futures customers. Specifically, the
Futures Investor and Customer Protection Act would establish the
Futures Investor and Customer Protection Corporation (``FICPC'').\17\
The proposed customer asset protection scheme would be mandatory,
universal, and would essentially mimic the protections afforded to
securities investors by the Securities Investor Protection Corporation
(``SIPC''). Unlike the scenarios described previously, the FICPC
scenario would not give FCMs or customers a choice regarding their
participation in the CAPI scheme--all FCMs and their customers would be
required to participate.
---------------------------------------------------------------------------
\17\ Statement of CFTC Commissioner Bart Chilton (August 9, 2012).
---------------------------------------------------------------------------
A FICPC designed along the lines of SIPC would provide up to
$250,000 to all FCM customers as reimbursement for losses sustained
from the failure of an FCM (apart from losses arising purely as the
result of financial market downturns). Following an FCM's insolvency,
its customers would file claims with a FICPC trustee (analogous to a
SIPC trustee). The trustee would have the authority to transfer
customer accounts to non-defaulting FCMs or to liquidate those
accounts.
Under this proposal, the FICPC would be funded by mandatory
payments from FCMs of up to 0.5 percent of each FCM's previous annual
gross revenues related to futures trading until reaching a target
funding level of not more than $2.5 billion. FICPC would be governed by
a board of directors to be confirmed by a majority vote of the U.S.
Senate. In the FICPC, there is no retained first-loss layer by either
customers or any other market participants.
Several potential concerns can be identified in the FICPC scenario.
In particular, the proposed funding scheme for the FICPC is highly
regressive--i.e., FCMs whose customers benefit the least from FICPC
coverage would provide a disproportionately high amount of the funding.
In 2012, a total of 70 FCMs reported positive annual gross revenues
from commodities to CME and NFA in their capacities as DSROs. The ten
FCMs with the highest amounts of customer assets at year-end 2012 would
have accounted for 44 percent of the FICPC funding. Yet, the median
value of customer assets on deposit at Large FCMs in 2012 (based on
data from the Contributing FCMs) was roughly $1.4 million, as compared
to median customer assets on deposit at Small and Medium FCMs in 2012
of $4,434 and $5,089, respectively.
In addition to the regressive nature of the proposed funding
scheme, another concern with FICPC is the total amount of funding that
the proposed plan would generate over time. In 2012, the 70 FCMs
reporting positive annual gross revenues from commodities to CME and
NFA had average annual gross revenues of $72.9 million, and the total
annual gross revenue for all FCMs was $5.1 billion. In the first year,
FICPC would receive (based on 2012 gross revenue numbers) an average of
$364,591 from each FCM for a total across all FCMs of $25,521,370.
If no losses and CAPI claims occur in the first year of the FICPC,
its assets would grow over time. Yet, the growth rate of FICPC's assets
would be incredibly slow vis-a-vis the target funding level of $2.5
billion. For example, assuming a two percent return on FICPC's assets
each year and an annual contribution by FCMs of $25,521,389 (i.e.,
assuming gross revenues for futures remains at 2012 levels), the FICPC
would not reach its target $2.5 billion funding level for 55 years.
Figure 1 below shows the assets of a FICPC Fund under those assumptions
and further assuming that the first $25.5 million was paid in during
2013 based on 2012 gross revenue numbers and that no claims payments
are made. The FICPC Fund would cross the $1 billion asset threshold in
2041 (i.e., 27 years after its inception).
Figure 1: FICPC Fund Projected Asset Levels
Notes: Assumes constant annual contributions to FICPC of
$25,521,389 (i.e., 0.5% of 2012 gross revenues from commodities
for all FCMs that reported positive gross revenues in 2012) and
that FICPC assets are invested in government bonds earning 2%
per annum.
The SIPC Fund faced the same problem when it was created by
Congress in 1970. Figure 2 below shows that the Fund grew sluggishly
over time and did not exceed $1 billion until 1996 (i.e., 25 years
after its inception). SIPC, however, is an entity in which the U.S.
Government is the equivalent of a reinsurer of up to $2.5 billion.
Specifically, if the SIPC Fund is or appears to be insufficient to
cover claims, the Securities and Exchange Commission can make loans to
SIPC (backed by notes issued to the U.S. Treasury) in an aggregate
amount not to exceed $2.5 billion.
Figure 2: SIPC Fund from Inception to December 31, 2012
Source: Securities Investor Protection Corporation, 2012 Annual
Report, p. 29.
So, FICPC might not provide much short-term comfort to futures
customers given the slow growth rate in the assets available to cover
any eligible customer claims. Without a government backstop (and the
corresponding taxpayer-financed contingent liability), the program
would be significantly under-funded both in absolute terms and relative
to the potential voluntary, private market-based solutions that we have
identified.
Because of its mandatory and universal nature, moreover, FICPC
likely would result in new costs for U.S. futures trading participants.
Those additional costs could deter customers from using futures markets
to satisfy their risk-management needs and depress market liquidity,
thereby potentially further raising costs for customers.
Conclusion
For nearly a year, we have been researching and studying the
potential benefits and costs of alternative CAPI programs. Our
discussions to date with various
(re-)insurers suggest a willingness and ability to provide capital to
underwrite a private, voluntary CAPI program along the lines of an
industry RRG in which FCMs bear the first-loss exposure to losses
arising from FCM under-segregation or fellow-customer risk. In other
words, the supply seems to be available to cover these risks, but we
remain uncertain at this date as to the cost of that risk capital and
the resulting demand for privately provided CAPI given those as-yet-
unknown costs. Yet, if there is sufficient demand for CAPI amongst FCMs
and customers at the price that the reinsurance market charges and a
willingness of FCMs to contribute their own capital to cover the first-
loss layer, then those willing FCMs and customers could have access to
customer funds protection through a non-mandated, market-based
solution.
If it turns out, however, that there is limited demand for private
CAPI solutions at the market price, then a mandated CAPI solution may
be even more unrealistic. In other words, to the extent that a subset
of market participants are unwilling to pay for voluntary CAPI, it is
very likely that requiring all market participants to purchase CAPI at
the mandated expense of the industry will be undesirable. A mandated
CAPI solution, moreover, would likely be feasible only with either
implicit or explicit taxpayer-backed government support. In addition,
the added transaction costs that such a solution could ultimately
impose on customers might simply cause some customers to stop relying
on U.S. futures markets for their risk-management needs, which could
reduce market liquidity and give rise to even higher transaction costs
for remaining market participants.
The Chairman. Thank you, Dr. Culp.
Mr. Anderson.
STATEMENT OF MICHAEL J. ANDERSON, REGIONAL SALES MANAGER, THE
ANDERSONS INC., UNION CITY, TN; ON
BEHALF OF NATIONAL GRAIN AND FEED ASSOCIATION
Mr. Anderson. Thank you. Good morning, Chairman Conaway,
Ranking Member Scott, and Members of the Subcommittee.
I work at The Andersons, Incorporated. I live in northwest
Tennessee and run a series of elevators there. The Andersons is
a diversified company rooted in agriculture. We were founded in
Maumee, Ohio, in 1947, and we conduct business across North
America in grain, ethanol, plan nutrient sectors, railcar
leasing, turf and cob products, and consumer retailing. Today,
I am here representing the National Grain and Feed Association.
I serve on the NGFA's risk management committee, and I am
NGFA's representative to the CFTC Ag Advisory Committee.
In my written testimony, I have detailed several areas that
we believe are important for Congress to consider during the
CFTC reauthorization. I am going to focus today on the rule
proposed by CFTC last November that would radically change the
way business is done in the futures industry. We believe
strongly that despite CFTC's goal of enhancing customer
protections, that these two provisions of the rule will
actually cause a dramatic increase in customer risk.
The first provision would decrease the time in which
customer margin calls must arrive to their futures commission
merchant, or FCM, from the current 3 days to just 1. Otherwise,
the FCM would have to take a capital charge for this
undermargined account. Even in today's environment, of money
moving electronically, 1 day is not sufficient for all
customers to make their margin calls. We are urging CFTC to
maintain the current 3 day timeline; otherwise, we fear some
FCMs would require customers to pre-margin these hedge
accounts, potentially putting more customers' funds at risk in
another FCM insolvency.
The second provision of concern, and maybe more troubling
than the first, would change the timing of the FCM's
calculation of residual interest, which are the funds the FCM
contributes of its own money to top up customer accounts until
margin calls are received. For decades, this provision of the
Commodity Exchange Act has been interpreted by the Commission
as allowing some period of time for the FCMs to do this. The
CFTC proposal would change that consistent historical
interpretation to require that every customer be fully margined
on a 24/7 basis. It may sound like a good idea, but in the real
world, it causes major problems. Future Industry Association
has estimated this provision alone would cost as much as $100
billion per day to be contributed to hedge accounts either by
FCMs or by futures customers. This would severely stress FCM's
liquidity, especially the smaller and mid-sized FCMs that we
rely on to serve the ag industry, again, leading us to believe
that pre-margining would be a likely conclusion.
An unintended consequence could be further consolidation in
the FCM world as smaller firms cannot compete with larger firms
who are able to top up these hedge accounts. To bring this down
to the everyday world, I am going to repeat an example that has
been given before, so apologies if you have heard it.
Consider an average Midwestern grain elevator that handles
5 million bushels of grain every year. Before harvest, this
elevator may have 40 percent of its annual grain volume
purchased from its farmer customers through forward contracts,
and assuming a crop mix of 60 percent corn, 30 percent soybeans
and ten percent wheat, that elevator would have to hedge 300
contracts of grain. Today, that would result in a minimum of
$920,000 that that country elevator has to send to the FCM just
to establish its hedged positions, and recall, this is just one
country elevator.
Now, if we look at the additional financial requirements,
if the CFTC proposal was put into effect, we will assume that
the elevator's FCM is going to require pre-margining of the
customer to cover a 1 day limit move, which is a reasonable
precaution, that country elevator would then have to send an
additional $1 million more to the FCM for the possibility of
this limit move that may or may not occur. If MF Global had
been requiring pre-margining of this fashion, that country
elevator is now exposed more than two times what it would have
been originally, about $1.9 million as opposed to the original
$900,000 it had to send to established positions.
Further, we continue to be confused as to why the meaning
of the Commodity Exchange Act has been changed after decades of
consistent interpretation. We believe that the Act provides
plenty of flexibility for the CFTC's historical interpretation,
and we would be happy to discuss that in more detail. We are
also mystified as to why the CFTC apparently has not undertaken
serious cost-benefit analysis before implementing such a major
change in the way the futures industry does business. An
indication of the serious problems this proposal would cause
for U.S. agriculture, 21 national organizations signed a letter
to the Commission on September 18th detailing consequences and
urging serious analysis by the CFTC before moving forward on
these two provisions.
And Mr. Chairman, I request that this letter be included in
the hearing record, if that is all right.*
---------------------------------------------------------------------------
* The document referred to follows Mr. Anderson's prepared
statement and is entitled Attachment.
---------------------------------------------------------------------------
The Chairman. Without objection.
Mr. Anderson. We would prefer to work with CFTC to resolve
these problems, but there may be a need for legislative action
to clarify the interpretation that the futures industry has
relied on for so long. I thank you sincerely for taking the
time to hear from our industry today, and I would be happy to
respond to any questions.
[The prepared statement of Mr. Anderson follows:]
Prepared Statement of Michael J. Anderson, Regional Sales Manager, The
Andersons Inc., Union City, TN; on Behalf of National Grain and Feed
Association
Good morning, Chairman Conaway, Ranking Member Scott, and Members
of the Subcommittee. I am M.J. Anderson, Regional Sales Manager of The
Andersons Inc. in Union City, Tennessee. The Andersons Inc. is a
diversified company rooted in agriculture. Founded in Maumee, Ohio, in
1947, the company conducts business across North America in the grain,
ethanol and plan nutrient sectors, railcar leasing, turf and cob
products, and consumer retailing.
Today, I am testifying on behalf of the National Grain and Feed
Association (NGFA), the national trade association representing more
than 1,000 companies including grain elevators, feed manufacturers,
processors and other commercial businesses that utilize exchange-traded
futures contracts to hedge their risk and assist producers in their
marketing and risk management strategies. We appreciate the opportunity
to testify before the Subcommittee today.
CFTC's Customer Protection Proposal--Customer Protection and Customer
Risk
For many years, grain hedgers and the futures commission merchants
(FCMs) with whom they work to manage their risk have relied on a
consistent interpretation of the Commodity Exchange Act by the
Commodity Futures Trading Commission (CFTC) with regard to posting
margin funds to their hedge accounts. Unfortunately, in the name of
customer protection, that interpretation recently has been thrown into
question by a new proposal from the CFTC that we believe would
dramatically increase customer risk.
We understand that CFTC Commissioners currently are evaluating a
final staff draft of this rule, with the goal of voting on a final rule
later this month. The rule seeks to bolster futures customer
protections--a laudable goal that the NGFA supports fully. However, two
very troublesome provisions would have the perverse effect of
significantly increasing financial risk to futures customers--and in
the process, dramatically changing the way business has been conducted
in futures markets for decades.
One provision concerns the timing of when an FCM is required to
take a capital charge for undermargined accounts. Currently, customers
have 3 days to make margin calls to their FCMs before the FCM is
required to take a capital charge. As we read the CFTC proposal, that 3
day period would be shortened to just 1 day. Even in today's
environment of money moving electronically, a single day is not
sufficient for all customers to make margin calls that quickly. We fear
this provision would compel FCMs to require that customers pre-margin
their accounts--especially the smaller and mid-size FCMs that are so
important in providing service to futures customers in the agribusiness
and production agriculture spaces.
The second provision potentially is even more troublesome and more
expensive to futures customers. It would change the timing of FCMs'
calculation of residual interest for futures accounts--in other words,
it appears the proposal would require all customers to be fully
margined at all times. While this may sound like common sense, it is a
huge departure from the CFTC's interpretation for decades that FCMs be
allowed a certain period of time to ``top up'' hedge accounts while
they wait for customers to make margin calls. This new proposal would
lead to one of two outcomes: either the FCM would have to move more of
its own funds (i.e., residual interest) into customers' hedge accounts;
or FCMs would be forced to require pre-margining and, perhaps, intra-
day margining, to ensure that each individual customer is fully
margined at any moment.
The practical end result would be that futures customers would be
required to send much more money to their FCMs in advance in
anticipation of futures market moves that might never happen. Some
customers likely would exit futures markets in favor of lower-cost risk
management alternatives. We believe this potential exodus from futures
markets would be most clearly seen among agricultural producers who
utilize futures for risk management purposes and among smaller grain-
hedging firms.
Taken to its logical conclusion, we believe strongly that neither
proposal accomplishes the Commission's stated goal of enhancing
customer protection. To the contrary, customers would be sending much
larger amounts to their FCMs, leading to much greater volume of funds
at risk if another MF Global situation occurs. If this rule had been in
place when MF Global failed, perhaps twice as much customer money would
have been missing and a correspondingly larger amount still would not
be returned to customers.
Much has been said about the meaning of the Commodity Exchange Act
with regard to residual interest. Some at the CFTC have seized on a
single sentence of the act in Section 4d(a)(2) to contend that the CEA
prohibits one customer's funds from being used to cover another
customer's margin calls. We believe strongly that the Commission's
recent public stance is an overly aggressive interpretation that
overturns decades of consistent administration of the regulations by
the Commission, Congress and the futures industry. As a recent legal
review by the Futures Industry Association has shown, there is ample
flexibility in the Act to justify the manner in which residual interest
rules historically have been implemented. Specifically, we believe the
first of three ``Provided, however,'' clauses immediately following the
limits in Section 4d(a)(2) give clear authority for the historical
interpretation.
Perhaps most troubling about this entire issue is that, to our
knowledge, the Commission has performed no credible cost-benefit
analysis relative to these specific provisions of the proposal. We
believe strongly that this fundamental change of direction by the
Commission--after decades of consistent interpretation--deserves a
serious effort to quantify benefits relative to the enormous costs and
risks imposed on futures customers. We respectfully urge the Commission
to undertake a serious and thorough review prior to any action on the
capital charge and residual interest provisions of the referenced
rulemaking.
On that note, we would like to thank you, Chairman Conaway and
Ranking Member Scott and others, for sponsoring H.R. 1003, legislation
that would require the Commission to perform both qualitative and
quantitative cost-benefit analysis of potential regulations before
issuing them. Such analysis likely would have provided the Commission
with important and helpful information prior to publication of the
customer protection rule. The NGFA supports inclusion of H.R. 1003 in
legislation reauthorizing the CFTC.
Discussions with the Commission have not resolved these issues to
date, and we continue to be mystified about how the meaning of the
Commodity Exchange Act, interpreted consistently on this matter for
decades, suddenly has changed. It is difficult to understand the reason
for such a dramatic change in the CFTC's stance after decades of
consistent interpretation. We continue to believe that the Act provides
sufficient flexibility. However, if the Commission continues to contend
that its hands are tied due to provisions of the Commodity Exchange
Act, Congressional action may be needed to clarify the matter.
Widespread Concern in U.S. Agriculture and Agribusiness
The proposed changes in capital charge and residual interest
provisions have provoked very deep concerns among a broad swath of U.S.
farmers, ranchers and agribusiness firms who utilize futures markets to
manage risk in their businesses. On September 18, twenty-one national
organizations wrote to CFTC Commissioners warning of the following
consequences if these provisions are finalized:
``FCMs will be forced either to use their own funds to `top
up' residual interest--not feasible given the huge amounts
involved--or, most likely, require that customers pre-margin
hedge accounts.
Many producers who use futures directly will be discouraged
from using futures markets to hedge their production risk.
Due to the significantly increased funding requirements of
pre-margining--perhaps nearly double the amounts currently
required--many small agribusiness hedgers will be forced to
consider alternative risk management tools or be forced out of
the market.
Futures customers will be compelled to send excess margin to
their FCMs in anticipation of future market movement on
existing positions--many billions of dollars more than needed
to cover existing positions--the last thing customers want to
do now, in the wake of MF Global and Peregrine Financial Group.
Much more customer money--maybe twice as much--will be at
risk in the event of another FCM insolvency.
Futures customers will be compelled to borrow more money
just to post margin on potential market moves--difficult for
both lending banks and for customers to predict, and
potentially difficult for smaller local banks. This increased
borrowing requirement negatively affects a customer's ability
to invest in their own business.
The entire hedging process will be made less cost-efficient,
thereby discouraging use of futures markets.''
