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ETF Specialist

A Relative Case for Commodity Funds

Customer segregated funds were once thought inviolable. My, how the times have changed.

Investors have plenty to worry about in merely allocating capital. Now it seems that even unallocated capital (cash positions) is at risk. As we've all read recently, several disconcerting events have unfolded throughout the derivatives industry.

Given that so many people have a pessimistic outlook on the global state of economic affairs, many folks have flocked to commodity investments over the past few years. Those who have used commodity exchange-traded funds and mutual funds may have been disappointed with their recent performance, but at least that was only a consequence of market performance. Many others that have gained access to these asset classes through specialized brokerage firms have had much more to fret about.

MF Global
Back in 2011, MF Global, the brokerage giant run by former New Jersey Governor and Goldman Sachs CEO Jon Corzine was faced with a large liquidity crisis. Historically, institutions like MF would borrow funds on an unsecured basis. Recent times, however, have seen these firms' counterparties implement collateral requirements.

As an enormous repo-trade moved into the red, MF found itself in hot water. Assuming that none of the bonds involved in the trade defaulted, the repo trade was relatively low-risk. So long as MF could maintain the positions until maturity, they would net out in the black. As circumstances in Europe continued to look bleak, however, additional collateral was required to prevent the firm's counterparty from pulling the loan. The trade was so large that coming up with additional collateral was no small task.

MF Global provided services for a large number of market participants. Among them were traders, hedgers, market makers and everyday investors. In their desperation, MF Global breached Customer Segregated Fund regulations. To mask its lack of liquidity, the firm transferred significant sums from its 51,000 customer segregated accounts. Effectively MF Global abused its position as a trusted custodian and converted private funds for its own proprietary trading. The final accounting of missing customer funds tallied up to $1.6 billion, much of which is still missing.

In the best possible scenario, MF Global's trade would have been seen through to maturity, and the stolen funds would have been returned. As it turned out, the scenario was far from optimal, and MF Global customers are likely never to be fully recompensed.

Peregrine Financial Group Inc.
More recently, the futures brokerage firm PFG was found to have committed similar trespasses. The CEO of PFG, Russell Wasendorf Sr., is accused of having misappropriated significant sums of customer money, nearly $200 million in total.

The NFA alleges that, after breaching Customer Segregated Funds regulations, the firm and its CEO falsified financial statements to cover it up. When the NFA found out, Wasendorf attempted to take his own life.

While details are still emerging, it seems that the firm had previously been investigated for complaints about mishandled customer funds. If the fact that the regulators didn't pick up on the ruse wasn't bad enough, it turns out that Wasendorf was actually a sitting member of the NFA's Futures Commission Merchant Advisory Committee.

Whether it was because he had the inside track with the regulators, the regulators merely did a sloppy job or that Wasendorf's doctored financial documents were of substantially high quality, it appears that there is little to stand between brokerage firms and their ability to mishandle customer accounts. Fortunately, these events have created enough of a stir to prompt calls for structural change.

Managing Incentives
There is a fundamental problem with the current Customer Segregated Fund system. At its core, market participants are required to trust their money to firms that are far from disinterested. The setup is akin to telling a Rottweiler to guard a juicy rib-eye steak. If the pooch is well fed, it may do its job. If it's hungry, the steak might not be so safe. You might reconsider where you place your trust.

The recent breaches of Segregated Fund policy have rightly become high-profile. If market participants can't feel confident that their cash will be ready and available when they need it, it creates a disincentive to participate as heavily. Trust is necessary if liquidity providers are to participate, and liquidity is necessary if markets are to function efficiently.

As it stands, many have called for tighter regulation, but we posit that no amount of oversight will remove bad incentives. PFG's CEO was willing to take his own life. He knew the potential costs of his actions. His incentive was not to protect customer money. His incentive was to make sure he didn't get caught. There are a large number of brokers and these two shortfalls don't implicate the rest of the industry, but these firms shouldn't be using customer segregated funds in the first place, so there should be no problem in allocating customer cash accounts to a truly disinterested party. Rather than trying to curb poor incentives, such a move would circumvent the issue entirely.

Recently, CME Group, the dominant institution in the derivatives industry and owner of the Chicago Mercantile Exchange, Chicago Board of Trade and NYMEX, proposed that the clearing house hold all segregated funds. This could well turn out to be a very prudent change. Unlike brokerage firms, many of which participate in the markets for their own accounts, clearing houses and exchanges do not. Their businesses hinge on the existence of aforementioned administrative trust. Without it, people won’t trade and won't invest. Because their profits are tied to volume based fees, a drop in volume means a drop in the health of the clearing house and exchange system. Whereas brokerage houses have mixed incentives, the clearing houses and exchanges have one focus: to maintain the safety and accessibility of customer funds.

Until these changes actually take place, investors should take a proactive stance in guaranteeing the safety of their unallocated funds. While balances in derivative accounts are essentially cash, and therefore easily hypothecated, balances in securities accounts holding ETFs are not. Customers that are intent on taking positions in commodity and futures oriented instruments can do so by holding registered funds and have their balances subject to SIPC guarantees. This means that your positions and cash holdings (up to defined amounts) are insured against a default by the brokerage firms (fraud or otherwise).

The safest option is to refrain from leaving the rib-eye for the Rottweiler to guard. Though until the futures industry is able to straighten out its act it may be inconvenient and generate additional trading costs, reallocating cash margin used to maintain futures positions into insured secured instruments such as ETFs is likely to be safer.



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