The PFGBest mess has forced a debate from the MFGlobal days to resurface – what, exactly, is a segregated account, and what should it look like?
It may, intuitively, seem like a segregated account is much like a bank account with your name on it, but in reality, it’s much more like one giant bank account in the name of all the customers collectively, with your name listed alongside the rest of the clients at an FCM. It’s still (supposed to be) protected and segregated from the firm assets, but if the recent crises have demonstrated anything, it’s that the current system is no longer sufficient. There are a lot of solutions being tossed around – including on this blog, where we’ve been calling for a full investigation of the regulators, the institution of an insurance fund for investors, and modification of the bankruptcy code and general procedures to better protect clients. However, beyond these solutions, should segregated accounts get made over to look more like what we might intuitively think of them? An interesting article from Futures and Options World pointed out the differences between how America has approached the segregated account, how Europe is tackling it, and what an attempted cross-over might mean:
European regulators are taking a different approach. The European Markets Infrastructure Regulation, which is due to come into effect next year, states that “a clearing member shall offer its clients at least the choice between omnibus client segregation and individual segregation and inform them of the cost and levels of protection”.
It also requires that if a client chooses to have an individually segregated account then “any margin posted in excess of the client’s requirement shall also be posted to the CCP and distinguished from the margins of other clients or clearing members and shall not be exposed to losses connected to positions recorded in another account”.
It sounds great on paper, but can the industry adopt the individual segregation model?
“A lot of comment in the industry at the moment suggests that’s where we’re headed,” says Hamish Purdey, chief executive of software-as-a-service front to back office provider FFastFill.
Individually segregated accounts, where a customer’s assets are ring fenced in their name, provide both transparency and protection. However, individual segregation is operationally very onerous given that it requires every piece of collateral provided by that customer to be tagged by the clearing member and placed in a separate account under that customer’s name. Increased complexity means increased costs and some industry participants are concerned about who will foot the bill.
“When it comes to segregating funds there will be a lot of nice phrases and ideas thrown out around improving risk management but ultimately it is the end-user who pays for it. And it always will be,” claims John McCann, director of Trinity Fund Administration.
Although it is still unclear how individual segregation will be priced, the expectation is that it will not come cheap.
The problem is that the models that are legally clean are operationally intense and the models that are operationally more attractive are legally more complicated, particularly across multiple bankruptcy jurisdictions as in the EU.
Rather than being just individually segregated accounts or omnibus accounts, firms in Europe are anticipating a tiered structure in which different levels of segregation are offered. The cost of each model could be operational, capital related or risk related and each model will trigger a different price structure.
FCMs to struggle
Essentially, firms will have to conduct a cost/benefit analysis of the varying tiers of segregation to work out which is the most economically viable for them. Anthony Belchambers, head of the Futures and Options Association, has voiced a number concerns about this model.
Belchambers argues that regulators and politicians have not thought through the implications of this increase in cost to the industry. He also says that there is a growing tension between public policies that target better risk management while simultaneously stifling growth and making risk management too expensive for some firms.
The risk is that smaller firms will be priced out of the market. McCann warns that the new regulation will have unintended consequences as small and mid-size firms disappear, reducing competition in the market place.
Belchambers adds: “Everyone knows that costs are going to go up in this environment, but they will go up so significantly as to put all these other post-crisis public policy objectives in jeopardy? I think that everyone needs to think very seriously about how much cost they can expect the industry and their customers to bear.”
To sum that up – essentially, individually segregated accounts can protect against scandals like PFGBest, to some extent, but will force the already strained FCM space to take on additional costs that inevitably get passed down to the investor. Some of them might be okay with that. But if not enough are comfortable with those additional costs, the strain of building out a new infrastructure or hiring new staff could force firms to be priced out of the market. The largest banks already have infrastructure in place that is either similar or identical to what would be required for them to provide those individually segregated accounts.
But here’s what the article doesn’t get at. Those large banks? They don’t care about the “small business.” No, that doesn’t just mean someone with $10k in a trading account. It means someone with $500k, $1 million, $10 million. It means someone who is NOT an institutional investor. The big banks won’t churn enough of a profit off of accounts that “small” to justify their expenses in maintaining an individually segregated account. Even today, with the current segregated account infrastructure, they’re not interested in the business.
Raise the costs of running an FCM too substantially, and you run the risk of crowding out the players that service those “small” accounts. What do they have left? Don’t get us wrong, we’ve been loud and relentless about the types of reforms we believe are necessary for the industry – and we’re not substantially opposed to this idea – but we have to consider what it means for investors before we pull the trigger.