It is very important to note again that these organizations are not
investors or speculators. They represent farmers, ranchers and the
agribusinesses that work with production agriculture to hedge their
business risk. We believe it should be of deep concern to the
Commission that many of the affected individuals and firms may be
forced by the huge added expense of using futures to find other, less-
costly forms of risk management--and that the smaller and mid-sized
FCMs that provide such important service to U.S. agriculture stand to
be disproportionately disadvantaged. It is in no one's interest to
cause consolidation among FCMs, thereby concentrating risk in a smaller
number of firms.
Reforms to the U.S. Bankruptcy Code
Nearly 2 years after the implosion of MF Global, companies and
individuals that were customers of that FCM continue to deal with the
aftermath of parent company MF Global Holdings' bankruptcy and misuse
of futures customer funds. Most U.S. futures customers so far have
received distributions from the trustee of about 97% of their funds--
funds that were supposed to have been segregated and protected. Recent
developments have made it increasingly likely that 100% of customer
funds will be returned to customers, but the NGFA believes strongly
that statutory reforms are needed with the twin goals of preventing
similar occurrences in the future and enhancing the rights and
protections of futures customers in the event of a future FCM
insolvency.
Among those changes, we believe that reforming the U.S. bankruptcy
is the single most important step essential to preserving and codifying
customers' rights and protecting customers' assets. To that end, the
NGFA recommends the following statutory changes:
The Bankruptcy Code should state clearly that customers
always are first in line for distribution of funds, ahead of
creditors, and that all proprietary assets including those of
affiliates must go to customers first. This would provide
clarity to regulators and to the courts in terms of
prioritization of claims, an area in which precedent has not
been established.
Part 190 regulations of the CFTC should be incorporated into
Subchapter IV of Chapter 7 of the Bankruptcy Code to harmonize
the statutes and remove any interpretative inconsistencies.
Generally, the Bankruptcy Code provides a limited description
of the liquidation process of a commodity futures broker. The
Commodity Exchange Act and bankruptcy regulations drafted by
the CFTC provide much greater and more detailed guidance for
the liquidation of a commodity broker or FCM.
Under current bankruptcy law, powers of a trustee to recover
customer funds are limited under so-called ``safe harbor''
provisions unless actual intent to defraud customers/creditors
can be shown. The NGFA strongly recommends that any transaction
involving the misappropriation of an FCM's customer property
should not be protected under safe harbor provisions,
regardless of the intent behind a fund transfer.
To strengthen commodity customer protection, the CFTC should
have a specifically identifiable role in the liquidation of an
FCM. The CFTC should have the authority to appoint its own
trustee to represent exclusively the interests of commodities
customers. In a case like MF Global, in which over 95% of the
assets and accounts affected were those of commodities
customers, we believe the CFTC's authority should be
strengthened and clarified.
In the MF Global situation, creditor committees were
established under the MF Global Holdings Chapter 7 proceeding,
but there was no statutory provision under the SIPA liquidation
of the MF Global Inc. for establishment of customer committees.
The NGFA recommends that the Bankruptcy Code expressly should
authorize the establishment of customer committees to represent
FCM customer interests.
We are aware that other organizations also are working toward
specific recommendations for changes in the Bankruptcy Code that will
enhance customer protections. The NGFA intends to work cooperatively
with such groups to develop consensus reforms that can be moved by
Congress expeditiously.
Insurance or Liquidity Protection for Commodity Futures Customers--
The NGFA recommends that insurance or insurance-like products should be
available to commodity futures customers. Customers and their lenders
who finance hedging in commodity markets must have confidence that
their funds are safe and protected. We are aware that the Futures
Industry Association and others currently are finalizing a
comprehensive analysis of potential products and costs, and we consider
it prudent to see that study before recommending a particular
structure. We also are aware that the Commodity Customer Coalition
recently has completed an online survey of commodity futures customers
to gauge interest and input on insurance products. This data also could
prove useful in crafting appropriate solutions.
Since the NGFA began working on potential customer protection
enhancements early last year, we have been very mindful that most new
customer protections will come at a cost--and that, eventually, the
cost most likely will be borne by the customer. For that reason, we
have taken a deliberate approach to recommending specific new
protections, and we respectfully suggest that Congress and all
stakeholders adopt a similarly cautious view. On the bright side, since
the collapse of MF Global, significant new operational safeguards that
should enhance the safety of customer funds have been put in place on
commodity futures accounts by exchanges and regulators. These
enhancements, already in place, should help mitigate costs of insurance
or other customer protection efforts.
It is important to note that the solution on insurance to protect
customers is not necessarily a government solution or a legislated
solution. It may be that some form of privately provided product is
more cost-effective and more appropriate. The NGFA has taken no formal
view at this point on any specific structure. We advise strongly that
data from the above-referenced efforts should be carefully considered
prior to making such an important decision.
Fully Segregated Customer Accounts/Pilot Program--Currently, the
Commodity Exchange Act and U.S. Bankruptcy Code provide for pro rata
distribution of all customer property that was held by a failed futures
commission merchant (FCM). Almost 2 years after the fact, former
customers of MF Global still have not received back 100% of their
supposedly safe segregated funds. This is unacceptable. Restoring the
confidence not only of customers, but also of their lenders, is
critically important. To that end, the NGFA has recommended
establishment of an optional fully-segregated account structure to be
offered and utilized by mutual agreement of customers and their FCMs.
Creation of a fully-segregated account structure necessarily would
result in some additional costs that likely would be borne by customers
that utilize such accounts. It is likely that some customers would opt
for the added protections despite extra costs, while other customers
might be unwilling or unable to bear those extra costs. For that
reason, we propose that the full-segregation option be utilized on a
voluntary basis at the agreement of an FCM and its individual
customers.
We suggest that a pilot program involving a limited number of
commodity futures customers, FCMs, and lenders, along with regulators,
would be a useful means of testing the mechanics and identifying the
viability and true costs of a full-segregation structure. It is our
understanding that similar structures already are in place in the swaps
marketplace, and perhaps that can offer insights into similar accounts
for futures customers who may desire the same kind of protection. The
NGFA does not recommend legislative action to establish a full-
segregation account structure, but support for a pilot to test concepts
would be constructive.
High Frequency Trading
Increasingly, traditional customers of agricultural futures markets
are concerned about the impacts of high-frequency trading. Especially
immediately preceding and following release of important crop and
stocks reports by the U.S. Department of Agriculture, we believe high-
frequency trading has caused and magnified volatile market swings.
These disruptions have led many hedgers to avoid futures markets at
such times, leading the NGFA to recommend a short pause in trading
around releases of key USDA reports. Concerns also have been raised
about the impact of high-frequency trading on order fills for
traditional hedgers and about timely access to USDA reports, especially
for those without mega-high speed connections.
It may be that regulatory action by the CFTC is the more
appropriate way to address high-frequency trading issues. Should high-
frequency traders be required to register with the Commission? Should
such traders be required to post margin even if no positions are held
at day's end? Are there other measures that should be considered to
help ensure that high-frequency trading does not disrupt futures
markets in ways that render them less useful to hedgers managing
business risk? The NGFA suggests that these kinds of questions should
be part of the conversation during reauthorization.
We look forward to working with the Committee on these and other
matters during the reauthorization process. Please do not hesitate to
contact the NGFA with any questions.
Attachment
September 18, 2013
Hon. Gary Gensler,
Chairman,
Commodity Futures Trading Commission,
Washington, D.C.
RE: RIN 3038-AD88: Enhancing Protections Afforded Customers and
Customer Funds Held by Futures Commission Merchants and
Derivatives Clearing Organizations, 77 Fed. Reg. 67866
(November 14, 2012)
Dear Chairman Gensler:
The undersigned organizations represent a very broad swath of
agricultural futures market participants, including crop and livestock
producers who use futures directly to manage their risk; agribusiness
firms who rely on futures markets as they assist producers with risk
management plans and in their own risk management programs; as well as
lenders that support the industry's risk management activities.
We support strongly the Commission's efforts to enhance futures
customer protections. However, the capital charge and residual interest
provisions of this rule will have the opposite impact--if adopted,
customers will be exposed to significantly greater financial risk.
If adopted as proposed, these provisions likely will have the
following impacts:
FCMs will be forced either to use their own funds to ``top
up'' residual interest--not feasible given the huge amounts
involved--or, most likely, require that customers pre-margin
hedge accounts.
Many producers who use futures directly will be discouraged
from using futures markets to hedge their production risk.
Due to the significantly increased funding requirements of
pre-margining--perhaps nearly double the amounts currently
required--many small agribusiness hedgers will be forced to
consider alternative risk management tools or be forced out of
the market.
Futures customers will be compelled to send excess margin to
their FCMs in anticipation of future market movement on
existing positions--many billions of dollars more than needed
to cover existing positions--the last thing customers want to
do now, in the wake of MF Global and Peregrine Financial Group.
Much more customer money--maybe twice as much--will be at
risk in the event of another FCM insolvency.
Futures customers will be compelled to borrow more money
just to post margin on potential market moves--difficult for
both lending banks and for customers to predict, and
potentially difficult for smaller local banks. This increased
borrowing requirement negatively affects a customer's ability
to invest in their own business.
The entire hedging process will be made less cost-efficient,
thereby discouraging use of futures markets.
Much has been said about the meaning of the Commodity Exchange Act,
particularly with regard to the timing of residual interest
calculations and FCMs' receipt of customers' margin. With respect, we
believe strongly that the Commission's recent public stance is an
overly aggressive interpretation that overturns decades of consistent
administration of the regulations by the Commission, Congress and the
futures industry. As a recent legal review by the Futures Industry
Association has shown, there is ample flexibility in the Act to justify
the manner in which both capital charge and residual interest rules
historically have been implemented.
Clearly, the proposed rules are a huge change to the way the
futures industry does business. However, by its own admission, the
Commission has performed no credible cost-benefit analysis relative to
these specific provisions of the proposal. We believe strongly that
this fundamental change of direction by the Commission--after decades
of consistent interpretation--deserves a serious effort to quantify
benefits relative to the enormous costs and risks imposed on futures
customers. We respectfully urge the Commission to undertake a serious
and thorough review prior to any action on the capital charge and
residual interest provisions of the referenced rulemaking.
Sincerely,
AMCOT
American Cotton Shippers Association
American Farm Bureau Federation
American Feed Industry Association
American Soybean Association
CoBank
Commodity Markets Council
National Association of Wheat Growers
National Barley Growers Association
National Cattlemen's Beef Association
National Corn Growers Association
National Cotton Council
National Council of Farmer Cooperatives
National Grain and Feed Association
National Pork Producers Council
National Sorghum Producers
National Sunflower Association
North American Millers Association
USA Rice Federation
U.S. Canola Association
U.S. Dry Bean Council
CC:
Hon. Bart Chilton,
Hon. Scott O'Malia,
Hon. Mark Wetjen,
Members of Senate and House Agriculture Committees.
The Chairman. Thank you, Mr. Anderson.
Mr. Koutoulas.
STATEMENT OF JAMES L. KOUTOULAS, ESQ., PRESIDENT AND CO-
FOUNDER, COMMODITY CUSTOMER COALITION, INC., CHICAGO, IL
Mr. Koutoulas. Chairman Conaway, Ranking Member Scott,
Members of the Committee, thank you for the opportunity to
testify at this important hearing. My name is James Koutoulas,
and I am the President and Co-Founder of the Commodity Customer
Coalition. While I also serve on the board of directors of the
National Futures Association, my testimony does not necessarily
represent the views of that organization. While I am deeply
honored that our organization was invited to testify before
this Committee before the 2 year anniversary of our creation,
the fact that we exist at all is evident of the need to improve
protections for commodity customers.
For those unfamiliar with us, a lot of things had to go
wrong for the CCC to be formed. With MF Global teetering on the
bankruptcy, it's DSRO, CME Group had grave concerns about the
sanctity of segregated accounts and, 4 days before FCM's global
bankruptcy, instructed its management that no transfers were
permitted without CME's express written consent. However, CME
Group did not take the extra step of enforcing that instruction
by requiring CME approval for wire transfers initiated from MF
Global's customer accounts, and it did not require CME's
approval in JP Morgan assets, its treasury software. That would
have only taken a few minutes to configure. This oversight
allowed MF Global staff to transfer customer funds to meet
house margin calls at JP Morgan, creating a shortfall of over
$1 billion, according to the MF Global, Inc., trustee's report.
This occurred despite the fact that, per the trustee's
report, JP Morgan's chief risk officer personally informed MF
Global senior management that JP Morgan thought customer funds
were at risk. JP Morgan sent MF Global management three
variants of a comfort letter asking them to certify that no
customer funds were transferred. And although none of these
letters were signed and returned by MF Global management, JP
Morgan did not return those customer assets for over 18 months
after the bankruptcy.
Once MF Global filed for bankruptcy, its counsel
represented there was no shortfall in customer accounts,
despite internal communication otherwise. On that basis, the
bankruptcy judge permitted MF Global holdings to enter Chapter
11 rather than Chapter 7 and appointed another trustee to
oversee that reorganization. The appointed trustee permitted MF
Global senior management to remain at the firm, even though
well over a billion dollars of customer money was still
unaccounted for and even went so far as to claim attorney/
client privilege on their behalf in his dealings with criminal
investigators. This transpired in conjunction with the SIPA
trustee's alarming initial plan to keep MF Global customers'
cash frozen for a full 9 months after the bankruptcy and only
then allow the release of 60 percent of the funds.
In the face of this long list of obstacles delaying the
return of their property, thousands of customers reached out to
John Roe and myself and asked us to help them. We had farmers
saying we are incapable of buying seed. Retirees couldn't
withdraw their savings to buy medicine. We had a single mom who
said she was in danger of losing her home, because of this we
spent thousands of hours doing pro bono service to help recover
this property.
Now here we stand where the CFTC is asking customers to
double down on this FCM system that they don't trust after MF
Global, they really don't trust after PFG, and comply with this
new residual interest rule. And this rule will definitely do
more harm than good. We understand where the CFTC is coming
from, wishing to protect customers from fellow-customer risk,
which is a very valid concern, but asking that the hedge
accounts, the farmers and ranchers, to go to $900,000 up to $2
million and expose that to FCM malfeasance when the regulators
have proven that they can't stop this, I think that is
ridiculous.
And I think that what the CFTC could do is to go and maybe
enforce this residual interest rule on high frequency traders,
on firms which, in a couple of minutes, with a rogue algorithm
can blow up an FCM, but they shouldn't impose it on general
commodity customers and upon hedge customers.
And moving on to insurance. In testimony before the Senate
Committee on Agriculture, Nutrition, and Forestry, the CCC
advocated for the creation of a private insurance mechanism to
cover FCM malfeasance, much like the one Dr. Culp delineated.
We were the only group to advocate for such a plan before the
PFG failure, and we still believe it is a good idea. We agree
with Dr. Culp that private opt-in insurance is the only
feasible method for implementation of that, and we urge your
Committee to consider that.
And again, thank you, Chairman Conaway, Ranking Member
Scott, for having us here today. We are deeply honored and hope
that our feedback is helpful.
[The prepared statement of Mr. Koutoulas follows:]
Prepared Statement of James L. Koutoulas, Esq., President and Co-
Founder, Commodity Customer Coalition, Inc., Chicago, IL
Chairman Conaway, Ranking Member Scott, Members of the Committee,
thank you for the opportunity to testify at this important hearing. My
name is James Koutoulas and I am the President and Co-Founder of the
Commodity Customer Coalition. While I also serve on the Board of
Directors of the National Futures Association, my testimony does not
necessarily represent the views of that organization.
While I am deeply honored that our organization was invited to
testify before this Committee before the 2 year anniversary of our
creation, the fact that we exist at all is evident of the need to
improve protections for commodity customers. For those unfamiliar with
us, a lot of things had to go wrong for the CCC to be formed.
Industry Failures Results in the Formation of the CCC
With MF Global teetering on the brink of bankruptcy, its DSRO, CME
Group, had grave concerns about the sanctity of segregated accounts
and, 4 days before the bankruptcy, instructed MF Global management that
no transfers were permitted without CME's express written consent.
However, CME Group did not take the extra step of enforcing that
instruction by requiring CME approval for wire transfers initiated via
MF Global's treasury software, JP Morgan Access, something that would
have only taken a few minutes to configure. This oversight allowed MF
Global staff to transfer customer funds to meet house margin calls at
JP Morgan, creating a shortfall of over $1 billion according to the
MFGI trustee's MF Global Investigation Report. This occurred despite
the fact that, per the trustee's report, JP Morgan's Chief Risk Officer
personally informed MF Global management that they thought customer
funds were at risk. JP Morgan sent MF Global management three variants
of a comfort letter asking them to certify that no customer funds were
transferred, and, although none of the three letters were signed and
returned by MF Global management, JP Morgan did not return these
customer assets for over 18 months after the bankruptcy.
Once MF Global filed for bankruptcy, its counsel represented that
there was no shortfall in customer accounts, despite internal
communication by MF Global senior management to the contrary. On that
basis, the bankruptcy judge permitted MF Global Holdings to enter
Chapter 11 rather than Chapter 7, and appointed an additional trustee
to oversee that ``reorganization.'' The appointed trustee permitted MF
Global senior management to remain at the firm, even while over a
billion dollars in customer money was still unaccounted for, and even
went so far to claim attorney-client privilege on their behalf in his
dealings with criminal investigators. This transpired in conjunction
with the SIPA trustee's alarming initial plan to keep MF Global
customers' cash frozen for a full 9 months, and then allow the release
of only 60% of the funds.
In the face of this long list of obstacles delaying the return of
their property, thousands of customers reached out to John Roe and
myself after we received early media attention for our efforts to
expedite the return of our own customers' property. After hearing
stories of farmers incapable of buying seed, retirees unable to
withdraw their savings to buy medicine, and a single mother who was in
danger of losing her home, John and I organized the CCC and each
contributed thousands of hours of pro bono service to help expedite the
return of the property throughout the estate.
Outcomes for MF Global Customers
Thankfully, our advocacy and litigation efforts, helped by the
indemnity that CME provided to the trustee, all customers received 72%
of their property back that was in 4(d) designated accounts 7\1/2\
months ahead of the trustee's initial plan--although 30.7 customers had
no such luck and only received a majority of their funds back 20 months
after the bankruptcy. Now, thanks to the CFTC's proposed settlement
with MF Global, Inc., all customers are expected to receive 100% of
their property back roughly 2 years after the bankruptcy. While this
outcome exceeds almost all of the expectations formed upon the
realization that there was a shortfall of over a billion dollars in
customer accounts, it is simply unacceptable that customers were
deprived of their property for even 1 day. Worse still, they felt they
had little choice other than to rely on a handful of volunteers, with
no bankruptcy or litigation experience, to represent them against the
country's biggest bank and a former FBI director.
