Here’s Why the FTX debacle wouldn’t happen in the Heavily Regulated Futures World

November 30, 2022 rcm-alternatives 0 comment  Like
Alternative Investments, Crypto Currencies, Managed Futures

You know how the old saying goes…where there’s smoke, there’s fire:

Like many, those in the Futures world are stunned at the lack of control regarding Customer Money. But we’re not going to lie; we were glued to our screens as the Twitter bombshells continued to drop.

But one may ask, “How does this work in the heavily regulated futures industry? Here’s a quick breakdown for you to get familiar and up to speed on the 411. First, when you, Mr. Retail trader, or you, Mrs. Hedge Fund manager, open a futures account… That account gets opened at a registered Futures Commission Merchant (FCM). For reference, check out this stat from FIA showing about $354 B across 47 FCM:

Your money gets wired into the ‘Customer Segregated Funds account’ at such and such FCM. By regulation and definition, this account is separate from the FCM’s operating accounts (check out the CFTC rules on customer funds here.)

Next, the bank’s required by US law to title the account with “customer seg” (no SBF type confusion who’s money is whose), acknowledge that those funds are the customer’s and cannot be used to satisfy debts of the FCM and provide CFTC direct electronic access to verify balances. In return, as a registered FCM, there are only a few things they can do with this money:

  1. Post margin to exchanges like the CME
  2. Accept and send money to customers
  3. Hold the money in liquid instruments like U.S.-guaranteed securities (T-Bills, etc.)

 

These regulations have been tightened since 2011 when Mr. Corzine invested customer assets in Italian and Spanish bonds (this can only be translated into one saying, “not good”). These assets can be confirmed daily via direct electronic access between the FCM and CFTC and are verified annually via certified audits, the bank balance portion of which is conducted electronically.

But it doesn’t stop there. Confirms continued to tighten once again after PFG in 2012, aka Mr. Wassendorf, fooled the NFA for 20 years by having the regulators send a confirmation letter to a PO Box, which he controlled, and fraudulently confirmed the bank balances himself. Don’t believe us, check out the receipts here.

The FCMs keep their own extra money in the segregated customer account to act as a buffer should any one customer lose more than in their account. You can see how much each FCM has in segregated funds, different segs, and their target ‘residual’ here:

In addition, the FCMs are required to have a ‘net capital, current assets minus current liabilities, greater than 8% of the margin requirement of its customers. There are many pages of rules on what counts as an asset and liability, like this one here. And as noted, if the customer fails, if the introducing broker fails, and if the FCM fails….there’s also an exchange guaranty fund that kicks in; we cover that is a Twitter there here.

 

Now, with all that is said and done, here is where the unregistered FTX failed drastically:

  1. Sent money to customer seg acct
  2. Daily verification of customer seg balance
  3. Customer funds only held in TBills/U.S. guarantees
  4. 10% of customer (Alameda) margin required in net cap
  5. Disallowing illiquid as current assets

 

This is why it is a pretty bad idea to have the same firm be:

  1. Broker
  2. Exchange
  3. Security issuer

 

There is way too much temptation and opportunity to turn to the dark side. But that’s what SBF was trying to get changed by having meetings in D.C. And, the craziest part of it all is, we have already figured most of this out. I mean, that is exactly why the laws and regulations are there for this reason alone.

 

So there’s the tea, and one thing we can’t deny is that crypto will continue the process of rediscovering every aspect of the history of modern finance. If you don’t believe us, drop us a comment to change our minds.

If you’re interested in learning more about this current situation, check out FIA’s guide on Protections of Customer Funds here: https://www.fia.org/sites/default/files/2019-05/Protection-of-Customer-Funds—FAQs.pdf.

For interesting industry threads and commentary, follow RCM’s main Twitter account here, and our Managing Partner, Jeff Malec here.

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