Just a few days removed from the National Futures Association’s live fire drill to reexamine and perhaps retool its audit functions, the CME Group brought its fire hose in the form of a letter to customers on Monday.
In the letter, CME’s leaders Terry Duffy and Phupinder Gill proposed that clearing houses or other depositories hold all customer segregated funds, with any interest earned going back to the FCMs. This third-party custodian model has been around for decades, for managed futures firms, hedge funds and other institutions that need their cash separate and secure.
A CME Group spokesperson said the idea is being discussed with customers now but that there are no distinct details on how it would work with the exchange’s clearing house. Among the details worth asking about are:
- Will the customer funds be held in separate FCM accounts or commingled?
- How much of the excess cash will be held in overnight investments and how much will rest in other longer-term passive investments?
- What are the fees involved with such a set-up?
- What type of account will it be? In other third-party custodial arrangements, cash is sometimes held in a trust, completely separate from the bank’s balance sheet.
- And ultimately, in the case of a massive default, who or what funds back up the clearing house?
I contacted an independent investment firm that specializes in managing cash for managed futures and hedge funds to get their take on such an idea. Of course, they think creating a third-party custodial account system would be good – they’ve been doing it successfully for more than 20 years. And they were flooded with calls a couple of weeks ago when Peregrine Financial Group went under. What is interesting is that some of those calls were coming from FCMs themselves. And there are industry best practices already documented from the Alternative Investment Management Association (AIMA), Managed Funds Association and others.
The question now is whether the CME Clearing and other clearing houses are up to the challenge. Can they protect and monitor customer accounts better than a specialized firm and a bank? Can CME also offer a reasonable return back to FCMs? On that count, if recent earnings reports are worth noting, it seems it can. In the first quarter of 2012, CME Group reported $12.1 million in investment income, and has reported similar numbers in recent quarters. So they can manage cash safely and profitably, even in tough markets. That leaves a couple more questions. Can they do so for the rest of the industry? And does the rest of the industry want them to?
The futures industry’s confidence depends on it.