After MF Global's collapse, the industry has shown a renewed vigor
towards protecting customer funds, and has implemented many thoughtful
reforms, such as those delineated by Mr. Roth, namely: the ``MF Global
Rule,'' more stringent standards for FCM internal controls, and the
daily electronic confirmation of segregated account balances.
Nevertheless, in the less than 2 years since MF Global's bankruptcies,
eight FCMs have already been fined for failing to comply with various
segregation regulations, PFGBest's transgressions the most grave
amongst them.
Industry Failures Continue
PFGBest's customers have fared far worse than MF Global customers.
Despite entrusting their funds to segregated accounts held by a
regulated entity that was audited annually by a SRO, last summer their
customers were told that over $200 million of assets had been stolen
over 20 years. At this time, their only hope to recover more than 50%
of their property is for the CFTC to prevail in its litigation against
US Bank, which allegedly allowed PFGBest to treat its segregated
accounts as if they were commercial checking accounts.
Strengthening Protections through Bankruptcy Reform and Insurance
While both governmental and private regulators have generally done
a good job protecting customers historically, everyone makes mistakes.
Unfortunately, customers have bared almost all of the consequences of
both debacles, as no regulator has lost their job, JP Morgan has not
faced an enforcement action for knowingly receiving customer funds, and
no member of MF Global management has been charged with a crime or been
investigated for the many potential misrepresentations they may have
made before this, and other Congressional Committees. Thus, sole
responsibility for the safety of customer property currently relies on
a combination of public and private entities, none of whom have skin in
the game, to maintain segregation at all times, which they have
repeatedly failed to do.
Despite declining to enforce many of the existing regulations we
already have on the books, the CFTC has now proposed over 500 pages of
new rules, some of which we think add real value to customer
protections, such as the expanded testing of FCM internal controls, the
implementation of improved risk management procedures, and the required
filing of certified FCM annual reports. Unfortunately, these proposed
new rules also contain the most onerous burden ever placed on
customers: the new residual interest rules.
The Proposed Changes to Residual Interest Do More Than Good
These rules would require customers whose faith in the segregated
account system has been badly shaken by the failures of MF Global and
PFGBest to double down on it, by almost literally requiring twice the
amount of cash that is currently held in segregation industry-wide. The
would-be Russ Wassendorfs of the world do not need access to more cash
from farmers, ranchers, and investors should they wish to engage in
future malfeasance. Moreover, the businesses of small-to-midsize
agricultural users and traders have been severely strained over the
last several years due to the difficulties of making money in a
persistent zero interest rate environment and the loss of customer
confidence due to the MF Global and PFGBest insolvencies. Requiring the
industry to comply with hundreds of pages of new rules while also tying
up additional capital could very well be the final straw that puts many
out of business.
Instead of implementing many of these new rules, especially the
proposed residual interest change, the industry as a whole would be
better protected by consistently enforcing the existing. With respect
to criminal penalties, I would like to remind the Committee that any
willful violation of the Commodity Exchange Act is a felony punishable
by 10 years in prison. There are least a few cases where this law
should have been enforced, but as of now, justice has yet to be
pursued. On the civil side, penalties have generally been assessed in
relatively fixed amounts, giving the regulatory regime the worst of
both worlds--devastating small firms while failing to provide a
meaningful deterrent to large firms.
It is Time to Finally Fix Griffin Trading and Restore Customer Priority
That is not to say some additional rule changes are not necessary.
A few pages of legislative language would go a long way towards
preventing future commodity customers from waiting years to receive the
return of their property should another FCM go bankrupt with a
shortfall in customer funds. In 1999, a small FCM named Griffin Trading
was in such a situation. In Griffin, customers wound up recovering all
of their property after an eventual settlement. Before that happened, a
District Court judge held that the CFTC overstepped its authority by
regulating that customers had priority over assets needed to fill a
shortfall in segregated accounts. While this ruling was vacated by the
settlement, it has still been cited as precedent for denying customers
the immediate return of their property. The industry has been well
aware of the weakening of customer protections caused by Griffin for 14
years. Nevertheless, it did not make an effort to address it as part of
the 2005 revisions to the Bankruptcy Code, which would have mitigated
much of the suffering of Sentinel, MF Global, and PFGBest customers,
and reduced the massive fees charged to those respective estates by
bankruptcy trustees.
Restoring Customer Priority Through Subordination
It is time that we address this long-neglected issue and take this
opportunity to modify the CEA to require FCMs to subordinate the claims
of their affiliates and lending institutions to customer claims in the
event of a shortfall in segregated accounts. This would allow future
bankruptcy trustees to return funds to customers much more quickly, as
they would not have to reserve and wrangle over dubious claims of
preference made on customer assets. Some members of the industry
complain this change would be burdensome for FCMs seeking funding;
however, this provision would simply return the operation of the law to
the way it was written in 1974.
Strengthen Customer Priority by Giving Proper Statutory Authority to
CFTC
In addition to enacting this subordination provision, the CFTC's
current regulation Section 190.08(a)(i)(J) should simply be codified in
the CEA directly to invalidate the authority argument made by Griffin's
judge. The regulation states that ``customer property'' includes . . .
``cash, securities or other property of the debtor's estate, including
the debtor's trading or operating accounts and commodities of the
debtor held in inventory, but only to the extent that the property
enumerated [above] is insufficient to satisfy in full all claims of
public customers.'' Codifying that regulation in conjunction with
enacting a subordination provision would leave no doubt as to the
priority of customer funds in a bankruptcy without opening up the
Bankruptcy Code, which we have been told is akin to a zombie
apocalypse.
Customer Account Insurance
In testimony before the Senate Committee on Agricultural,
Nutrition, and Forestry, the CCC advocated for the creation of a
private insurance mechanism to cover FCM malfeasance before the
uncovering of the PFGBest fraud. We agree with our colleagues here that
insurance for commodity accounts is a complicated matter which requires
deliberative study. The type of insurance as well as its triggers and
limits are just a few of the nuances which will drastically affect the
costs and benefits of such insurance; however, you do not need a study
to determine that there is a type of customer who would benefit from an
insurance mechanism. As MFGI Trustee Giddens noted in his MF Global
Investigation Report, 78% of MF Global customers could have been fully
insured with a $200 million fund. That amount seems to be a much easier
sum to raise than the billions required by the CFTC's Residual Interest
proposal. Indeed, 91.5% of commodity customers surveyed by the CCC are
in favor of some type of an insurance mechanism.
Ring-Fencing New Account Classes
Finally, the addition of new, segregated account classes for retail
FX customers and for safekeeping accounts is a simple legislative
change that would improve customer protections for groups that are
often neglected. Many in the industry view FX customers as the red-
headed stepchildren of the futures regulatory regime, and argue that
they do not deserve the protections of segregation if they do not trade
exchange-cleared products. We beg to differ, though, and if the futures
industry is responsible for regulating retail FX, it should not expect
retail customers, most of whom are also futures customers, to
understand that nuanced argument. Rather, it should do its best to
protect all customers by giving them segregation protections, so they
do not end up as general creditors like PFGBest customers probably
will, even though no theft occurred in the FX accounts there.
There has also been significant demand for safekeeping accounts,
especially from mutual funds, which would allow customers to hold their
excess margin in an individually-segregated account at a custodial bank
rather than in a commingled segregated account at a FCM. Currently,
CFTC Interpretation 10 essentially prohibits that practice, stating
that such an account would still suffer a pro rata loss during a FCM
bankruptcy for which there was a shortfall in the general segregated
pool. We recommend creating a separate account class for safekeeping
accounts and repealing Interpretation 10 to make the implementation of
such an account class viable.
Thank you again Chairman Conaway, Ranking Member Scott, and Members
of the Committee for inviting us here today. We are honored to be
included in these important discussions as to how best protect
commodity customers going forward.
The Chairman. Thank you, Mr. Koutoulas.
Mr. Johnson.
STATEMENT OF THEODORE L. JOHNSON, PRESIDENT, FRONTIER FUTURES,
INC., CEDAR RAPIDS, IA
Mr. Johnson. Chairman Conaway, Ranking Member Scott, and
Members of the Subcommittee. Thank you for inviting me to
provide testimony regarding the customer protection rules
proposed by the CFTC. My name is Ted Johnson, and I am
President of Frontier Futures, a small family-owned futures
commission merchant based in Cedar Rapids, Iowa. It was started
by my father nearly 30 years ago to provide low cost futures
execution to people who want to make their own decisions
regarding their trading needs.
The vast majority of our customers are farmers or small
agricultural firms who use futures markets to hedge their
risks.
Today, I am here to provide the views of a small FCM on the
rule changes the CFTC has proposed to protect customer funds.
There have been a number of highly publicized failures by
futures commission merchants in the past several years
involving substantial loss of funds and shaking the confidence
of many users of the markets. I have had more conversations
than I can count with customers who are worried about the
safety of the funds they invest with us.
All these recent failures have involved fraud or
malfeasance on the part of the FCM and a failure to follow
rules and regulations regarding keeping the proper amount of
funds in segregation. The NFA, the CFTC, and other regulators
should be applauded for the great strides they have made in the
last few years using technology to verify information provided
by FCMs. Prior to this, the only--we were required to report
our funds in segregation to the NFA daily, but the only
confirmation they received was when they came in for an annual
audit. PFG showed even this could be subverted for a time.
Today, our balances are independently confirmed daily, and if
there is a discrepancy, I can tell you the NFA is following up
on that quickly.
We have also new reporting rules regarding withdrawing
funds from segregation. I fully support the rules that seek to
codify these changes and to give CFTC backing to them, and I
believe they will enhance public confidence in the futures
markets.
The other issue is the co-customer risk that the other
members of the panel here have talked about. If debit amounts
from a certain customer exceed the capital of an FCM, the rest
of the losses are made up by other customers of that FCM whose
funds are held in these segregated accounts. To my knowledge,
there has not been a case of a customer losing money due to
another customer's debit since I have been in the futures
industry for about 25 years.
Commission and interest income is too small when compared
to the risk incurred if customer accounts aren't properly
monitored to avoid debit accounts. If any markets were going to
cause a problem for FCMs, last summer's volatile ag markets
would have. However, at least in our case, we don't have a
single customer who is unable to meet their obligations. Many
of the proposed rule changes address this issue. Requiring FCMs
to increase risk management standards, increasing requirements
for residual interest in segregation and reduction in days to
collect margin calls before they become capital charges are all
aimed at protecting an FCM's customer from losses incurred by
other customers of the FCM. Most of these changes have
significant costs associated with them.
For an FCM--the requirement to maintain a separate risk
management department is not only expensive for an FCM of our
size but ignores the fact that our entire staff is, in effect,
a risk management department. The requirement to maintain
residual interest in segregated funds greater than all margin
calls at all times would be very difficult for us to track and
also will require us to choose between greatly increasing our
capital or the funds we require customers to deposit. Smaller
customers who are unable to meet their margin calls at a
moment's notice would risk liquidation of their positions.
For Frontier Futures as a firm, the option to increase our
capital may not even be possible, and the increasing margins
may cause many of our customers to either leave us for others
firms or cease trading all together.
The residual interest rule may also force consolidation in
a number of small to mid-sized FCMs. Currently, FCMs charge
margins based on requirements set by the exchanges. The new
rules will create a competitive imbalance favoring firms with
access to large amounts of capital, such as bank-owned FCMs, as
these firms will be able to fund margin calls by their
customers.
Firms without this access would be forced to charge much
higher rates and may result in migration of customers out of
these firms. With fewer customers available, there is bound to
be consolidation. This will mostly affect the small to mid-
sized FCMs who clear these small hedgers.
In the end, all government regulation should meet a cost-
benefit analysis standard. Much of the discussion surrounding
these rules is focused on the cost side of this equation.
In the case of the rules which enhance the ability of
regulators to ensure that existing rules are followed and to
prevent fraud, the FCM failures at MF Global and PFG have made
the benefits clear. However, the benefits of the new rules
regarding risk management and residual interest are far less
clear, and the cost to the industry and end-users of the
markets are real and substantial, especially smaller firms,
farmers, and ranchers.
Thank you for this opportunity to comment on this issue. I
look forward to answering any questions you might have.
[The prepared statement of Mr. Johnson follows:]
Prepared Statement of Theodore L. Johnson, President, Frontier Futures,
Inc., Cedar Rapids, IA
Chairman Conway, Ranking Member Scott and Members of the
Subcommittee, thank you for inviting me to provide testimony regarding
the customer protection rules proposed by the CFTC. My name is Ted
Johnson, and I am the President of Frontier Futures, Inc, a small
family owned futures commission merchant based in Cedar Rapids, IA.
Frontier Futures was started by my father nearly thirty years ago with
the intent to provide low cost futures execution to people who want to
make their own decisions regarding their trading needs. The vast
majority of our customers are farmers or small agriculture firms who
use the futures markets to hedge their risks.
Today I am here to provide the views of a small FCM on the rule
changes the CFTC has proposed to protect customer funds. From a broad
perspective, there are two ways that customer funds can be put at risk.
The first is when the FCM removes funds from segregation, leaving the
customer accounts under-funded. This problem has manifested itself
recently as a number of highly publicized failures by futures
commission merchants in the past several years involving substantial
loss of funds and shaking the confidence of the end-users of the
derivatives markets. I have had more conversations than I can count
with customers who are worried about the safety of the funds they
invest with us. This was especially true following the failure of PFG,
given the fact that they were located just up the road from us in Cedar
Falls, IA, and the local news coverage of the case was extensive. Our
firm was also directly affected by a less publicized FCM failure in
2007 when Sentinel Management Group was discovered to have been
illegally investing customer funds. In that case, the shortfall was
made up by other FCMs, including Frontier Futures, who had invested
customer funds with Sentinel. This cost my firm most of our capital and
forced us to close one of our three offices.
All of these recent failures have involved fraud or malfeasance on
the part of the FCM and a failure to follow the rules and regulations
regarding keeping the proper amount of funds in segregation. The NFA
and the CFTC should be applauded for the great strides they have made
in the last few years in using technology to verify information
provided to them by FCMs. Prior to this, we as an FCM were required to
report our funds in segregation to the NFA daily, but the only
confirmation they received was when they came in for an annual audit.
PFG showed that even this could be subverted. Today, our balances are
independently confirmed daily, and if there is a discrepancy, the NFA
seems to be following up quickly. We also have new reporting rules
regarding withdrawing funds from segregation, although there is no
independent confirmation mechanism for this yet. Many of these proposed
rules seek to codify these changes and give CFTC support to them, and I
fully support these rules. Most of them involve the use of technology
and procedure to greatly increase the level of protection provided to
customer funds from malfeasance by their FCMs, and should enhance
public confidence in the futures markets.
The second way customer funds in segregation can be jeopardized is
the result of large losses by other customers of an FCM. Customers of
an FCM that generate debits reduce the amount in segregation. An FCM is
required to make up that debit out of its own capital until that debit
is collected. This is a main reason for FCMs maintaining a residual
interest in the funds in segregation. If the debit amounts are larger
than the capital of the FCM, a shortfall in segregation occurs, and
results in losses by other customers whose funds are held in these
segregated accounts. To my knowledge, there has not been a case of a
customer of an FCM losing money due to a customer debit since I have
been in the futures industry. FCMs are already greatly incentivized to
avoid this risk. Commission and interest income is simply too small of
a percentage of the risk incurred if customer accounts aren't properly
monitored and debit accounts avoided. If any markets were going to
cause problems for FCMs, last summer's volatile ag markets would have.
However, we did not have a single customer who was unable to meet their
obligations.
Many of the proposed rule changes address this issue while FCMs are
already focused in this direction. Requiring FCMs to increase risk
management standards, increasing the requirements for residual interest
in segregation, and the reduction in days to collect margin calls
before they become capital charges are all aimed at protecting an FCM's
customer from losses incurred by other customers of the FCM. Most of
these changes have significant costs associated with them. The
requirement to maintain a separate risk management department is not
only expensive for an FCM of our size, but ignores the fact that our
entire staff is in effect a risk management department. The requirement
to maintain residual interest in segregated funds greater than all
margin calls at all times will not only be very difficult to track, but
force us to choose between doubling or possibly tripling our capital,
or greatly increasing the funds we require our customers to deposit to
ensure they never have a margin call. For smaller customers, or those
who can't follow the markets on a minute to minute basis, meeting
margin calls on a moment's notice is a difficult thing to do. This is
especially true of small hedge customers, who would then be faced with
liquidation of hedges. For Frontier Futures as a firm, the option to
increase our capital by that much may not be possible, and increasing
margins may cause many of our customers to either leave us for other
firms or cease trading altogether.
The broader consequence of the residual interest rule may be to
force a consolidation in the number of small to mid sized FCMs.
Currently, FCMs charge margins based on margin requirements set by the
exchanges. The new rules will create a competitive imbalance favoring
firms with access to large amounts of capital, such as the bank owned
FCMs, as these firms will be able to fund margin calls by their
customers with this capital. Firms without this access will be forced
to charge much higher margin rates to their customers, and may result
in a migration of some customers out of these firms. With fewer
customers available to some firms, there is bound to be consolidation.
This will mostly affect small to mid sized FCMs who clear small hedgers
as well as guarantee Introducing Brokers.
In the end, all government regulation should meet a cost-benefit
analysis standard. Much of the discussion surrounding these rules has
focused on the cost side of this equation. In the case of the rules
which enhance the ability of regulators to ensure that existing rules
are followed and to prevent fraud, the FCM failures at MF Global and
PFG have made the benefit clear. However, the benefits of the new rules
regarding risk management and residual interest are far less clear and
the costs to the industry and end-users of the markets are real and
substantial, especially smaller firms, farmers and ranchers.
Thank you for this opportunity to comment on this issue. I look
forward to answering any questions you might have.
The Chairman. Thank you, Mr. Johnson.
I also thank our panel for strict adherence to the 5 minute
rule. I appreciate that discipline this morning.
The chair will remind Members that they will be recognized
for questioning in order of seniority for Members who were here
at the start of the hearing. After that, Members will be
recognized in order of arrival. I appreciate the Members'
understanding, and I recognize myself for 5 minutes.
