SYDNEY, Nov 3 (Thomson Reuters Accelus) - The failure of MF Global has highlighted loopholes in the Australian regulatory system which allowed the firm to use client money to hedge its own positions with full consent from the Australian Securities and Investments Commission (ASIC).
The shortcomings under Australian regulations mean that regulators will be unable to take action if investors’ funds have been pooled together and used for hedging purposes.
In other markets where the U.S. futures broker operated, including the United Kingdom, it is a breach of regulations to use clients’ funds for any of the provider’s own activities, including hedging.
The Australian rules on over-the-counter (OTC) derivatives prevent firms from using client funds to trade on their own account but allow a range of trades if they are designed to hedge positions. This includes margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee, including hedging positions taken by other clients.
Industry participants and compliance officers have suggested that the growing speculation that MF Global breached client segregation requirements in overseas markets is set to shine a spotlight on how ASIC treats client money in the OTC derivatives space.
Compliance practitioners said the position set out by ASIC in Regulatory Guide 212 in July 2010 was out of touch with other markets and exposed investors to an excessive level of counterparty risk that they were not in a position to assess.
The regulations put the onus on providers of derivative products, including contracts for differences (CFDs), to make a full disclosure of any risks to clients. They fall short, however, of preventing firms from taking those risks in the first place.
Criticism of ASIC’s model has also come from within the industry, with retail OTC derivative providers saying the reputational fallout from the collapse of a firm such as MF Global could undermine the reputation of the industry as a whole if client funds were to be lost.
Natalie Beirne, head of compliance in the Asia-Pacific region for IG Markets, said that ASIC was flying in the face of global best practice by allowing providers to use their clients’ funds. She said the disclosure model was flawed because retail investors were ill-equipped to assess or price the counterparty risk that this presented.
Beirne told Thomson Reuters: “Unlike in many other jurisdictions, derivatives providers in Australia are allowed to use client money for hedging purposes. We do not believe that is a prudent approach, since it effectively puts client funds at risk if the company is unable to service its debt or becomes insolvent. In our view, client capital should be fully protected and, from a regulatory perspective in particular, I cannot see a positive argument that supports the idea of CFD providers using their clients’ capital to fund both sides of a trade.”
The current rules on client money in OTC derivatives transactions were formed in 2010 following an industry consultation (PDF) that attracted just four responses. One of those submissions, from IG Markets, was strongly opposed to the light-touch “disclosure-based” approach to client money segregation. The other three submissions from industry associations were either supportive, ambivalent or said the issue needed further monitoring and consideration.
ASIC said in the paper that it was unconcerned about the level of counterparty risk involved in OTC derivative hedging using client funds. It was concerned, however, that investors were not fully aware of the risks to which they were exposed when paying money to these licensees. The regulator also said it was concerned that financial services licensees might not be fully aware of their obligations under the provisions, particularly relating to uses of client money and the limitations as to what money can be taken from a client money account.
The Australian Bankers’ Association and the Securities and Derivatives Industry Association were supportive of the ASIC position on client money. The outcome of that consultation, in the form of Regulatory Guide 212, ruled that licensees were allowed, under s981D of the Corporations Act, to use their clients’ money for margining, guaranteeing, securing, transferring, adjusting or settling derivatives trades.
These activities, which are known in the industry as “hedging,” vary from firm to firm. According to a local CFD provider, whatever portion of client money that the firms might need to use to hedge (based on their own hedging policies and broker margins) will be deducted from the client money trust account, in accordance with Australian client money regulations. This may in some cases amount to all of the client’s money.
The regulator also ruled that OTC derivative providers could pool their clients’ funds together, which effectively means that one client’s money could be used to finance dealings conducted on behalf of another client. It drew the line, however, at using client funds to engage in proprietary trading activities, which is not permitted.
