Monday, November 12, 2012
Expanding the Role of SIPC to Provide Futures Account Insurance
Following the collapses at MF Global and Peregrine Financial Group the futures industry has been considering various steps to reclaim investor confidence in the safety of funds deposited with registered futures commission merchants. Regulators have adopted various proposals to improve audit standards by requiring electronic record submissions, and self-reporting by FCMs of transfers of segregated funds that exceed prescribed thresholds.
Still waiting on the sidelines is the discussion around an insurance fund for futures accounts held at FCMs. The futures industry, for all its value to the financial markets, is quite small compared to the securities markets. An insurance fund solely dedicated to protecting futures accounts raises concerns over the prospect that significant fees will need to be added to futures trades, and that liquidity will be curtailed as a result. These fears are entirely reasonable. The markets have become accustomed to low transaction costs, and enjoy a level of efficiency that we do not want to lose.
MF Global and Peregrine Financial were relatively small actors in the scheme of things. However, in combination, they represent the fear of clients of federally registered FCMs that they do not have an effective mechanism to evaluate the financial health or financial honesty of the firms with which they do business. Certainly, investors do not have a better process to evaluate these firms than the federal regulators and the SROs. The financial crisis of 2008 highlighted the fragility of even the largest firms (and by deduction their affiliated FCMs). Whom can you trust?
In the 1960s, the securities industry had to deal with similar concerns about the safety of customer accounts held by federally registered broker-dealers. In the late 1960s, the increase in volume in securities transaction began to overwhelm the system. The NYSE was forced to close early on Wednesday afternoons to help deal with the logjam caused by a spike in volume up to 12 million shares per day. The amount of errors, or fails, became so substantial as a result of a fourfold increase in volume from the start of the decade that many firms were left with large errors. In a self-correcting process, volumes began to decline as investor confidence eroded in the ability of the industry to perform as needed.
In 1969, share prices started to fall and volumes fell along with them. The plunge in volume reduced commission income, and along with the liabilities incurred because of the fails resulting from operational difficulties in clearance and settlement, approximately 160 NYSE member firms declared bankruptcy, closed, or merged with other firms in an effort to survive.
The SEC and Congress acted aggressively to restore investor confidence in the securities industry. It took tangible steps to improve the record keeping mess, raise broker-dealer capital requirements, and the transparency of financial well-being of each broker-dealer.
It was in this environment that Congress passed the Securities Investor Protection Act of 1970, or SIPA, which created the Securities Investor Protection Corporation, commonly known as SIPC. The prospect of investors wondering about the safety of their accounts after numerous broker-dealer failures was not tolerable, and Congress along with the SEC acted decisively. There were other significant actions taken at the same time to consolidate clearing and simplify processing, but the introduction of an insurance plan that was modeled on the FDIC to insure bank accounts was a big piece of the solution.
Whether Congress and the regulatory agencies are up to decisive and aggressive action to address the current problem of customer trust in the futures industry is an open question. Certainly, our national finances do not permit many new government initiatives. However, in the case of SIPC account insurance, the burden is on the industry to finance the insurance fund through small transaction assessments, and is not a government funded initiative. The introduction of something similar for the futures industry suggests that a government created safety net for financial accounts need not be an add-on to the current deficit.
Nonetheless, introducing a fee large enough to create a meaningful fund for the futures industry risks affecting the liquidity of the markets. Additionally, for Congress to pass an entire new piece of legislation is a daunting and unlikely prospect. However, amending SIPA to combine insurance funds across both the securities and futures industries is an attractive concept to resolve our current crisis of confidence among futures customers. Significant hurdles must be overcome. Two of the biggest are the willingness of one industry to subsidize a benefit for the other; and where jurisdiction lies post-SIPA amendment over the futures industry. But, in looking at the separation of jurisdiction and regulation of the markets, we might find a better way of managing oversight of futures and securities, and placing both industries on level ground of customer trust.
Canada has a regulatory system for financial markets that is separated among provincial regulators, while the insurance coverage for securities accounts and futures accounts is still a national program – the Canadian Investor Protection Fund. Getting Congress to act across Committee jurisdictions, and regulators to act across regulatory fiefdoms are complex and difficult tasks. The SEC and CFTC would need to jointly lead on this issue, and coordinate between themselves and across Congressional oversight committees to show that client concerns over funds deposited in securities or futures accounts are affected by a lack of trust in either area.
Similar to the 1960s, the lack of confidence that clients have in the safety of their futures accounts is not tolerable. A solution is needed, and an integrated fund for securities and futures accounts is a plausible one.