Mr. Duffy or Mr. Roth--regarding the reinterpretation of
the CEA by CFTC--they claim there is a sound legal basis for
how they came to that new conclusion that they need to
reinterpret the Act and change this longstanding
interpretation. Can you give us your opinion as to whether or
not the CFTC has a sound legal basis for that new
interpretation?
Mr. Roth. Mr. Chairman, I think the suggestion by the
Commission that the statute ties their hands on this issue,
that is their position, that their hands are tied because the
statute provides what the statute provides. In my experience,
regulators, including NFA, when they want to do something--or
they don't want to do something, their hands are tied. When
they do want to do something, they can untie knots quicker than
a boy scout, so it strikes me as being odd that for 39 years,
the Commission consistently misinterpreted the statute. And I
think the suggestion that the current proposed rule is mandated
by the statute flies in the face of logic to me.
I don't think, as a matter of statutory interpretation,
they are correct, and I think, further, the fact that for 39
years the Commission took the other position undercuts their
position.
The Chairman. All right. Thank you.
Terry, anything further?
Mr. Duffy. I couldn't add to that metaphor, so I will leave
that one alone.
Mr. Conaway. All right.
Mr. Johnson--or Mr. Anderson, I am sorry. Yes, Mr.
Anderson.
One of the issues that is of importance to family farmers
is funding, financing and providing themselves with protection
from market volatility by hedging in the commodity markets. We
are concerned that the CFTC has nearly finalized its customer
protection rules, but the very farmers and ranchers that it is
supposed to help have recently come out opposed to it. In your
opinion, is the staff of the CFTC ignoring the concerns of
smaller agricultural customers, despite the overwhelming
concern that Congress and the Administration has expressed for
the financial well-being of family farms?
Mr. Anderson. I am not sure if they are ignoring it, but we
are all here today to make sure that that voice is getting
heard. I think there is momentum. Obviously, the messages today
are pretty similar, so we just want to make sure that is heard.
The Chairman. All right. Dr. Culp, thank you for your work
on this insurance study. Can you spend a little time walking us
through the mechanics of how a $25 million fee will grow to
$2.5 billion in 2067, and why that is not necessarily a viable
option?
Dr. Culp. Sure. In order to get to that particular number,
there is a chart that is contained in my written testimony,
made the assumption that there is no change in the gross
revenues from the futures industry, from the FCMs from 2012
levels; in other words, no increase nor no decrease. So using
the 0.5 percent annual contribution rate for all 70 FCMs that
reported in 2012, that gets us to a $25.5 million a year
number. We then assume it is invested at two percent a year and
that there are absolutely zero claims or losses. In that
situation, the fund would grow to $2.5 billion after 55 years.
The same thing happened with SIPC, and there is also a
chart that is in my written testimony. If you look at the
profile of SIPC when it was funded in the first place, the
funds in SIPC grew very slowly, so had there been a very large
loss early in the life of SIPC, the only thing that would have
made the SIPC facility at all credible was the $2.5 billion
line of credit that SIPC has with Treasury. That is why, to me,
the idea of a universal government mandated fund along these
lines just isn't a credible, viable option to provide capital
and assurances to investors, unless it is including an implicit
or explicit government backstop.
The Chairman. All right. And in the time remaining, could
you flesh out a little bit why the futures market may not be
well served by a model that is designed for clients in a retail
equity market.
Dr. Culp. Sure. In fact, those are related issues. It is a
good question. I mean, futures are risk-shifting markets. You
have heard this from my other co-panelists already. Securities
markets are markets for investment in capital formation. The
historical role of participants in futures markets has not been
of retail investors. There is a retail component, but the vast
majority of futures trading participants are commercial hedgers
that are managing the risks of their businesses, institutional
investors, like pension funds, et cetera. Often, the sizes of
the accounts held by these participants are relatively large,
especially compared to a $250,000 policy limit.
So, to some extent, having a retail-type government-backed
fund for a wholesale sophisticated market is a bit like ramming
a square peg into a round hole.
The Chairman. All right. Thank you, gentlemen.
I will have some other questions later.
Mr. Scott, for 5 minutes.
Mr. David Scott of Georgia. Thank you very much.
Mr. Duffy, may I start with you?
I listened to your testimony and you recommend the Future
Industries Association's alternative proposal to residual
interest, that is, to permit an FCM to calculate its required
residual interest as of 6 p.m. On the first business day after
the trade date.
Mr. Duffy. Correct.
Mr. David Scott of Georgia. So, as we do not have the FIA
here to testify, can you explain to the Committee how this
proposal accomplishes what the CFTC is aiming for in its
proposed rule, without the cost that everyone here has
testified to?
Mr. Duffy. Well, without having FIA here, what we are--our
understanding is, and what I have talked with our risk folks
and our clearing folks is, in talking with all of our FCMs,
they believe that they can calculate--or they can collect
somewhere in the neighborhood of 80 to 90 percent of the margin
that is due by the next day.
Mr. Roth is correct. Everybody does not do wire transfers.
Many still do checks, but for the most part, we can probably
wire most of the money in by 6 p.m. the next day, but there is
this still outstanding ten percent. So, that is really what the
alternative calls for. I think what is important here, the
Commission's interpretation of ``at all times,'' you heard the
gentleman to my far left make a comment about how they can't
complete--they cannot comply with such a requirement, and this
is a compromise that makes complete sense.
So that is really how they came up with it. We believe
firmly that we can get most of the margin in by 6 p.m. the next
day.
Mr. David Scott of Georgia. Very good. Now, to you, Mr.
Roth and actually, if we have time, I would like the whole
panel to respond to this. Many of you highlight two particular
risks to customer segregated accounts, those arising from the
futures commission merchant itself and those arising from
losses experienced by fellow-customers. Now, given the history
of the futures market, which of these risks is greater and
which risk should we be most worried about attempting to
address in this CFTC reauthorization? And if I could get as
many responses as we could.
Mr. Roth. Thank you, sir. The--back in, I guess it was
around 1986, NFA did a study of FCM insolvencies, going all the
way back to 1938, and if you look at the whole history of FCM
insolvencies, by far, the most frequent cause of an FCM
insolvency is malfeasance. By far. So, the most--just in terms
of frequency, the customer, or rather FCM malfeasance is the
greatest risk.
In terms of magnitude of the risk, if you did have these
sort of cataclysmic market events that sparked a number of
defaults by major institutional customers, the magnitude of
those losses that could be caused by fellow-customer risk would
be far greater than what happens through malfeasance. But as
far as frequency, by far, would be the malfeasance by the FCM
historically.
Mr. David Scott of Georgia. Dr. Culp, would you comment on
that?
Dr. Culp. I think Mr. Roth is right. I would actually add
one thing, though, that if you think about the fellow-customer
risk, we actually have done analyses of these numbers, again,
working with CME and the stress testing model. In order for the
magnitude of fellow-customer risk to exceed the malfeasance/
misfeasance risk, you would not only have to have a truly
catastrophic market move but you would actually have to have a
fairly large number of the customers of the FCM fail to make
their margin payments. If you look at just a few hundred for a
large FCM, and we went through a number of iterations of this,
but if you don't have widespread failures to pay, then even the
magnitude of fellow-customer risk can actually be below the
misfeasance or malfeasance risk. So, I agree, I think that is
bang on.
Mr. David Scott of Georgia. All right. Now, very quickly.
In previous testimony, this Subcommittee has had calls for
increased penalties for market manipulation, attempted
manipulation, other violations in order to better protect
customers by having stronger punishment for wrongdoers. Do you
agree, or do you think current penalty levels are sufficient to
dissuade wrongdoing in the derivatives market?
Mr. Roth. I am sure everybody wants to talk about that, but
I will jump in first because I was quickest with the button.
You know, ultimately, the strongest deterrent you can have is
criminal enforcement of rules. Civil penalties are fine. They
are important. But nothing is more effective than vigorous
prosecution of existing laws. And it is frustrating for
everybody because there are always so many competing interests
for the resources of the prosecutors as well as any other facet
of government, but that is really where you are going to
achieve the greatest deterrent impact, is vigorous criminal
prosecution of the existing laws. Civil penalties are
important. I don't mean to minimize them, but nothing is more
important or effective than criminal prosecutions.
Mr. David Scott of Georgia. Well, thank you so much. I see
my time has expired. Maybe we will come back, and in a second
round, I can get responses from others on that.
The Chairman. All right. Thank you, Mr. Scott.
Chairman Lucas, 5 minutes.
Mr. Lucas. Thank you, Mr. Chairman. And I thank you and the
Ranking Member for this hearing and all of the work you have
done on this subject matter.
And I certainly appreciate our witnesses appearing today to
discuss an issue that has garnered a lot of attention.
We have been discussing the CFTC's proposed rule that seeks
to improve customer protections. However, I worry that the
Commission has missed the mark with much of its proposal. As
currently drafted, the futures commission merchants would be
forced to use their own capital to cover all customers
positions at all times of the day, in addition to farmers and
ranchers that would have to meet 1 day margin requirements, and
for many of our rural folks, our farmers and ranchers, a 1 day
margin call is simply unrealistic.
So, I ask the group: To anyone's knowledge, have there been
conversations between USDA and CFTC about the impact this
customer protection rule will have on farmers?
That is what I was afraid of.
Given the vocal outcry from producers in the ag
marketplace, and I ask again this question generally to the
group, are you optimistic that the Commission will repropose
this rule or at least make meaningful changes?
That is what I was afraid you would say. Let the record
show that there was not any optimism on either question in that
regard.
I just would note that I wrote a letter to the CFTC last
week with the leaders of both House and Senate Agriculture
Committees asking the Commission to not ignore the concerns of
the small ag players in the market.
And Mr. Chairman, I would like to ask unanimous consent
that the letter be entered into the record, written by myself,
Ranking Member Peterson, Chairwoman Stabenow, and Ranking
Member Cochran from the Senate Agriculture, Nutrition, and
Forestry Committee.
The Chairman. Without objection.
[The letter referred to is located on p. 61.]
Mr. Lucas. Thank you, Mr. Chairman.
Finally, I will ask this question, Mr. Duffy, and of
course, if anyone else would care to answer. If the proposed
changes to the residual interest and 1 day margin are
implemented by the CFTC, what will the futures commission
merchant industry look like in 5 to 10 years, and what will
happen with the farmers and ranchers who they have served for
decades?
Mr. Duffy. I will give you the 5 to 10 minute version first
because that is what will happen in 5 to 10 minutes. We had a
meeting in Chicago, the former Secretary of Agriculture, Mr.
Glickman, and myself, held with all the ag producers and all
the groups from around the country, and we had everybody from
NCBA to the National Farm Bureau, and they said to a person,
they would be out of the market instantaneously if that was to
happen.
So, I don't know what is going to happen in 5 to 10 years,
Mr. Chairman, because that is a very difficult thing to try to
look into the future, but I can tell you, this is a very
serious issue for our farm community. We only have a handful of
FCMs that they have the ability to go to today. If those FCMs
are burdened with an additional cost, these participants will
have nowhere to go in the marketplace except to do over-the-
counter type transactions or things of that nature due to risk
management. That is exactly what Dodd-Frank called for them not
to do. You want them on a listed exchange doing it in the
clearinghouse.
This is a critical issue for a good part of the average
daily volume of liquidity for farmers and ranchers because not
only does this impact farmers and ranchers, the people that
create that liquidity, they will have nowhere else to go. What
happens is, these spreads will widen dramatically, and when
those spreads widen dramatically then the producers of
agricultural products will have to pass on that cost of their
risk management onto the American consumer. That is not a good
outcome on a very bad rule, sir so, I cannot tell you where 5
or 10 years will go. I can tell you what is going to happen in
5 or 10 minutes once this passes, though.
Mr. Lucas. Anyone else wish to comment?
Sadly, Mr. Chairman, I think that sums it up. I yield back
the balance of my time.
The Chairman. Well, I thank the Chairman and appreciate
your questions this morning.
Let us now go to Gloria for 5 minutes.
No questions.
Mr. Costa for 5 minutes.
No questions.
Dr. Benishek for 5 minutes.
Mr. Benishek. Thank you, Mr. Chairman.
Have any of you had conversations with the CFTC about the--
what is the response to your concerns? I mean, it seems like
you said that our hands are--they said our hands are tied. Is
that the only response that you have gotten to your inquiry
about this?
Mr. Roth. The conversations that I and others have had, you
do have the response that, one, our hands are tied; this is
just mandated by the statute. I think there are times when
certain members of the Commission staff proposed alternatives
that would extend the time at which the funds had to be in
place to the end of the clearing cycle, which is like 3 a.m.,
the next day, and which does really no good at all.
Frankly, in response to the Chairman's question, I am kind
of an optimistic guy by nature, and I think that there has been
enough outcry on this that I am very hopeful that the
Commission will ultimately adopt a rule that makes sense.
It takes three votes up there--I am optimistic that reason
will prevail. But in conversations, it has been largely again
that their hands are tied, this is mandated by the statute, and
that they are willing to extend it to some point but not as far
as the FIA proposal, which NFA would certainly support.
Mr. Benishek. Let me ask you, has there been a change? I am
not familiar enough with the Commission to--has there been a
change in the composition of the Commission or the staff that
would result in loss of institutional knowledge or the fact
that this has been interpreted one way for 39 years doesn't
seem to bear any weight in the decision making process? Can you
elaborate on that?
Mr. Duffy. Yes. I think the only change, obviously, has
been Commissioner Sommers, who has stepped down. The Commission
has not filled that vacancy yet. They put up a nominee. The
President has put up a nominee so far but yet to be confirmed,
so we don't have a full complement of Commissioners. As far as
staff goes, they have only made one announcement as of recently
that was on the enforcement side.
On this particular rule issue, again, you said it
correctly, it has been 39 years of interpreting it one way, and
I believe this is what Mr. Roth said in his testimony, this
is--has nothing to do with what happened to protect customer
funds under MF Global or PFG. This wouldn't have done anything
to prevent what MF Global did to the marketplace. What MF
Global did, we won't rehash all the things that they did,
because I testified in front of this Committee and others, they
committed a fraud, for the most part. And that goes with what
Mr. Roth said earlier, we need to have penalties, more than
civil, criminal penalties to make sure that these things don't
happen again, but this rule, sir, makes absolutely no sense
whatsoever from the Commission's standpoint.
Mr. Benishek. Thank you.
Mr. Anderson. I could add to that as well, though. Last Ag
Advisory Committee meeting, they said the same thing, hands are
tied. We have done a little bit of work, and it appears they
are pulling one line out of the Commodity Exchange Act, and the
very next line in there says, ``Provided, however,'' and goes
on to have a list. I don't know exactly off the top of my head
what that says, but we believe that ``Provided, however,''
phrase might have a little flexibility, and we included that in
our written testimony as well.
Mr. Benishek. Does anyone else want to comment?
Well, I think I will yield back my time. Thank you.
Mr. Duffy. Mr. Chairman, may I make one more comment,
please?
I think what is really important, sir, to recognize and not
get lulled to sleep by the Commission or its proposal, as I
said in my testimony, and others have also, it is a phased-in
proposal, where sometimes that gets very attractive where the
first year there is no change and so people feel, well, we will
worry about in a year from now.
This, even though it is a phased-in proposal, I assure you
that people that are looking at this will not wait 1 year to
see what year 2 and 3 and 4 are going to look like. They will
be out of the market long before that, because what will happen
is FCMs are going to have to set up business models. They can't
have business models for 30 days. They have to put out a 2 or 3
year or 5 year business model. This will impact that 2 or 3 or
5 year business model if they try to implement it, so I would
hope that the Congress would recognize that this 4 year
implementation is no different in year 4 than it is today.
Mr. Benishek. Thank you, sir. I will yield back.
The Chairman. The gentleman yields back.
Austin Scott for 5 minutes.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
We have heard a lot today about the things that are wrong
in the proposed rule, and I am going to--Mr. Roth and Mr.
Anderson, if the two of you would--what are the things in the
rule that you think are right, if anything?
Mr. Roth. There are a number of things, and we support most
of the proposal. Certainly, to the extent that the Commission
codifies the changes that have already been made by SROs, we
are fully supportive of that. In addition, though, they
require--they require FCMs to expand our test in FCM internal
control. I think that is a good idea. They required FCM
certified financial reports to be filed within 60 days of the
firm's fiscal year-end instead of the current timeframe. I
think that is a good idea. It is a harmonization step. They
would require that FCMs that are undercapitalized provide
immediate notice to the SROs and to the CFTC. That is a good
idea. There are a number of things in there that are a good
proposal. There are others that--residual interest isn't the
only interest that we had trouble with, and I recited in my
testimony some of those concerns that we have, none of them as
grave as with respect to residual interest, so there are a
number of things in here that we fully support, and I hope the
rule proposal goes forward, and I certainly hope they make the
changes that they need to make.
Mr. Anderson. NGFA has been a big proponent of customer
protections. You know, again, these two points, we have debated
them here. But in general, a lot of the transparency that they
are trying to bring through the new rule is positive. So we are
certainly supportive, again, of most of what is proposed.
Mr. Austin Scott of Georgia. I guess the loss of faith in
the markets is just as detrimental as the increased costs that
may drive people out. Either one of them can drive people out
of the markets. I hope we are able to get a commonsense, good
resolution that increases that transparency and does not
increase the cost astronomically.
Mr. Chairman, with that said, I will yield the remainder of
my time out of respect for other Members.
The Chairman. Thank you, Austin.
Randy Neugebauer, 5 minutes.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Duffy, I enjoyed your editorial in The Wall Street
Journal.
Mr. Duffy. Thank you, sir.
Mr. Neugebauer. You know, one of the things that I am
hearing is that, does anybody support the enhanced settlement
rule?
Mr. Anderson. Could you repeat that?
Mr. Roth. Congressman, I am sorry, does anybody support the
residual interest rule, is that the question?
Mr. Neugebauer. Right. Yes, I am sorry. Yes.
Mr. Duffy. No.
Mr. Neugebauer. One of the things that I wanted to bring
out, Mr. Duffy, in your day-to-day operations at the exchange,
I mean, you all are monitoring market movements and where there
is potential risk. I mean, it is not like you wait until 2 or 3
days later and say, what happened? Some of those things are
happening in a real-time environment, are they not?
Mr. Duffy. Congressman, they might have been happening in a
real-time environment, they have been happening for a long time
in a real-time environment. So we do what is considered twice
daily mark to market. We can do pays and collects on an hourly
basis if need be under what market conditions dictate. We spend
a tremendous amount of money to make sure to police our markets
not just from abuses in them, but from a risk management
standpoint, and that is critically important to the health of
the marketplace. So, yes, sir, we do that.
