Comment Text:
Re: Roundtable Discussion on Customer Protection
Here are my recommendations that will, in my opinion, substantially improve customer protection.
Develop a system for receiving, storing and analyzing key financial data pertaining to the segregation of customers’ funds. The primary purposes of this system are: (1) to remotely monitor from a central location compliance with CFTC segregation and set aside requirements; (2) to provide an early warning through the ready availability and analysis of financial and risk components that might endanger customers funds; and, (3) to maintain a database that can be used to periodically publish for the benefit of customers the statistical ranking of all futures commission merchants in terms of the protection they provide.
The use of technology is the key to provide maximum protection at lowest cost. The type of computer system that could be used would need to store and process great amounts of data. The system would store the data in a database where applications could be built to retrieve the information and provide analytics and statistical data.
One example of a system with these capabilities would be an IBM iSeries AS/400 server. This server runs a relational database called DB2 that supports business–critical applications. Applications could be created that will automate the process of reporting the pertinent components.
Require by regulation that futures commission merchants file the statements of funds required and provided as described in Section 1.32 and 30.7(f) of CFTC regulations. Require further that the statements be filed daily and electronically online with an appropriate regulatory organization.
Ideally the regulatory organization should be the CFTC or the NFA. All the designated self-regulatory organizations should have access to the data of their respective members so that they can fulfill their obligations for self-regulation.
The statements should be expanded to include the following components: (1) the aggregate of risk based margins for customers and for house accounts; (2) transfers into and out of segregation; (3) commissions and fees charged to the accounts of customers; and, (4) purchases and sales of investment securities.
The statements should be streamlined by the elimination of the following from the liability section: (1) ledger balances; (2) open trade equity; (3) market value of options long; and, (4) market value of options short. These are components maintained in the accounts of customers. The sum of all four values constitutes the aggregate for the net liquidating value. The net liquidating value can be substituted for the four components. Accounts with a net liquidating deficit are excluded from this aggregate but still reported as a separate line item.
[The current format and the specific content of the liability section (funds required) are not mandated by the regulations. The formula for the computation of funds required was created in 1936 by an industry professional to overcome the lack of automation. He found a way to come up with net liquidating value without computers. It has been unnecessarily and blindly perpetuated by industry and government ever since. It is time to modernize.]
A reliable and easy way to test the accuracy of the daily segregation statement is to reconcile excess funds in segregation. The daily change for this number should equal to the sum of the change in the amount for accounts in deficit and the value of investment securities plus the amount for transfers in and out of segregation and commissions and fees charged to accounts of customers. The analytics of the system can perform this reconciliation and produce exception reports.
The components to be reported are readily available from systems deployed by intermediaries for exchange traded derivatives and other financial instruments.
Sections 1.32(c) and 30.7(f) require that the computation of excess or insufficiency of funds in segregation be made by noon the next business day. Retain this provision but add another. Require same day and on line reporting of transfers in and out of segregation not later than the close of the Fed Wire on date of transfer. This is a key and a must requirement given the events that caused the shortfall in customers’ funds at MF Global.
Establish standards and licensing requirements for persons authorized to make entries in the reporting system and for those with final authority for submission.
The amount required to be set aside for customers trading on foreign markets as defined in Section 30.7 of the regulations is woefully inadequate. It defines the amount as margin required plus unrealized gains and less unrealized losses on the open positions. The required set aside amount could be more or less than the current obligation or liability to the customer. In one situation it would be zero notwithstanding the existence of a liability to the customer. For example, a customer liquidates his open position and is left with only a credit balance and no margin requirements. The required set aside amount is zero under the current definition. Amend the definition to conform it to the interpretive statement in Appendix B of Part 30.
When comments on the proposed regulation 30.7 were solicited I voiced my objection to the definition in a public forum. It fell on deft ears. It wasn’t until years later that Appendix B was made a part of the regulations. Does the interpretation have the same weight as the regulations?
I again want to emphasize the use of technology as a first priority to prevent another MF Global rather than adding more regulations that merely address the issues on the periphery. Just think how many regulations were added and the attendant costs during the age of automation. All of that failed in one of the essential purposes of the Commodity Exchange Act – protection of customers’ funds.
The establishment of a reporting system with the use of technology is the way to go. This view is held by no less an authority on this subject than John Davidson, an industry leader. Other leaders like Phil Johnson are advocating automation for another system. In common, is the use of technology for a solution.
Briefly, the benefits of the system would be: (1) reduction of audit and compliance examinations costs; (2) the capability to detect internal control weaknesses; and (3) transparency for the regulators and the public. The magnitude and frequency of corrections to the reported line items would be indicia of control weaknesses. Statistical data would be available for the customers and the regulators to judge the adequacy of an intermediary. This concept is similar to the current system for releasing market data.
Sincerely yours,
John Mattesich
President