A product disclosure statement for MF Global Australia (MFGA) makes it clear the broker did in fact pool its clients’ funds and warned them that they might lose it if “there is a deficit in the client money account and MFGA becomes insolvent or is otherwise unable to pay any amount owing to you.”
Duncan Fairweather, executive director of the Australian Financial Markets Association (AFMA), told Thomson Reuters that one of the advantages of this approach was that it allowed providers to make more efficient use of their capital. Rather than needing separate capital for the hedging transactions, they were able to use money that they held on account for clients.
Fairweather said: “The law allows pooling of client monies which are managed by the CFD broker. This can include using hedging to cover client positions. There can be practical benefits in the operation of pooled funds that create operational efficiencies in the provision of broking services.”
The critical issue, according to Fairweather, was that clients needed to be made aware that this was the case, and of the counterparty risks that it entailed. He pointed to Regulatory Guide 227 for guidance on the type of disclosure that should be provided to clients in terms of how their funds were managed, which he said the industry was following.
The abrupt fall of MF Global into the hands of administrators this week has highlighted the risks posed by OTC derivative transactions for investors. As ASIC has been pointing out for some time, investors may not only lose on trades, they may also lose on winning positions if their counterparty collapses. In the UK and the U.S. there are strong suspicions that the firm was in breach of the regulators’ client money requirements and was using client finds in an attempt to recover its position via proprietary trading.
In Australia, the position in terms of client money is still very unclear. A spokeswoman for administrator Deloitte said the team working on MF Global had yet to make an announcement on whether there were sufficient funds to pay back investors. “At this stage they’re trying to source the money, check each bank account, balance the books, all those sorts of things. They’re still trying to get on top of the situation,” she said.
The administrators said yesterday that it appeared some Australian funds may have been sent offshore and not returned. If this was for “margining, guaranteeing, securing, transferring, adjusting or settling” trades, however, MF Global will not have breached Australian client money rules.
A spokesman for ASIC said the regulator had no suspicions at this stage that MF Global was in breach of the rules. He pointed out that ASIC had made its position on client money clear to the industry in RG 212 back in July 2010.
The spokesman told Thomson Reuters: “This provided guidance to the OTC derivatives sector about the use of client money, including the permitted use of client money under s981D of the Corporations Act 2001. Under s981D, CFD providers may use client money to meet obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee, including dealings on behalf of people other than the client.”
He added that ASIC’s “permitted uses” did not extend to a licensee using client money in connection with trading derivatives on its own account. “If ASIC believed a licensee was doing this, it would consider taking action to suspend the licensee’s license,” he said.
In the compliance community, however, some practitioners voiced concerns that ASIC’s position was far too lenient in view of the risks to retail investors. One Sydney-based practitioner who works for a securities broker said that ASIC’s decision to allow client funds to be pooled was also likely to throw up problems if there were to be a shortfall of funds. He said that under the existing rules one client’s funds could be used to hedge a position taken by another client, which would no doubt come as a surprise to many investors.
“The regulator has tried to apply a traditional view of what is client money in the broking sector to a situation that is very artificial. It also raises a big question as to what constitutes hedging. Where does hedging end and prop trading begin? Until this gets tested in court, no one’s really going to know what the umpire says,” he said.
In the UK, the Financial Services Authority (FSA) has taken a hard line on client money breaches, especially in the derivatives sector, after it discovered that firms were exploiting loopholes in the regulation. Its Client Assets Sourcebook (CASS) stands in stark contrast to the rules set by ASIC in Australia, with a total prohibition on using client funds. It is an approach that CMC Markets has described as the “fully segregated client margin model.” Essentially the derivatives promoters, including CFD providers, must hold enough capital aside to pay out any open positions. This means that as a client’s position improves, they must set aside more capital to cover that position.
In addition, money cannot be pooled so each investor’s funds must be held in a separate protected client bank account. This means that if an investor’s position drops into negative territory, that cannot reduce the amount of capital that the provider must hold on any other transactions. In capital terms, the debt is given a zero weighting, which eliminates the contagion risk associated with pooling.