Mr. Neugebauer. And, Mr. Johnson, I mean, you have
customers out there, some large and some small, and with
various positions out there. You are monitoring the
marketplace, as you said, all of your people are basically risk
managers because you are helping your clients manage their
risk. But you are also managing your risk in the sense that
making sure that you will be able to meet the exchange
requirements. Is that a fair statement?
Mr. Johnson. Yes, that is correct. I mean, the bottom line
is if one of our customers is unable to meet their requirements
and goes debit, it is our money that is on the line first. From
that standpoint certainly we are constantly monitoring what our
customers are doing, how their positions are being affected by
market moves at any given time. I mean for us, as I said, our
whole firm is essentially a risk management department, and we
are doing that all the time.
Mr. Neugebauer. Mr. Roth, you mentioned that the response
from the CFTC is that their hands are tied and that they feel
like there is a legal obligation for them to implement this
rule. We are headed for a reauthorization period here. What
legislative fix would you suggest that we look at if it appears
that the Commission is going to go ahead and implement this
rule?
Mr. Roth. I think if the Commission, in fact, went forward,
Mr. Anderson pointed out that there is--the qualifying language
to the requirement that no one customer's funds be used to
margin another customer's positions, the Provided, however,
language that follows that, in our view, currently provides the
Commission the flexibility that it needs. But if the Commission
determines otherwise and goes forward with this rule, God
forbid, then that is an area where Congress might be able to
insert language into the Commodity Exchange Act to make clearer
that the Commission's rule is invalid and not necessary.
Mr. Neugebauer. Mr. Duffy?
Mr. Duffy. If I could just add to that, what would be
acceptable is, at least from CME's standpoint and the Futures
Industry Association, is adopt the rule that they have put
forward, which is to do trade day plus 1 at 6 p.m. And as I
said earlier, we feel very confident in surveying a lot of our
FCMs that the moneys can be collected 80 to 90 percent by 6
p.m. trade day plus 1.
Mr. Neugebauer. Anybody else want to comment?
Mr. Chairman, with that I will yield back.
The Chairman. Thank you.
Mrs. Hartzler, 5 minutes.
Mrs. Hartzler. Thank you, Mr. Chairman.
Dr. Culp, I was very interested in your testimony about the
insurance study. And you said, given the projection that a
government-mandated creation of a Futures Investor and Customer
Protection Corporation would not have $1 billion in assets to
protect futures customers until around 2041. Would that imply
that a taxpayer-funded line of credit at the Treasury
Department would be necessary for it to be viable in the
foreseeable future?
Dr. Culp. That is a good question. But part of the answer
to the question revolves around where the target funding level
comes from. I mean, the target funding level of $2.5 billion is
basically what SIPC's target funding level is. The $1 billion,
I made mention of that in my written testimony because it is a
nice round number.
The real question is how much do you actually need to cover
big potential losses. And with a mandated universal scheme,
given what the potential risks are, I find it extremely
unlikely that there would be adequate funding without a
government backstop to cover a truly catastrophic loss
scenario.
Part of the problem is it covers everyone. It is mandated
by the government and it is universal, so that includes small
customers and really large customers. Even though there is a
contemplated policy limit, there is a lot of risk out there.
And the advantage of the voluntary solutions is it enables the
people who most value insurance to try to get the insurance
that is tailored to their needs as opposed to, again, forcing
the square peg into the round hole of one size fits all for the
whole industry.
Mrs. Hartzler. Now, you have used the word scheme twice, so
we know where you are coming from there.
Dr. Culp. Sorry.
Mrs. Hartzler. No need to apologize. You are the expert.
And I just, from a gut level, feel like we would be
establishing another Federal Flood Insurance Program, or FDIC,
or some new government-backed insurance program where the
taxpayer ultimately could be responsible for loss there. I
appreciate your input on that. I will look forward to hearing
what the insurance companies come back with as far as quotes
for other options there.
But I want to move on. Mr. Anderson, first of all, I think
I might have some of your facilities in my district in
Missouri. Do you have any retail outlets in my district?
Mr. Anderson. No, our retail outlets are all in northwest
Ohio, Toledo area.
Mrs. Hartzler. Oh, well, that is all right. I wanted to ask
you a question, though. Your testimony highlights the points
that had the CFTC's proposed rule been in place when MF Global
failed, possibly twice as much customer money, the hard-earned
money of many farmers and ranchers would have been lost. So how
must the CFTC change its proposed rule in order to avoid such a
stark possibility from happening in the future? I believe Mr.
Duffy said something about criminal penalties earlier. I don't
know if both of you want to respond, but if you want to start,
Mr. Anderson, and then Mr. Duffy.
Mr. Anderson. Sure. You know, frankly, we have supported
going back to the consistent interpretation that has been
there, which would allow a lot of the futures industry to
continue operating as it has. That is our opinion. And FIA also
had a proposal a little bit different than that, but either of
those will keep--the goal is really to keep the FCM from asking
for money upfront----
Mrs. Hartzler. Yes.
Mr. Anderson.--to cover that move that may or may not come.
If we can go back to the consistent interpretation that we have
always had, that would suffice.
Mrs. Hartzler. Okay. Mr. Duffy, do you want to add
anything, go back to the----
Mr. Duffy. Actually, I was only emphasizing the point that
Mr. Roth made, he said it earlier about the civil and criminal
penalties.
Mrs. Hartzler. Okay.
Mr. Roth. I am sorry, did you need to hear more than that?
Mrs. Hartzler. Sure.
Mr. Roth. Just the point, the question is whether we should
increase the civil penalty sanctions that the CFTC can impose,
and my only point was that civil sanctions are very important,
but in my experience the most effective deterrent to wrongful
conduct by far is not civil penalties, but criminal penalties.
And so ultimately you have to enforce the rules that are on the
books and get criminal prosecutions when people steal money.
Mrs. Hartzler. Okay. Yes, do you want to add something?
Mr. Koutoulas. Just to add to Mr. Roth, the rule is already
on the books that any willful violation of the Commodity
Exchange Act is a felony and bears up to 10 years in prison.
The CFTC has already brought a civil enforcement act against
the CEO of MF Global. We think that the Department of Justice
should go ahead and bring criminal prosecutions along the same
vein. And we also think that the Department of Justice needs to
investigate the misrepresentations made by MF Global senior
management before this Committee and other Committees when
testifying about their conduct in the days leading up to the
bankruptcy.
Mrs. Hartzler. All right. Thank you very much.
Thank you, Mr. Chairman.
The Chairman. I thank the gentlewoman.
Mr. LaMalfa, 5 minutes.
Mr. LaMalfa. Thank you, Mr. Chairman.
For Mr. Johnson here, earlier you testified how your family
has been around 30 years in the business, and you work
primarily with the smaller firms, the smaller growers. And you
already went through some difficulty obviously back in 2007
because you were caught up in that, you had to close one of
your offices. What was the impact on the number of personnel
because of that, or in general since then, with the changes in
rulemaking, et cetera?
Mr. Johnson. Well, in that case we closed one of our three
offices, which had about 25 percent of our staff, total staff,
and that was as a result of--we have talked a lot about the two
main FCM failures here, the PFG and MF Global, and that was
another FCM failure which didn't result in any customers losing
money but a number of other FCMs who had money invested there
did lose money, and we were one of those.
Mr. LaMalfa. Okay. If CFTC rules are adopted as proposed
for your operation, how much would you have to alter or are you
one of the ones that in 10 minutes is in big trouble?
Mr. Johnson. Well, that is a possibility. For us, because
we are a very small FCM, we clear a lot of our business at, for
instance, the CME through another FCM. So it will depend a
little bit on how they treat it. If they force us to double or
triple our margins, we will initially have to do that to our
customers, and then it becomes an issue. I don't think that we
would be gone in 5 or 10 minutes. In our case it would be a
question of how many of our customers are going to leave us
because of that.
Mr. LaMalfa. Will they have a better place to go under
those conditions then, it would be more attractive to go to a
larger?
Mr. Johnson. It may be if they can find a larger FCM that
is even willing to clear them.
Mr. LaMalfa. Yes.
Mr. Johnson. In a lot of cases with many of our smaller
customers, the larger FCMs aren't even interested in doing
business with those people. So a lot of them may just decide to
leave the futures markets altogether----
Mr. LaMalfa. Completely.
Mr. Johnson.--which is a problem for them and for the
industry as a whole.
Mr. LaMalfa. Certainly. Certainly.
Mr. Duffy, we are hearing about a proposal from the White
House to impose a transaction tax on the operations of CFTC.
Now, we have seen similarly that the SEC's budget over a decade
has practically doubled. What do you see if this tax is imposed
and there is a larger budget for CFTC, what do you see
happening in the future there with that additional requirement
for a budget for CFTC and what they are going to be doing with
it as far as enforcement?
Mr. Duffy. I think that the user fee question and the CFTC
budget question and the SEC has doubled their budget,
obviously, Professor Culp mentioned the difference between
capital formation and risk management. Capital formation you
can go ahead and charge a per share stock, per transaction fee
to fund the SEC because most people will hold on to a share of
stock much longer than they will a derivative product, and you
have many more participants in the marketplace to make it up,
so it is much easier.
In our world there is not nearly as many of the liquidity
providers that are in the marketplace, and right now our
highest liquidity providers that are standing there all day
long creating tight bid offers, in order to get the $300
million that the CFTC has proposed, there would have to be a
4.5 charge to our largest liquidity providers to raise that
$300 million annually. That is a 70 percent increase in their
cost of doing business to provide liquidity.
If, in fact, you charge any business a 70 percent increase
in cost to do business, they are going to do one of two things.
They are going to figure out how to lay off that risk to
somebody else or that cost to somebody else, and the only way
market makers could do that is to widen their bid offer as I
talked earlier. So if, in fact, we were to impose a transaction
tax or a user fee on the participants of liquidity providers,
the bid offer spread would widen, so the producers of products
of grains and livestock and products like that, those costs
would either be out of the market and have to be assumed
themselves, passed on to the consumer.
And there is one thing that is really important here,
Congressman. The United States Treasury has an auction every
week, and at that auction every week, as you know, the yields
have not been very great, but they are aggressively in there
bidding for them. The reason people can aggressively bid for
the United States auction every week is because there is a
liquid futures market to lay that risk off. If that spread
widens in the futures market because the cost of business goes
up by 70 percent, the amount that will cost to taxpayers in
facilitating that debt will go up by billions and billions of
dollars because those spreads will widen. That will force the
yield to go up on the Treasury debt.
So this is one of the most penny-wise, dollar-foolish
things I have ever seen in my entire life. We have seen user
fees, just as an example being in India, just this past summer,
absolutely destroyed their market by 25 percent. Sweden 20
years ago imposed a transaction fee; they no longer are a
financial services center whatsoever. In Europe there was a
Tobin tax proposed, as we all know. That Tobin tax has not been
implemented and been watered down to basically nothing
throughout the rest of Europe and will not even apply to
derivatives.
So there are big issues associated with these markets, how
fragile liquidity can be and what the cost of liquidity can be.
Mr. LaMalfa. I appreciate that answer. My time is up, but
thank you.
Mr. Duffy. Thank you, sir.
The Chairman. All right. Mrs. Roby for 5 minutes.
Mrs. Roby. Thank you, Mr. Chairman.
Thank you all for being here today.
We have touched on this, Mr. Johnson, but I really want to
drill down and if you could elaborate. If the industry
consolidates as a result of the proposed rule, let's talk about
the little guys, what the impact is going to be on small
farmers and agricultural firms that make up most of your
customers, if you would.
Mr. Johnson. Well, as I stated earlier, most of our
customers are small farmers, maybe some larger farmers or small
agricultural firms. The issue with a consolidation of the FCM
industry is that for the most part the larger FCMs, especially
the bank-owned FCMs, are not interested in doing business with
really small customers. From their standpoint, doing the risk
management on a small customer is really about the same amount
of work as it is on a large customer in terms of time and staff
and things like that, and yet the benefits that they get from
those larger customers are a lot greater.
You know, from our standpoint, we have been doing business
with our customers for years. I mean, we will celebrate our
30th year next year. Many of our customers have been with us
for a long time, a large portion of that time. Our order desk
staff averages between 15 and 20 years of experience in the
industry. So we know our customers, we are able to do the risk
management on those customers in an efficient way.
If a firm like us were to no longer be able to do business
because a number of our customers left us for some reason, I
believe that a lot of them would have a very difficult time
finding another place to do business or, if they did, the
business would be a lot more expensive for them. They would
either be required to put up a lot more margin or pay a lot
higher commissions to other firms to cover their costs in terms
of doing the risk management and things like that.
But the real issue is that the small FCMs, the midsize FCMs
like us are the ones that do the farmer business, and those are
the ones that are most at risk.
Mrs. Roby. Sure, thank you very much.
And, Mr. Anderson, can you elaborate as well what the
consequences for your business and your customers if the CFTC's
proposed rule on the customer protections is finalized with no
changes?
Mr. Anderson. Sure. The double margining--we think that is
a reasonable conclusion, it is going to drive up our cost of
doing business. When we buy grain from the farmer, we sell
futures on the Chicago Board of Trade or CME Group, and now it
is going to cost us twice as much to do that. We typically pass
on some sort of fee to the farmer, so it is either going to
come to them on the front end or, we are a low-margin business,
so we will look to make a little more margin to offset some of
those fees. And I don't think that is unique among the elevator
industry. I think that people will look to recoup that cost one
way or another.
Mrs. Roby. Thank you again for all being here today.
Mr. Chairman, I yield back.
The Chairman. I thank the gentlelady.
Mr. Davis for 5 minutes.
Mr. Davis. Thank you, Mr. Chairman.
And thank you to all the witnesses. Raise your hand if you
are from Illinois. Let the record show. Thank you, Mr. Enyart.
Let the record show that four witnesses raised their hand being
from the great State of Illinois. I just wanted to gloat to my
fellow colleagues how important the State of Illinois is to
this issue.
The Chairman. Gloating was noted and offensive.
Mr. Davis. Thank you. Duly noted, sir. Offending the
Chairman is probably not a good way to start the hearing today,
is it?
But a lot of questions have been asked. And, Mr. Duffy, to
start with, I enjoyed your expanding on the White House's
proposal for the transaction tax. Are there any other issues
you would like to address on that particular question that you
may not have had time for?
Mr. Duffy. Other than--this is one of those fees--I was
asked this in the United States Senate a couple months ago--if
the industry is not going to pay for it, who should pay for it?
And it is a very difficult scenario to say.
This is one of those situations where we are talking that
the CFTC is looking for funding because they have to have
oversight of $641 trillion over-the-counter business. I like to
remind Congress that the $640 trillion over-the-counter
business has less than 2,000 transactions a day. We don't
measure risk in notional value; we measure it in the amount of
transaction and participants in the marketplace. We do 15 to 20
million transactions in the futures markets today; we trade
over a quadrillion dollars of risk on an annual basis. I mean,
that is 17 zeros, Congressman, so that is a lot of risk. And we
have been doing that flawlessly for many, many years. So I
don't think we can measure the amount of funds associated with
an agency on the notional value of the contracts.
Second, I think that any time we look to impose user fees,
the detriment that that could do, like I said earlier, I mean,
if you want to charge an industry $300 million, unfortunately
you are going to charge the taxpayers several billion dollars
of the offsetting cost that people will pass on to the users,
not just in the Treasury debt facilitation, but in the price of
wheat, corn, barley, livestock, and everything else because it
will have to go up if there is no risk management or the cost
of risk management goes up. So this is essential for the food
supply of the United States of America.
Mr. Davis. I agree, and thank you very much.
One other question. I mean, obviously MF Global has been an
issue that has been discussed already in most of the testimony
and in some of the questions. What is CME's role in
facilitating the processes that are being put in place to avoid
another MF Global situation?
Mr. Duffy. Mr. Roth and I both have outlined several things
in our testimony, both orally and written, and I think that
these are new things that have not had a chance to be fully
either implemented but let's see the full value of them, and
that is what is important here. We have put many new
protections in, and Dan said it right, the look-through into
the customers' balances is something that we didn't have
before, which if we had had the electronic look-through before,
PFG wouldn't have happened or would have been discovered much
earlier.
First of all, with all due respect, Congressman, you can
put a cop on every corner and somebody is going to still try to
commit a crime. There was falsified records associated with MF
Global. I don't want to debate all the facts, we have done that
many times in this Committee and others. The good news is that
there are many new protections for the clients today, and if we
can have the deterrent that Mr. Roth referenced where we have
criminal penalties associated with some teeth in it, that would
be the most important thing.
Mr. Davis. Thank you.
And last, obviously we have heard through your testimony,
Dr. Culp and others, that if customers are unwilling to
purchase private insurance, that a government-mandated program
funded by market participants might be a viable option.
Mr. Duffy, I have seen your testimony, you disagree with
this, and can you expand on that, too?
Mr. Duffy. Yes, I am not big on government-mandated
programs. I don't think they are good. I like the private
sector answers better. If people want to have an opt-in
insurance policy that they want to pay for, I have said it
before in public testimony, that should be their right to do
so.
I will tell you, Congressman, we have a $100 million fund
set aside for farmers and ranchers for this type of activity,
so if there is any type of fraud or things of that nature, we
will pay bona fide hedgers, which we have done in PFG's case,
where we didn't even have the obligation to do it because we
weren't even a DSRO for PFG, but we paid them out on that
particular program.
That $100 million, think about that, that is not a lot in a
business that has got multibillions under management. We have
$105 billion of margin on account. That $100 million was
uninsurable from a practical standpoint. So I can't imagine how
we could ever get a scheme together--I don't want to use the
word scheme again--but a scheme together to put together enough
money to oversee the system. And the last thing that I or
anybody at CME Group would support would be to have a
government backstop.
Mr. Davis. Thank you. My time has expired.
The Chairman. The gentleman's time has expired.
Mr. Enyart, any questions?
Mr. Enyart. I will waive my time to Mr. Scott. I have no
questions.
The Chairman. The gentleman yields to Mr. Scott for 5
minutes.
Mr. David Scott of Georgia. All right. Thank you.
Let me go back. I want to make sure we get everybody on the
record on this. Does everybody agree? I think, Mr. Duffy, you
concur that we should have criminal charges being brought, you
spoke to that. Is that correct?
Mr. Duffy. Yes, sir.
Mr. David Scott of Georgia. All right.
And, Mr. Roth, you gave an eloquent answer.
What is interesting is, Mr. Chairman, you put such a nice
diverse panel here, it would be good to see if we could get
everybody on board on that, so I put that question to everybody
pretty quickly. To really protect the customers and to punish
these violators and manipulators, do you all agree or disagree
with Mr. Roth and Mr. Duffy that we should bring criminal
charges and that that would help this if we could put some of
these folks in prison, and that would cut it down? Is everybody
on board with that or is somebody different?
Mr. Anderson. NGFA, we haven't recommended any specific
penalties, but we certainly believe there needs to be
appropriate teeth in the law. We just haven't quite advocated
exactly what we mean by that yet.
Mr. David Scott of Georgia. So you do not agree that we
should bring criminal charges?
Mr. Anderson. Today we would not have enough information to
say yes or no to that.
Mr. David Scott of Georgia. All right. Mister--I do not
want to murder your name. What is it?
The Chairman. Koutoulas.
Mr. David Scott of Georgia. Koutoulas.
Mr. Koutoulas. Koutoulas. Perfect.
Mr. David Scott of Georgia. Thank you, I am sorry.
Mr. Koutoulas. Not at all. Thank you.
We believe that the current law is there to bring criminal
charges for MF Global, we believe there is a mountain of
evidence to support that, as Mr. Duffy alluded to, and we think
the bringing of criminal charges would do a lot to restore
confidence in the futures markets.
Mr. David Scott of Georgia. Very good.
And Mr. Johnson?
Mr. Johnson. Well, I certainly believe that any time that
somebody commits fraud or steals money from their customers
they deserve to be criminally charged.
Mr. David Scott of Georgia. Thank you. Thank you very much
on that.
Now, Mr. Anderson, let me ask you, in your testimony you
call for a pilot program of a customer option for a fully
segregated account structure to be set up, but by the industry
itself and not through legislation, correct? But the point is,
if Congress fails to make changes to the Bankruptcy Code
clarifying that customer funds in segregated accounts are
always first in line for disbursement, then does a fully
segregated account structure really provide much additional
protection?
Mr. Anderson. That is a very good question, and it is going
to come down, like you said, to the Bankruptcy Code and where
those assets lie.
The reason for a pilot program is maybe to see a little bit
of how that would work as well with those funds being
completely fully segregated away from the FCM, how does that
work, how do the mechanics work, what are the costs associated
with it. I think some time needs to be spent on the law as
well.
Mr. David Scott of Georgia. Okay.
Dr. Culp, in your testimony, you mentioned that over the
long history of the futures industry few customer funds have
been lost either from the failure of futures commission
merchants or losses arising from the result of fellow-customer
risk exposures. That is until recent events with MF Global and
Peregrine Financial Group.
On the securities side, the Securities Investors Protection
Corporation has initiated at least 325 proceedings under the
Securities Investment Protection Act to recover cash or
securities for customers, and approximately $120 billion have
been distributed back to customers over SIPC's 42 year history,
$1.1 billion of that from the SIPC Fund. And as you have
researched the possibility of some kind of futures insurance
fund like SIPC Fund, have you found any explanation for why
over time we have seen far more instances of customer losses on
the securities side than we have seen on the futures side?
Dr. Culp. I can say that wasn't a question that we
specifically addressed in the study, but from my familiarity
with the markets it goes a little bit to an earlier comment,
the fundamental difference between securities and futures and
the constituents of those markets. Many of the investors in
securities markets are investors, they are buy-and-hold stock
purchasers, and a lot of the claims that the SIPC has
encountered over time have been related to the fact that there
are different risk managements and controls in place in
securities than there are in futures. For example, the at least
twice daily margining that Mr. Duffy mentioned, that is not
something that we do in securities markets. We do that in
futures markets. And there is a litany of other risk
managements and controls.
But it is easy to think securities and futures are more
similar than they are. They are actually very, very different
in a lot of ways. And although, like I said, I didn't research
this for this study, I am pretty convinced that is the answer.
Mr. David Scott of Georgia. Thank you, sir.
I yield back.
The Chairman. Thank you, Mr. Scott.
First off, I ask unanimous consent to enter into the record
the written statement from the Managed Funds Association.
Without objection, so ordered.
[The information referred to is located on p. 61.]
The Chairman. Dr. Culp, one of the criticisms of the
insurance product was that you have a disproportionate burden
of the funding of this thing versus the risks being protected
based on a 0.5 percent fee on gross transactions for everybody.
Did you look at other funding models that would be more in line
with risks covered being paid for by that risk? In other words,
is there any possible way of scaling the fee structure back to
cover just the $250,000 that is the gross of the account, other
funding models?
Dr. Culp. Just to clarify, you mean in a universal mandated
scheme?
The Chairman. Yes, universal mandated scheme.
Dr. Culp. No. You know, we thought about it. The problem is
there are a lot of different possibilities. So for the mandated
universal coverage scheme we focused on the proposal that is
out there. Part of the problem with the scenario-based approach
that we used is you can come up with an almost endless number
of potential scenarios, so we tried to focus on the ones that
were most likely to be proposed.
The Chairman. So, in other words, the $2.5 billion in
reserves that you think are needed to cover the scheme in 50
years, whatever, covers just the $250,000 per account risks?
Dr. Culp. Yes, sir.
The Chairman. So you pull the folks whose assets are beyond
$250,000 and not charge those a fee. The fee would be such that
it just makes no rational sense at all to get to the $2.5
billion, if you billed your fee just to the activities within
the $250,000 accounts and less?
Dr. Culp. Then it would be even harder to get to that
target number, substantially so.
The Chairman. Okay.
Mr. Roth, I have two questions regarding your initial
confirmation of account balances prior to the failure of PFG
Best. One, there was some evidence that the owner there had
been falsifying the bank statements provided to you on a daily
basis. Could you reverse that now and falsify the confirmation?
In other words, you are comparing the balances confirmed by the
FCM as to segregated accounts with what the bank says is there.
Mr. Roth. Correct.
The Chairman. And so could this fellow have falsified the
records that you are comparing to, to cook the books, just the
reverse of what PFG did?
Mr. Roth. Yes, Congressman, I am never going to suggest
that there is a silver bullet which prevents----
The Chairman. No, no, I am not suggesting that. I am just
saying, but at least the second question is, after the PFG
issue your organization went through an extensive review of
your own process and own audits.
Mr. Roth. Right.
The Chairman. Can you walk us through that?
Mr. Roth. Yes. We actually retained a group, the Berkeley
Research Group, and the principals of the Berkeley Research
Group are the same individuals that performed a study for the
SEC on the Madoff study. And we asked them to come and review
the entire history of NFA's dealings with Peregrine in
particular, and to review all the examinations that we had
done. And in the course of their study they reviewed three
million pages of documents going over our entire history, and
they made a number of really helpful suggestions. They
basically found that the exams that we had performed were
professionally and competently done but that we need to do
better, and we are incorporating all of those suggestions.
And the core suggestion really is to just always inculcate
an attitude of professional skepticism in your staff. We have
had all of our staff now, anyone who has been at NFA in the
Compliance Department for more than a year will have to go
through a certified fraud examiner training process to try to,
again, develop and nurture that sort of attitude of
professional skepticism of always trying to view every
possibility of uncovering fraud.
The Chairman. All right. And the idea that if I am the FCM
and I am stealing out of my segregated account, and I send the
NFA a falsified document, but, I am tracking what is actually
there. I have been stealing from customers.
Mr. Roth. Right.
The Chairman. I send you the document that says, here is
what I think is in the account. You get from the bank a
confirmation that that is where I have stolen. But how do you
catch me stealing from the account?
Mr. Roth. Well, if you are claiming to have $200 million in
the bank and the bank says that you have $5 million----
The Chairman. I have that part. If I say I have $200
million, and the bank says I have $200 million, but I really
should have had $400 million.
Mr. Roth. Yes. So that is when you are undercounting your
assets and underreporting your assets, and what we do to try to
address that issue is in the examination process we do
confirmations with customers. So on a select basis.
The Chairman. Okay.
Mr. Roth. But you test certain customers and say the firm
is reporting that you have X. Do you in fact have X? That can't
be done on a daily basis, but it is part of the examination
process.
The Chairman. Right. I got you. I appreciate that.
One question that we haven't really touched much on is the
CFTC's attitude toward cost-benefit analysis on proposed
rulemaking. David and I and, quite frankly, the Committee is
working toward strengthening those cost-benefit analysis
procedures at the CFTC. Can any of you or all of you comment on
your experience with--not that we are going to retread or redo
Dodd-Frank, but I have plenty of anecdotes where the CFTC said,
here is what we think it will cost the industry or the
participants to comply with this rule, and it has turned out to
be a multiple of that number in most instances. Can you talk to
us about what your attitude is about the cost-benefit analysis
attitude at the CFTC and how they are mechanically going about
it one more time?
Mr. Roth. This may not be particularly helpful, but----
The Chairman. Well, then, don't say it. Just kidding.
Mr. Roth. The rulemaking process within NFA is that we
develop rules and you are always trying to develop rules that
are cost-effective, and we just get input directly from the
industry. And as part of our rulemaking process when we have to
deal with our advisory committees and our board of directors
and we have to go to the industry professionals and say this is
the public policy we are trying to achieve, this is how we are
proposing to do it, they would give us real good and real
direct input about what the costs are. So in NFA we get that
input directly from the industry as part of the rulemaking
process, and it is very, very helpful.
The Chairman. But in terms of what the CFTC has done
through the Dodd-Frank implementation and their ability to use
cost-benefit as a part of their decision-making process as to
what rules to put in place or what rules not to put in place,
i.e., the residual interest information this morning, did the
CFTC look at the concerns that you talked about as a part of
their deliberations to get to their rule that they think is
appropriate?
Mr. Roth. I don't know what their internal deliberations
were, but I can certainly tell you that they didn't have any
contact with NFA where they asked us for our input on that
topic.
The Chairman. Mr. Duffy?
Mr. Duffy. There has been a tremendous amount of comment
letters filed on this particular issue, and obviously the
Congressional testimony, so the final rule is yet to be voted
on. So hopefully the cost-benefit analysis that you are
referencing, they are taking all the comment letters along with
this Congressional hearing and taking that into account, which
will come up with a decision that is yet to be made. So
hopefully, we are getting a little ahead of ourselves yet, and
to Chairman Lucas' point earlier, we may not have a lot of
faith, but at the same time we do need to let the process go
through.
The Chairman. All right.
Other Members on the Committee have questions? Yes, David.
Mr. David Scott of Georgia. Let me follow up a little bit
on our bill, H.R. 1003, cost-benefit analysis, which is very
important. The President in his Executive Order has ordered all
those agencies to do cost-benefit analysis for rulemaking. The
CFTC, being the primary regulator, or making joint rulemaking
with the SEC, for example, they have assessment and cost-
benefit analysis before each. However, again, I just make this
comment, that the CFTC doesn't have enough staff right now to
do what it is that they are doing.
And so I just urge each of you, and each of you have your
own constituencies, that we have to increase the funding of the
CFTC. If we don't, it is going to hurt all of us. No matter, we
could pass all these bills and all these regulations that put
it on it, and it needs to be. But this needs to happen, but we
need to give the CFTC the tools with which to work right now.
Right now they are bleeding people.
So I just make an appeal to you in the industry to join
with many of us here in these real tight budgetary times. Right
now the government is shut down. Right now we are running the
government by crisis. I mean, I don't know how long this is
going to go on.
But this is a primary example of what I am talking about
that brings about the uncertainty, unassuredness that we have.
And I always am taking the opportunity to push and hope people
will hear, not like John the Baptist in the wilderness, but I
guarantee you, I am asking for you all to join with me in that
and say, look, doggone it, let's give the CFTC the money they
need, not pour this load on them, so they can do the job that
we absolutely need.
And finally, the other reason we need this is to be able to
put the CFTC in a stronger defense position for any lawsuits or
legal activity, for if they had the cost-benefit analysis
requirement to back themselves up, they would be more in a
better position to sustain these outward charges and lawsuits.
Yes, Mr. Duffy?
Mr. Duffy. Mr. Scott, so I don't leave any misimpressions,
I have been on the record and the CME has been on the record
for many years that we do believe that the CFTC needs to be
adequately funded. So we wholeheartedly support what you are
saying.
We have one of the more dynamic businesses in the United
States. If you look at the growth rate of the listed
derivatives, regulated derivatives business in the United
States over the last 40 years, it has been just exploding, and
it has benefited farmers, ranchers, bankers, all the different
people--mortgage people--that use the marketplace. These are
all benefits to the United States of America.
So we agree with you wholeheartedly that it needs to be
fully funded and it is absolutely essential to do so. So we
echo your comments. And I hope we didn't leave the impression
that we don't think it should be funded to a proper level.
Mr. David Scott of Georgia. Thank you very much.
Anybody else? Yes, Mister----
Mr. Koutoulas. Ranking Member Scott, we agree also
wholeheartedly that the CFTC needs adequate funding, especially
when you contemplate the implementation of Dodd-Frank and
essentially that the industry is building a new regulatory
regime for cleared swaps essentially from scratch.
I will give, I guess, an anecdote as to the attitude inside
CFTC when it comes to managing funds, that we met with just
about every Commissioner to discuss the conversion of MF
Global's holding company to a Chapter 7. And we continuously
got the response, why would you do that? Just let the trustee
handle it. And, I mean, they just didn't seem to grasp how
expensive relying on the three different trustees that were
there in MF Global was. And after testifying last February at
the roundtable on customer protections regarding residual
interest, staff really did not seem to grasp just how expensive
that proposal would be for the industry and how damaging it
would be to the gentlemen on my left and right.
I think a little bit of attitude adjustment is required,
but more funding would go a very long way to helping them
fulfill their mission.
Mr. David Scott of Georgia. Thank you very much.
Thank you, Mr. Chairman.
The Chairman. I thank our witnesses.
And, David, do you have any kind of closing remarks,
anymore John the Baptist references or anything?
Mr. David Scott of Georgia. This has been a very effective
hearing and very enjoyable. I have learned a lot from it, and
you did a good job in getting a great diversified group from
different areas, although most of them are from Illinois.
The Chairman. Well, I also want to thank all the witnesses,
including the ones from Illinois. We will do a little better
job of looking for Texas witnesses next time perhaps.
But on a serious note, I appreciate each of you coming in.
I know there was some uncertainty this week about whether or
not we would have this hearing. There may be those out there
that criticize Dave and I for going ahead and having this
hearing in the face of the shutdown.
It is our constitutional responsibility to reauthorize the
CFTC. It is better off if we reauthorize it than if we don't,
and this hearing is integral to that. We would not be able to
get your comments and the written record established had we not
had the hearing today, if we moved forward with the
reauthorization at the pace that we are going to try to move
forward with, so David and I made a decision to go ahead and
hold the hearing. And I appreciate the witnesses taking their
time to come share that with us this morning and look forward
to folding your comments into our markup and the rules and the
bill that we will do in terms of the reauthorization.
So with those comments, I again thank the witnesses for
being here. And under the rules of the Committee, the record of
today's hearing will remain open for 10 calendar days to
receive additional material and supplementary written responses
from the witnesses to any question posed by a Member.
This hearing of the Subcommittee on General Farm
Commodities and Risk Management is adjourned. Thank you.
[Whereupon, at 10:48 a.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Letter by Hon. Frank D. Lucas, a Representative in Congress
from Oklahoma
September 25, 2013
Hon. Gary Gensler, Chairman;
Hon. Bart Chilton, Commissioner;
Hon. Scott O'Malia, Commissioner;
Hon. Mark Wetjen, Commissioner;
U.S. Commodity Futures Trading Commission,
Washington, D.C.
Dear Chairman Gensler and Commissioners Chilton, O'Malia and
Wetjen:
We write regarding concerns that have been brought to our attention
with the Commodity Futures Trading Commission's (CFTC) November 14,
2012, proposed rule to improve protections for futures customers. While
we support your efforts to protect customers in the futures markets and
believe the Commission's proposal contains needed reforms, we have also
heard from a wide variety of farmers, ranchers and small-to-medium
sized futures commission merchants (FCMs) who argue that parts of the
rule could dramatically change their business models and prohibitively
increase costs.
We certainly recognize that the failures of MF Global and Peregrine
Financial Group inflicted terrible losses on futures customers, many of
whom were farmers and ranchers merely seeking to hedge their commercial
risks. We are pleased that the CFTC, self-regulatory organizations,
industry trade groups, FCMs, and market participants have worked
together in the interim to strengthen customer protections.
However, as you work to finalize the rule on customer protections,
we ask that you weigh the benefits of these regulations against both
the costs to America's farmers and ranchers and the potential impact on
consolidation in the FCM industry. In making this determination,
carefully consider the consequences of changing the manner or frequency
in which ``residual interest''--the capital an FCM must hold to cover
customer positions--is calculated. The goal of increasing futures
customer protections should be to strengthen the markets without
harming the ability of American farmers, ranchers, and end-users to
hedge their legitimate business risks.
Our Committees place a high priority on the concerns of the
agricultural marketplace. We urge you to take these views into account
as you review and vote on a final rule.
Sincerely,
Hon. Frank D. Lucas, Hon. Debbie Stabenow,
Chairman, Chairwoman,
House Committee on Agriculture; Senate Committee on Agriculture,
Nutrition, and Forestry.
Hon. Collin C. Peterson, Hon. Thad Cochran,
Ranking Minority Member, Ranking Minority Member,
House Committee on Agriculture; Senate Committee on Agriculture,
Nutrition, and Forestry.
______
Submitted Statements by Hon. K. Michael Conaway, a Representative in
Congress from Texas
managed funds association
Managed Funds Association (``MFA'') is pleased to provide this
statement in connection with the House Agriculture Subcommittee on
General Farm Commodities and Risk Management's hearing held on October
2, 2013 on ``The Future of the CFTC: Perspectives on Customer
Protections''. MFA represents the majority of the world's largest hedge
funds and is the primary advocate for sound business practices and
industry growth for professionals in hedge funds, funds of funds and
managed futures funds, as well as industry service providers. MFA's
members manage a substantial portion of the approximately $2.375
trillion invested in absolute return strategies around the world. Our
members serve pensions, university endowments, and other institutions.