The FSA discovered last year that firms were using title transfer collateral arrangements (TTCA) to take advantage of more lenient regulations within the Markets in Financial Instruments Directive (MiFID). The TTCAs allowed providers to use clients’ margins (the amount put up as collateral) as their own working capital instead of locking it away as client money. In response, the FSA banned TTCAs for all retail clients.
Jim Muir, director of AutoRek, a UK-based adviser on client money and data reconciliation, said that the UK had taken a sensible approach in relation to protecting client assets. He said the Australian model of disclosure seemed to be highly flawed - particularly in relation to retail investors.
“I find it incredible that any private client would feel comfortable if they truly understood that their savings and deposits were put at risk on behalf of their service provider,” he said.
Among the UK-headquartered CFD providers operating in Australia there is strong support for ASIC to put in place higher standards that are equivalent to those under the FSA regime.
Louis Cooper, head of CMC Markets in Australia and New Zealand, said that in the absence of action from ASIC, OTC derivatives providers should voluntarily segregate all client money for the sake of their clients’ interests and the industry’s reputation. He said that a regulatory solution was still needed, however, as the issue was so complex that it was hard for investors to understand the benefits of using a provider with higher client money standards.
Cooper said: “We currently segregate client funds as per the Australian client money rules. Client money is not used to meet the trading obligations of other clients. CFD funds are safely held in a separate trust account with a top-tier Australian bank, and are established, maintained and operated in accordance with the Australian client money rules. This means that client money is protected and offers our clients financial security.”
Cooper added that CMC’s Australian business would stop using client funds for margining “in the near future” to bring it into line with the UK rules.
IG Markets, meanwhile, has always adopted the UK-style client money requirements and continues to criticize ASIC’s decision to allow others to put their clients’ money at risk. In the case of a CFD, for example, whatever portion of client money the CFD provider needs to use to hedge can be deducted from the client money trust account. This decision can be based on the licensee’s own hedging policies and broker margins. Depending on the CFD provider, that could potentially amount to all of a client’s assets.
Although this provides a convenient and cheap source of funding for the derivatives providers, Beirne warned the arrangement was exposing clients to significant counterparty risk. She said that, until recently, it had been difficult to use this as competitive advantage. The concept of fully protected segregated accounts simply had not registered on many customers’ radars. She said the MF Global failure, however, has very quickly alerted retail investors to the issue.
“We have been promoting this concept for quite some time, focusing in particular on the idea of financial security and counterparty risk, but until now, nobody really caught on to it. Following the MF Global case, however, we are receiving a lot of queries from customers about it, both on the retail side as well as on the professional side,” Beirne said.
In practice, ensuring that the various accounts are appropriately segregated requires a separate, dedicated compliance function. At IG Markets a “financial control team,” which is part of the compliance function, manages the process from offices in London and Melbourne.
Beirne said: “You need to have good governance and controls in place in terms of client money and your segregation, and make sure that the processes around that are effective and have good oversight. At IG Markets, we run daily checks to ensure the funds that are in our clients’ accounts are consistent with the client money trust accounts, which has to be equal to or greater than the amount of money that is on our system.”
ASIC, meanwhile, is understood to be planning a further consultation on the topic, which will include the disclosure requirements with which licensees must comply.
Beirne said that industry standards had not improved as a result of the consultation run by ASIC in 2010.
“If anything, it has reinforced the view that client money can be used by derivatives providers to fund hedges, which we consider a major risk to clients. However, ASIC is tightening up disclosures around the use of client money which, particularly for retail clients, is not an easy concept to understand. There is probably not sufficient disclosure by companies about when and how they might use client money,” she said.
As a lone voice on this issue for many years, IG Markets said it was a shame that it took a provider’s collapse to draw investors’ and regulators’ attention to the issue.