MFA's members are among the most sophisticated institutional
investors and play an important role in our financial system. They are
commodity pool operators (``CPOs'') and commodity trading advisors
(``CTAs''), which are customers of futures commission merchants
(``FCMs''). Our members are active participants in the commodity and
securities markets, including over-the-counter (``OTC'') derivatives
markets. They provide liquidity and price discovery to capital markets,
capital to companies seeking to grow or improve their businesses, and
important investment options to investors seeking to increase portfolio
returns with less risk, such as pension funds trying to meet their
future obligations to plan beneficiaries. MFA members engage in a
variety of investment strategies across many different asset classes.
The growth and diversification of investment funds have strengthened
U.S. capital markets and provided investors with the means to diversify
their investments, thereby reducing overall portfolio investment risk.
As investors, MFA members help dampen market volatility by providing
liquidity and pricing efficiency across many markets. Each of these
functions is critical to the orderly operation of our capital markets
and our financial system as a whole.
MFA appreciates the Subcommittee's thoughtful review of and focus
on customer protection issues. We supported financial reform and
policymakers' goals to improve the functioning of the markets and to
protect customers by endorsing central clearing of derivatives,
increasing transparency and implementing other measures intended to
mitigate systemic risk. We also appreciate that Congress remains
vigilant about and has held hearings related to the MF Global, Inc.
(``MF Global'') and Peregrine Financial Group, Inc. (``Peregrine'')
insolvencies. Our members have investors in their funds; and are
customers themselves, and therefore, we remain deeply troubled by the
MF Global and Peregrine events and the consequences of their
insolvencies.
Accordingly, we support thoughtful legislative and regulatory
changes to strengthen protections of customers. We believe some
additional refinements to the Commodity Exchange Act (``CEA'') and the
regulations of the Commodity Futures Trading Commission (``CFTC'')
would further fulfill the Subcommittee's objective to enhance
protections for customers.
In these respects, we believe Congress should: (1) encourage the
CFTC to finalize its proposed rules on enhancing customer protections
with certain modifications intended to bolster the rules' efficacy; (2)
amend the Bankruptcy Code to help shield the collateral of cleared
swaps customers from another MF Global or Peregrine-like failure; (3)
encourage the CFTC to repeal the prohibition on futures customers' use
of third-party custodial accounts as a mechanism to protect their
collateral; and (4) amend the CEA by adopting stronger protections for
confidential information.
MFA appreciates the Subcommittee's consideration of this written
statement. As customers and active participants in the derivatives
markets, we are committed to working with the Congress, the CFTC and
other interested parties in addressing customer protection issues.
CFTC Rules on Enhancing Customer Protections
MFA strongly supports the CFTC's issuance of proposed rules on
enhancing customer protections (the ``Proposed Rules''),\1\ and the
CFTC's efforts to ensure adequate protection of customers and their
funds by augmenting the requirements imposed on FCMs and enhancing the
oversight of FCMs. As customers in the derivatives markets, we applaud
the CFTC for recognizing the potential weaknesses in the current
customer protection regime and proposing thoughtful measures to
increase the protection and confidence of customers. We ask the
Subcommittee to support the CFTC in finalizing the Proposed Rules with
certain modifications that we, as customers, believe would assist
Congress and the CFTC in furthering its customer protection goals.
---------------------------------------------------------------------------
\1\ 77 Fed. Reg. 67866 (November 14, 2012).
---------------------------------------------------------------------------
Residual Interest Requirement
MFA agrees with the CFTC that the timely collection of margin is a
critical component of an FCM's risk management program, and that it is
important to require FCMs to bold sufficient funds to protect against
insufficient margin in customer accounts. However, from a practical
perspective, we are concerned about the CFTC's proposed residual
interest requirement, which would require an FCM to maintain its own
funds ``at all times'' in an amount sufficient to exceed the sum of all
of its futures customers' margin deficits.
MFA emphasizes that it supports the retention of the residual
interest requirement. However, as proposed, the continuous ``at all
times'' nature of the residual interest requirement would not provide
FCMs sufficient time to collect margin from their customers. The
unintended result for customers is that it could significantly increase
our operational burdens and costs because, to ensure compliance with
the residual interest obligation, FCMs might require their customers to
pre-fund their margin obligations or to meet intraday margin calls.
MFA views both of these outcomes as troubling and an unacceptable
imposition on customers. In particular, it would create margin
inefficiencies by causing customers to reserve assets to pre-fund their
obligations or in anticipation of intraday margin calls, and thus,
reduce the amount of assets that customers have to use for investment
or other purposes.
As a compromise, to preserve the residual interest requirement
(which we agree is important) while avoiding the negative impact and
burdens on customers, MFA recommends that the Subcommittee encourage
the CFTC to finalize the Proposed Rules but modify the proposed
residual interest requirement so that it is not a continuous real-time
obligation, but rather a ``point in time'' obligation. We believe the
appropriate ``point in time'' is close of business Eastern Time on the
business day after the FCM issues a customer's margin call, which is
consistent with current margin practices and infrastructure. This
approach would eliminate the need for customer pre-funding or intraday
margin calls, while also ensuring that FCMs hold sufficient funds to
protect one customer from another customer's shortfall or margin
deficit.
Disclosure of FCM Information to Customers
MFA strongly supports the CFTC's proposals that would require FCMs
to provide enhanced reporting and disclosure of certain information to
customers and the public. Increasing the transparency of customers and
the public into the operations, accounts, policies and procedures of
FCMs is crucial because it would place customers in a better position
to assess an FCM's stability, and if customers identify concerns and
deem it appropriate, to transfer their positions and funds to a
different FCM. Customers also would be in a better position to assist
the CFTC and designated self-regulatory organizations (``DSROs''), that
supervise FCMs for example, by alerting the CFTC or DSRO to customer
concerns with the FCM or the FCM's decisions. Therefore, MFA believes
that, in the aggregate, the enhanced disclosure in the Proposed Rules
will give customers comprehensive information about FCMs' risks, and
allow them to make meaningful judgments regarding the appropriateness
of using a particular FCM.
In light of the importance of FCM disclosures to customers and the
public, MFA believes that additional public disclosure of certain FCM
information (i.e., in addition to what the CFTC has proposed in the
Proposed Rules) will be beneficial to the market. In particular, as the
CFTC is finalizing the Proposed Rules, we ask the Subcommittee to
encourage the CFTC to mandate that FCMs make publicly available each
month their computations for, and compliance with rules related to,
segregated customer collateral as well as FCMs' summary balance sheets
and income statement information for the most recent twelve months.
MFA believes that imposing such a public disclosure obligation on a
monthly basis is important because an FCM's financial stability may
change significantly in a short amount of time. Therefore, we believe
less frequent disclosure to the public is insufficient from a customer
protection perspective.
Protection of Customer Collateral
Protection of Cleared Swaps Customer Collateral
MFA supports efforts to strengthen the legal framework applicable
to collateral for customers related to cleared swaps transactions with
FCMs. As mentioned, MFA remains concerned about the MF Global and
Peregrine Financial insolvencies. The misuse or misplacement of
customer funds in those situations resulted in customers experiencing a
delay, in some cases a significant delay, in the return or outright
loss of substantial amounts of their assets. Therefore, we believe that
Congress should amend the Bankruptcy Code to bolster the protection of
customer collateral.
Under current law, if an FCM becomes insolvent, all of the
collateral of the FCM's cleared swaps customers would be aggregated and
distributed to each customer on a pro rata basis. Therefore, even when
a customer was not at fault, if there is an insufficient amount of
cleared swaps customer collateral available in the FCM's customer
account to repay all customers who posted collateral, the customer
would lose a portion of its posted collateral. To remedy this concern,
we urge Congress to amend Chapter 7 of the Bankruptcy Code so that,
upon an FCM's insolvency, customer assets posted as collateral on
cleared swaps transactions would not be subject to pro rata
distribution. Such an amendment would ensure that cleared swaps
customers do not share in any shortfall due to the FCM's or another
customer's default.
An amendment to the Bankruptcy Code also would enhance the
effectiveness of existing and potential segregation protections for
cleared swaps customers. For example, the CFTC has adopted the
``legally segregated operationally commingled'' model (``LSOC'') for
cleared swaps, which should generally reduce the likelihood of there
being a customer asset shortfall in certain FCM default scenarios.
However, uncertainty remains as to how LSOC will perform in an FCM
insolvency. An amendment to the Bankruptcy Code, as discussed above,
would alleviate this uncertainty and further assure the protection of
non-defaulting customers in certain FCM default situations.
In addition, market participants are continuing to consider other
enhancements to customer protections, such as optional full physical
segregation of customer collateral. This arrangement would allow a
customer to put its collateral in an account with a custodian or other
third party in the customer's name, rather than have the customer's FCM
hold its collateral directly, and thus, protects the customer in the
event that its FCM or another customer becomes insolvent. Without a
Bankruptcy Code amendment, however, a cleared swaps customer's
physically segregated collateral might be considered part of the pool
of customer assets of the insolvent FCM, and thus, distributed on a pro
rata basis. Therefore, MFA believes that, if Congress amended the
Bankruptcy Code, it would significantly enhance customer protection.
Protection of Futures Customer Collateral
In light of the MF Global and Peregrine failures, MFA feels it is
also appropriate for the CFTC to re-examine the protections available
to participants in the futures market, and to assess the appropriate
balance between the costs of enhanced protections versus the costs to
investors and the market as a whole of a segregation failure. As
mentioned, we appreciate that the CFTC is working on proposals to
enhance customer protections. As a further step, we think that the
Subcommittee should encourage the CFTC to hold one or more roundtables,
as the CFTC did when considering segregation rules for cleared swaps,
to ensure full consideration of the lessons learned, and to assess
whether further protections of the collateral of futures customers are
appropriate.
In addition, MFA believes that the Subcommittee should encourage
the CFTC to repeal CFTC Staff Segregation Interpretation 10-1
(``Interp. 10-1''), which prohibits futures customers from holding
their collateral in accounts at a third-party custodian, rather than
with their FCM counterparty. Although the CEA already requires an FCM
to maintain all customer collateral separate from the FCM's own funds,
it is also important that futures customers have the right to maintain
their collateral remotely from their FCM counterparties at a third-
party custodian. Allowing futures customers to use third-party
custodial is an important step towards safeguarding customers' assets
because those accounts would: (1) protect one futures customer from
another futures customer's default; (2) protect futures customers from
FCM operational and investment risk; and (3) facilitate the prompt
transfer of futures customers' positions and collateral upon their FCM
counterparty's default.
Some of our members already have third-party custodial accounts in
place in the OTC derivatives market for collateral they have posted on
uncleared swap positions. Moreover, when the CFTC adopted LSOC for
cleared swaps, the CFTC clarified that the prohibition on the use of
third-party custodial accounts contained in Interp. 10-1 does not apply
to collateral posted by cleared swaps customers. MFA believes that
there is no difference between cleared swaps and uncleared swaps on the
one hand and futures on the other that supports retaining Interp. 10-1
for futures and limiting futures customers use of third-party custodial
accounts. Rather, it is important that all customers have equal
protection of their collateral regardless of what products they trade.
Therefore, MFA requests that the Subcommittee encourage the CFTC to
repeal Interp. 10-1 for futures and allow futures customers to use
third-party custodial accounts to ensure that the collateral that
futures customers post is protected in a manner that is robust and
equal to the protections available to swaps customers.
Strengthening Protections for Confidential/Proprietary Information
Reports of Commodity Pool Operators and Commodity Trading Advisors
MFA believes that Congress should strengthen the confidentiality
protections for proprietary data in the CFTC's possession. MFA
consistently has supported reasonable reporting requirements to ensure
that regulators have meaningful data upon which to make sound policy
decisions, but it is critically important that our members know that in
fulfilling their reporting obligations, their proprietary portfolio and
other confidential information is appropriately safeguarded. Market
participants--whether hedgers or investors--invest significant
research, time and resources into developing proprietary hedging or
investment strategies. Such trading strategies are proprietary
information; the CEA and other statutes have recognized the legitimate
commercial need to protect the confidentiality of such information.
At the same time that the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (``Dodd-Frank Act'') required members
of the Financial Stability Oversight Council (``FSOC''), including the
CFTC, to collect sensitive and confidential data for the purpose of
assessing financial stability, it also included important provisions
directing FSOC members to maintain the confidentiality of such data.
The Dodd-Frank Act specifically amended the Investment Advisers Act of
1940 to protect the confidentiality of reports that the SEC requires
for SEC-registered investment advisers, but no corresponding amendments
were made to the CEA for CFTC reports. Such amendments would be
appropriate to ensure that consistent confidentiality protections would
extend to the reports, documents, records and sensitive and proprietary
information of CPOs and CTAs.
The current inconsistency between the confidentiality protections
afforded to reports by investment advisers as opposed to reports by
CPOs and CTAs creates two potential difficulties. First, it may expose
data from CFTC-regulated entities to greater risk of public disclosure.
Second, it creates a potential unlevel regulatory playing field,
disadvantaging the CFTC in its efforts to collect, analyze, and share
data. For example, we note that the SEC and CFTC have jointly adopted
Form PF for certain reporting obligations. A dually registered entity
filing Form PF with the SEC would have greater confidentiality
protection than if the entity filed the exact same report with the
CFTC. To afford confidential information consistent treatment for CPOs
and CTAs as well as investment advisers, we recommend that the
Subcommittee consider amending section 8 of the CEA by extending these
important Dodd-Frank Act protections for sensitive or proprietary
information to CPOs and CTAs.
Protection of the Identity of Traders and the Confidentiality of Trade
Data
MFA believes that Congress should amend the CEA to strengthen the
confidentiality requirements for registered swap data repositories
(``SDRs'') and other regulated market utilities, such as self-
regulatory organizations, swap execution facilities (``SEFs''),
designated contract markets (``DCMs''), and derivatives clearing
organizations or clearinghouses (``CCPs'') (collectively, ``Regulated
Entities'') to protect customer information--specifically, the identity
of traders and the nature of their trading activities. In particular,
these confidentiality protections must explicitly extend to swap
transaction data reported to SDRs under the CFTC's data reporting
rules. Our concern is not hypothetical; we are aware of instances where
the confidentiality of customer trade data at SDRs was compromised. As
a result of the failure of confidentiality protections, market
participants may have had access to, and could have traded upon,
confidential information of competitors and counterparties.
The specifics giving rise to these concerns are best illustrated
under the CFTC's final SDR rules, wherein it is clear that an SDR must
protect the confidentiality of reported swap data and may not disclose
it to market participants. However, the same rules provide an exception
to this prohibited access rule, allowing a party to a particular swap
to have access to ``data and information'' related to such swap. The
final SDR rules do not define the broad phrase ``data and
information''.
For swaps that are traded anonymously on DCMs and SEFs and then
cleared in accordance with the CFTC's straight-through processing
requirements, the CCP or DCM/SEF reports the swap transaction data and
information to the SDR, which includes the identity of the two original
counterparties. If either one of those counterparties is then permitted
to discover the identity of the other by accessing information at the
SDR, notwithstanding the anonymous nature of the original trade, the
confidentiality of that market participant's trading positions and/or
investment strategies is breached. Such disclosure would harm
competition, and would impair the smooth transition to anonymous
trading on DCMs and SEFs.
Another source of data disclosure risk stems from the sheer volume
of data that the CFTC is now processing and analyzing from SDRs. While
the CFTC's access to such data no doubt presents an opportunity for
unprecedented regulatory insight into the derivatives markets--which we
support--we are also mindful that it creates another source of
disclosure risk if data confidentiality and integrity are not
rigorously protected by the CFTC's policies, procedures and internal
controls.
Accordingly, MFA recommends that Congress amend the CEA to clarify
the CFTC's and each Regulated Entity's obligations to maintain the
confidentiality and integrity of swap trade data and the consequences
of failures to perform this obligation. MFA further urges the
Subcommittee to use its oversight to ensure that both the CFTC and
Regulated Entities have appropriate safeguards to preserve the
confidentiality of sensitive customer information and data furnished to
regulators and Regulated Entities.
Finally, we are alarmed at reports from this spring that academics
have had access to confidential trading data and trading messages from
the CFTC. According to these reports, the academic used this
information to reverse-engineer trading strategies and published their
findings in academic journals. We commend CFTC Chairman Gary Gensler
for requesting that the CFTC Inspector General investigate this matter.
We believe this disclosure is a fundamental violation of
confidentiality and urge the Subcommittee to review the CFTC Inspector
General's findings and the steps the CFTC agrees to take to enhance its
policies and controls with respect to non-public information.
MFA has prepared a White Paper outlining its concerns regarding
protection of confidential information and submitted it to all members
of the Financial Stability Oversight Council. We include a copy of that
White Paper as an Appendix * to our testimony.
---------------------------------------------------------------------------
* The document referred to is retained in Committee file. It can
also be found at https://www.managedfunds.org/wp-content/uploads/2013/
05/MFA-Data-Confidentiality-paper-final-5-22-13.pdf.
---------------------------------------------------------------------------
Conclusion
MFA appreciates the Subcommittee's focus on, and the CFTC's efforts
to enhance, the protection of customers. To further this effort and
strengthen these protections, we believe that Congress should encourage
the CFTC to finalize the Proposed Rules with certain modifications,
amend the Bankruptcy Code to protect cleared swaps customer collateral,
encourage the CFTC to repeal the prohibitions in Interp. 10-1 for
futures, and provide stronger protections for customers' confidential
information. MFA is committed to working with Members and staff of the
Subcommittee as well as regulators to ensure that customer protections
under our legislative and regulatory system are appropriately robust,
extensive and effective.
Thank you for the opportunity to provide you a written statement of
MFA's views on customer protection issues. MFA would be happy to answer
any questions that you may have.
______
state street global exchange
State Street is pleased to submit this statement in connection with
the House Agriculture Subcommittee on General Farm Commodities and Risk
Management's hearing held on October 2, 2013 on ``The Future of the
CFTC: Perspectives on Customer Protections.''
As an initial comment, I commend Chairman Conaway, Ranking Member
Scott, and the Subcommittee for the careful consideration of customer
protection issues and how the future decisions by the Commodity Futures
Trading Commission (``CFTC'') will impact the markets.
State Street is one of the world's largest custodial banks and
processors of derivatives transactions, and we support regulations
which will benefit our customer base of large, buy-side, institutional
investors, such as pension funds, mutual funds, and endowments. We
support regulations designed to enhance customer protections in the
event of a failing futures commission merchant (``FCM'').
State Street believes a customer should have the opportunity to opt
for greater protection of its cleared swaps and futures collateral in
the event of an FCM bankruptcy by electing to hold collateral in a tri-
party custodial account that is exempt from pro rata distribution in
the event of an FCM failure. This type of account fully segregates a
customer's collateral by placing it in a specified account with a
custodian rather than being in the FCM's customer omnibus account. This
creates a solid protection of those funds in the event of attempted
misuse or fraud by the clearing member such as those recently
experienced during the failures of MF Global and PFG Best. However,
without a change to the Bankruptcy Code, it does not protect those
funds in the event of bankruptcy of the FCM. In order to provide the
fullest protection offered by a tri-party custodial account, the
Bankruptcy Code must be amended to exempt collateral held in such an
account from the definition of ``customer funds'' and, therefore, from
pro rata distribution in the event of the bankruptcy of an FCM.
As an initial matter, implementation of a robust customer
protection framework requires both regulatory and legislative action.
On the regulatory front, tri-party accounts are permissible for cleared
swaps under CFTC rules, permissible for uncleared swaps, and
permissible for both futures and swaps in Europe. These accounts have
proven effective in offering enhanced protections for customer funds
across these markets. However, tri-party accounts are not currently
permitted in the U.S. futures market per CFTC Amendment to Financial
and Segregation Interpretation No. 10-1, making them an outlier from
how the rest of the world's derivatives markets function. State Street
strongly supports permitting the use of tri-party accounts in futures
for the same reasons as it is permitted in uncleared and cleared swaps
and, therefore, believes the CFTC should repeal Interpretation No. 10-
1. We have submitted a formal comment letter supporting this repeal to
the CFTC and continue to work with the Commission as it evaluates how
best to address the issue.
On the legislative front, a statutory change is also required to
offer the fullest level of protection possible for customer funds
through tri-party accounts. The CFTC's legally segregated operationally
commingled (``LSOC'') release noted that Bankruptcy Code Section 766(h)
(which provides for pro rata distribution) likely would apply to swaps
customers. If the LSOC model performs as designed, any losses created
by a customer default will be absorbed by the derivatives clearing
organization (``DCO'') rather than the non-defaulting customers of the
FCM, and non-defaulting customers would be expected to receive their
full account equity in the FCM's bankruptcy distribution. However,
losses caused by FCM theft or market losses on investments of customer
funds would be subject to pro rata distribution in bankruptcy and would
thus affect all FCM customers.
It is of utmost concern to State Street that customer funds held in
a tri-party custody account could be subject to pro rata distribution
without a change to the Bankruptcy Code. That means that a customer
availing itself of the opportunity to increase protection of its
collateral by using a tri-party account could still see its funds
distributed in the event of an FCM bankruptcy because those funds,
without a change to the Bankruptcy Code, are considered ``customer
funds.'' Individuals with these accounts will not benefit from the full
protections that tri-party arrangements could offer if the funds are
subject to such distribution. Therefore, to ensure that the customers
and the benefits tri-party accounts offer are protected, we believe
that the Bankruptcy Code should be amended to exclude collateral held
in tri-party custody accounts from the customer funds that are subject
to pro rata distribution in the event of an FCM failure.
Again, State Street strongly believes in the importance of
protecting customers from another customer or an FCM default. We are
willing to assist the Subcommittee in any way possible to ensure that
customer funds held in tri-party custodial accounts are protected to
the fullest. Thank you for the opportunity to provide you a written
statement of State Street's views on customer protection issues. State
Street would be happy to answer any questions that you may have.
______
Submitted Questions
Response from Hon. Terrence A. Duffy, Executive Chairman and President,
CME Group, Inc.
Questions Submitted By Hon. K. Michael Conaway, a Representative in
Congress from Texas
Question 1. Mr. Duffy, as we all know, the failures of MF Global
and PFGBest deeply rattled confidence in the futures markets. To the
extent you are able, could you please update the Committee on the
status of the return of customer funds, and please describe the CME's
role in facilitating or expediting this process?
Answer. MF Global: Status of return of customer funds:
CME Group (``CME'') understands that, on November 6, 2013, the
Bankruptcy Court granted the motion of James Giddens, Trustee for the
liquidation of MF Global Inc. (``MFGI''), for an advance of funds from
the general property of MFGI in order to permit 100% payment of all
commodity customer account claims, and that a related motion is now
pending in the District Court. Former officers of MFGI and others have
appealed the Bankruptcy Court's decision, and the Trustee has recently
indicated that ``the appeal of the allocation motion [is] the only
barrier to 100 percent recovery by every single commodities and
securities customer.''
We further understand that in the interim, the trustee is
continuing to make additional distributions to customers using customer
funds as they become available to him. It is our understanding that
most customers who traded on U.S. exchanges (4d) have received a 98%
distribution, and most customers who traded on foreign exchanges (30.7)
have received a 78% distribution.
CME Group Efforts:
Our efforts in the wake of MFGI's misconduct speak to the level of
our commitment to ensuring our customer's confidence in our markets and
our role in facilitating the return of customer funds:
Guarantee for SIPC Trustee. CME Group made an unprecedented
guarantee of $550 million in order to accelerate the
distribution of funds to customers, thereby giving the trustee
and Bankruptcy Court comfort that interim distributions to
customers could be authorized without waiting for a
reconciliation of MFGI's customer records and claims.
CME Trust Pledge. CME Trust pledged virtually all of its
capital--$50 million--to cover potential customer account
losses due to MFGI's misuse of customer funds.
Customer Distributions. CME personnel invested thousands of
hours developing and implementing an unprecedented plan to
transfer MFGI customer accounts and related customer assets to
other commodity brokers, as well as making the interim
distributions of customer assets that were authorized by the
Bankruptcy Court and trustee in 2011. CME also was able to
deliver to the trustee in a usable format the significant
customer account reconciliation and transfer data that CME
accumulated as part of this process, thus helping the trustee
to resolve customer claim amounts on a highly expedited basis.
2012 Agreement with MFGI Trustee. On August 12, 2012, the
Bankruptcy Court approved an agreement between the trustee and
CME Group that provided for the distribution of approximately
$130 million of MFGI proprietary assets, on which CME and its
members otherwise held superior claims, to MFGI customers. As
part of that agreement, CME agreed to subordinate its otherwise
valid claims to all claims of MFGI customers until they were
paid in full.
2013 Agreements to Expedite Payments to Customers. On
November 6, 2013, CME Group, the Customer Class Representatives
in the ongoing MFGI multi-district litigation, and trustee
announced agreements that will further help expedite payments
to MFGI's former customers. Of the $29 million claim CME will
be allowed to assert against MFGI after all customers are paid
in full, which claim is based on unpaid obligations and
expenses incurred by CME as a result of MFGI's bankruptcy, CME
has agreed to deliver $14.5 million, \1/2\ of the distribution
that it will receive from the trustee, to the Customer
Representatives for distribution to MFGI's former customers.
The agreements are subject to court approval before they can
become effective.
CME Group Family Farmer and Rancher Protection Fund. On
April 2, 2012, CME Group launched the CME Group Family Farmer
and Rancher Protection Fund to protect family farmers, family
ranchers and their cooperatives against losses of up to $25,000
per participant in the event of future shortfalls in segregated
funds. Farming and ranching cooperatives also will be eligible
for up to $100,000 per cooperative.
PFG: Status of the Return of Customer Funds:
As you may know, Peregrine Financial Group Inc. (``PFG'') was not a
CME clearing member, and traded on CME Group exchanges through accounts
maintained at a CME clearing member. The National Futures Association
(``NFA'') was PFG's designated self-regulatory organization, or DSRO.
According to the bankruptcy trustee's Status Report of August 8,
2013 (published on the NFA website (www.nfa.futures.org)), in the fall
of 2012, the trustee made an interim distribution which represented a
return of approximately 30% to all domestic futures (4d) customers and
40% to all foreign futures (30.7) customers. The trustee anticipates
another interim distribution in the near future.
In addition, even though PFG was not a CME clearing member, CME
determined to permit family farmers and ranchers who maintained
accounts at PFG to submit claims to the CME Group Family Farmer and
Rancher Protection Fund. Eligible family farmers and ranchers received
payments of up to $25,000 per loss, and more than $2 million was
distributed by the CME Group Family Farmer and Rancher Protection Fund
to family farmers and ranchers who had accounts at PFG.
Question 2. Mr. Duffy, in order to provide customers with increased
protections without possibly eliminating an entire segment of the
marketplace that has served farmers and ranchers for decades, what
should a revised version of the CFTC's rule look like?
Answer. CME Group and the agricultural community opposed the
residual interest rule proposed by the CFTC because it would have
required futures commission merchants (``FCM'') to insure that each
customer's account is fully collateralized ``at all times,'' which
cannot be calculated in real time. Firms would have been required to
double their customers' margin requirements or to contribute very large
sums as ``residual interest'' on their behalf. The rule would have made
business unsustainable for many firms that serve the agricultural
community, and might have deprived them and their customers of access
to futures markets. We and many others supported a compromise to permit
an FCM to calculate and meet its required residual interest as of 6:00
p.m. ET the next day.
We are pleased that the 6:00 p.m. ET next day deadline is the
approach adopted by the CFTC in the final rule beginning next November
2014. But we continue to oppose the portion of the final rule that will
eventually move this deadline to 7:30 a.m. CT the next day. This change
will happen automatically at the end of the rule's 5 year phase-in
unless the Commission acts by rulemaking to propose a different
deadline. But the rule does not compel the CFTC to take any action, or
even to consider the results of its self-mandated study on the rule's
impact, before the 7:30 a.m. CT deadline is implemented.
The final rule, which seems to pre-determine the outcome of the
study, dismisses our concerns that the rule will adversely impact
customers and fundamentally change the way in which futures markets
operate without justification from a risk management standpoint or
otherwise. These concerns have been echoed by others in our industry,
participants in our agricultural markets and Members of Congress alike.
If this rule is automatically implemented in 5 years' time without
change, practically, the firms that serve the agricultural community
will have no ability on that ``next day'' to receive payments from
customers who are promptly meeting their margin calls. They will have
no choice but to require their customers to prefund margin or
contribute residual interest on their behalf in order to comply with
the morning deadline. This will unnecessarily increase the costs of
hedging especially for farmers and ranchers using our markets. We will
have achieved no balance between the CFTC's aim to further protect
customers and the rule's adverse impact on customers and market
structure.
Response from Christopher L. Culp, Ph.D., Senior Advisor, Compass
Lexecon
Questions Submitted By Hon. K. Michael Conaway, a Representative in
Congress from Texas
December 3, 2013
Hon. K. Michael Conaway,
Chairman,
Subcommittee on General Farm Commodities and Risk Management,
Committee on Agriculture,
Washington, D.C.
Dear Chairman Conaway:
Thank you for providing two supplemental questions for the record
regarding my testimony at the public hearing held on October 2, 2013
(``The Future of the CFTC: Perspectives on Customer Protections''). My
responses to your questions are below.
Question 1. According to your testimony, your analysis suggests it
would take 55 years for a government mandated SIPC-like fund to reach a
target amount of $2.5 billion, and would in fact not even reach the $1
billion mark until 2041. What would happen to the timeframe of reaching
these benchmarks if the FCM industry is consolidated or fewer customers
participate in the markets to manage their risks?
Answer. Our calculations were based on the following assumptions:
(i) the Futures Investor and Customer Protection Corp. (``FICPC'') Fund
would not experience any claims resulting from failures of under-
segregated FCMs over the projection period; (ii) assets in the FICPC
Fund would be continuously reinvested at a rate of two percent per
annum; and (iii) total annual contributions to the FICPC Fund by all
futures commission merchants (``FCMs'') would be $25,521,389 (based on
the actual annual gross revenues for 2012 reported by all FCMs) and
these funds would be contributed once each year.\1\ Under these ``base
case'' assumptions, the FICPC Fund would not exceed $1 billion until 29
years after its inception and would not reach its target funding level
of $2.5 billion until 55 years after its inception.\2\
---------------------------------------------------------------------------
\1\ Specifically, 0.5 percent of gross revenues from commodities
across all FCMs reporting positive gross revenues for the year 2012 was
$25,521,389.
\2\ In this instance, I round the estimated 54.58 years up to 55
years.
---------------------------------------------------------------------------
As your question suggests, assumption (iii) depends on gross
revenues from commodities for FCMs remaining constant over the
projection period, which might not be the case. If increases in
transaction costs (e.g., the costs to FCMs of mandated FICPC
contributions that are passed along to customers) precipitate a
reduction of customers that manage their risks with futures, gross
revenues of FCMs would almost certainly decline, which would result in
smaller total contributions to FICPC and an even slower rate of
accumulation of assets in the FICPC Fund.
For example, a $1 million reduction in annual contributions to
FICPC (i.e., a $200 million reduction in total gross revenues from
commodities across all FCMs) would increase the time for FICPC to
achieve its target funding threshold by approximately 1 year. In other
words, with $24,521,389 in total funds paid in by FCMs each year (i.e.,
$1 million less than 2012 levels), the FICPC Fund would not have more
than $1 billion in assets until 30 years after its inception (as
compared to 29 years based on actual 2012 gross revenues) and would not
reach its target $2.5 billion funding amount until 56 years after its
presumed 2013 inception (as compared to 55 years in the base case).
The larger the reduction in aggregate gross revenues from
commodities across FCMs, the more pronounced is this effect. For
example, if aggregate gross revenues from commodities across all FCMs
fell by $5 million vis-a-vis 2012 levels, it would take 34 years for
the FICPC Fund to cross the $1 billion threshold (i.e., 5 years longer
than the base case) and 62 years to reach the $2.5 billion threshold
(i.e., 7 years longer than the base case). And if aggregate gross
revenues from commodities for all FCMs is $10 million lower than 2012
levels, FICPC would not reach its target funding amount of $2.5 billion
for 72 years.
You also asked about the potential impact of consolidations across
FCMs. In principle, if such consolidations do not result in a loss of
customers, total gross revenues from commodities (and, hence, total
FICPC contributions) would only change to the extent that different
FCMs have different fee structures. If consolidations precipitate a
change in gross revenues (either as a result of changes in numbers of
customers, changes in per-customer fees, etc.), FICPC contributions
would change accordingly. Without knowing how consolidations would
impact gross revenues, however, it is difficult to say what the net
impact would be.
Question 2. Dr. Culp, can you please help the Committee better
understand the ``first-loss layer'' component of the risk retention
group option to protect futures customers--does that mean that the FCM
industry would come together as a group to pay the first layer of
losses up to a certain point if an FCM failed in the future? Would the
amount of losses be predetermined, or depend on the size of the
failure?
Answer. The first-loss layer is essentially a deductible on the
reinsurance policy that an industry FCM captive or risk retention group
would purchase. In the proposal submitted by the Futures Industry
Customer Asset Protection Co. (``FICAP''), the reinsurance syndicate
would provide $250 million in total reinsurance in excess of the first
$50 million in payments made by FCMs participating in the FICAP risk
retention group. This amount does not depend on the size of the loss
and is a fixed amount based on the reinsurers' assessments of the
underlying risk exposure.
Under this scenario, only customers of FCMs participating in FICAP
would be eligible to receive customer asset protection insurance
(``CAPI'') coverage. Suppose ten FCMs agreed to participate in the
FICAP risk retention group. Under the terms of the FICAP proposal,
customers of any one of those ten FCMs that fails while under-
segregated would have access to a maximum of $50 million per FCM
failure up to a total maximum across all FCM failures in one policy
year of $300 million. The first $50 million in losses arising from the
failure of one or more of those ten FCMs would be paid by the FICAP
risk retention group. The reinsurance would then cover all losses in
excess of the first $50 million per policy year up to $300 million.
For example, suppose one FCM of the ten that participate in FICAP
fails while under-segregated, and that failure results in a total loss
of customer assets (after recoveries by the bankruptcy trustee) of $25
million. Customers of that failing FCM would be fully covered for the
$25 million in losses. Those $25 million of CAPI claims would be in the
first-loss layer. FICAP thus would have to pay that $25 million out of
its own resources; the reinsurance would not cover any of those losses.
By contrast, suppose two FCMs fail in a single policy year, and that
losses at each FCM equal $50 million (after recoveries), or a total of
$100 million in losses for FICAP participating FCMs. In that case, the
first $50 million of claims would be paid by FICAP out of the first-
loss retention, and the next $50 million would be paid by the
reinsurance.
As to your question, the first $50 million in losses in the first-
loss layer would likely be financed by a combination of paid-in capital
contributions of the FCMs participating in FICAP and loans to FICAP
from external investors. FCMs and other futures industry market
participants that are not participants in FICAP would not be
responsible for covering any of the $50 million first-loss layer. Only
those FCMs whose customers have CAPI policies written by FICAP would be
required to provide part of the $50 million first-loss layer.
The FICAP proposal did not indicate exactly how much of the $50
million first-loss layer would have to be financed with capital
contributions from the participating FCMs. The reinsurers would insist
on some commitment of funds by participating FCMs to the first-loss
layer in order to align the incentives of participating FCMs with the
reinsurers and to encourage prudent risk management. Yet, the FICAP
proposal indicated that there is interest by outside investors to loan
the FICAP entity a portion of the $50 million. This means that small
FCMs with relatively small capitalization levels would not need to pre-
fund the entire first-loss layer. Regardless of the proportion of the
first-loss layer funded by FCMs participating in the captive vis-a-vis
the proportion financed by external investors, FCMs that do not
participate in FICAP and whose customers do not benefit from the CAPI
coverage provided by FICAP would not be required to contribute anything
to cover any CAPI payments or FICAP losses.
Chairman Conaway, please do not hesitate to ask for further
clarification if my responses above are unclear or to pose any
additional questions. I appreciated the opportunity to testify before
your Subcommittee and welcome the opportunity to provide any further
information you would like to review in your analysis of these issues.
With my best regards, I remain
Yours sincerely,
Christopher L. Culp, Ph.D.
Response from Michael J. Anderson, Regional Sales Manager, The
Andersons Inc.; on behalf of National Grain and Feed
Association
Question Submitted By Hon. K. Michael Conaway, a Representative in
Congress from Texas
Question. Among your recommendations to improve customer
protections are that the CFTC should have the ability to appoint its
own trustee in the event of an FCM bankruptcy. Why is this important?
Answer. Our recommendation in no way is intended as a criticism of
the trustee in the MF Global situation. To the contrary, we believe
James Giddens and his staff have done excellent work recovering futures
customer funds and distributing them back to their rightful owners.
Rather, we believe it would be advantageous in a situation like MF
Global where the vast majority of assets affected were those of futures
customers to have authority to appoint a trustee familiar with the
futures industry and issues faced by futures customers.