Firms That Fail: What to Look For in an FCM

By: DeWayne Reeves

Recent bankruptcies and failures of PFG and MFG have made execution and rates just a part of the search for a commodity brokerage. Now it is vital to know the features of the firms themselves. For years, brokers have relied on the CME's Safeguards in the CME brochure that described the step-by-step process for the financial failure of a commodity firm. The trading world was not prepared for default based on theft and manipulation by a trusted figure in the trading world. Trust is what the exchanges thrived on for years, along with the intensive background checks of the floor brokers and the financial requirements to weed out only the elite candidates for membership to the exchange. Falsifying bank records, which actually affected the holding accounts of the firm, was a shock to the trading world.

Since these incidences, changes have been implemented to oversee the brokerages for any potential red flags. Supervisory monitoring systems may track the movement and placement of funds for each commodity account. Clients are given tools to monitor their own funds and activity in their accounts. Furthermore, the resources are given to clients to track a firm's activity, net capital and customer segregated accounts. The activity of a firm may alert a client to potential unforeseen risk, such as currency valuations when trading in foreign markets. Should conflict break out, funds held for margin at the foreign exchange (which are seen as non-regulated) may be held within the country of the exchange. FCM audits and examinations have been increased as an early warning system where any problems may be detected in advance.

The Chicago Mercantile Exchange (CME) uses three independent guaranty funds and financial safeguard waterfalls as back-up within their structure: the Base Financial Safeguards Package, IRS Financial Safeguards Package and CDS Financial Safeguards Package. The CME is the buyer to every seller and the seller to every buyer, thereby guaranteeing both parties of each transaction. Each FCM is accountable directly with the exchange for the performance margin required for each client account. The CME Globex provides credit controls that preset the risk limits of the accounts. The exchange is constantly evaluating the risk exposure of each trade and any vulnerabilities projected in the firm and/or trading account. The CME has derived the SPAN (Standard Analysis Portfolio of Risk) system to evaluate the future risk of positions based on projected changing market conditions, which can arrive at suitable margin requirements for each account. The margin may be determined by calculating the volatility of the market, about 8 % of the contract valuation and the potential risk on the trade which may even include interest variables.

In general, the exchanges have instituted an International Information Sharing Memorandum of Understanding to aid in any emergencies to implement global cooperation. Disaster Recover and Business Continuity measures have been established by the Business Continuity Management (BCM) program. This provides an ensured survival of trading through any events by multi-redundant systems at varied locations. Also, data storage is not only held by the host computers, but at other locations as well. Additional staff for operations is a back-up with generators at hand to back-up any electricity malfunction. Drills to test the efficiency of the back-up systems are used to ensure that it is ready should a disaster strike. Customer protection has been put front and center for the exchanges to uphold the integrity of the commodity futures industry. The CME published its new policies and procedures on their website.

The CME Board of Directors meets about every other month with some of the committees that they oversee. The varied committees include: the Audit Committee, Compensation Committee, Executive Committee, Finance Committee, Governance Committee, Market Regulation and Oversight Committee, Nominating Committee, Strategic Steering Committee, Clearing House Risk Committee, CDS Risk Committee and the IRS Risk Committee, to name a few. The committees may act as internal surveillance, checking each other for efficiency and integrity as well as the firms and client accounts. More importantly is the wide business continuity governance residing with senior executives of firms and the stringent oversight of the firm's books. The exchanges may even delve into the banks used by the brokerages, other financial services and any private financial dealings of the firms or banks. The exchanges may even employ watch lists created to further aid them in surveillance. Products such as Treasuries and Gold have been held as collateral or margin for accounts. These products also fall under surveillance as the valuations may change marked to market.

What to look for in a brokerage?

  • Transparency: Online services implemented to keep clients up-to-date with the firm'ss assets, net capital and the totals in the customer segregated funds.
  • Compliance with tight controls: Issues where compliance may be tight and controlling may be your best sign of a more stable trading firm that filters out many elements that can eventually bury an FCM. The questions and the financial requirements are their protection from debit risk and/or unscrupulous entities that could jeopardize the stability of the firm.
  • Proprietary trading: Should the firm engage in proprietary trading, it could risk the firm's assets and eventually wind up in the customer segregated account as seen in the previous two firms that defaulted.
  • Broker dedication: Any broker that may be too slick without a worry about it attitude without answering your questions about him/her and the firm should be evaluated further. The NFA provides a website where you may look up the history of a broker and see how long one has been in business. A broker in business may have reparations, but that does not always mean that he/she may be guilty of any violation. There are reparations that are dismissed. However, you may find other charges that may be of concern.
  • Smoking mirrors: There has been no correlation to date that has evaluated the use of rainmakers for commodity brokerages or eccentric facilities, but one may want to be sure to check the financials on brokerage business gains as opposed to investment dollars propping up the firm. If brokerage heads are focused on investor dollars coming in, are they focused on a tight brokerage operation?
  • Knowledge: Knowledge is important, not only of the economy and the markets, but of the industry as well. Going back to the 80's, there have been legal opinions appearing in newsletters addressing a potential default situation and the ramifications it would bring. Heads of brokerages would be on top of industry what ifs? A well-run firm may want to tally the short/longs of specific markets that may show increased volatility. The priority for a well-run firm may be safety surpassing marketing. It would behoove clients to follow the industry for tips on the financial wear-with-all of the brokerages and how they handle events internally. The Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) may furnish information on each brokerage.

The regulatory bodies have constructed regulations to protect the client accounts. The CME and the NFA are the primary supervisory bodies for commodities trading. The exchanges, such as the CME and the ICE, offer their rule books as a way to provide clarity in the operational functions of the exchanges and client protection. Since the debacles of PFG and MFG, a new organization has come into focus. The Customer Commodity Coalition has been founded by the renowned Attorney and Commodity Trading Advisor, James Koutoulas, as an association with an exclusive focus on customer rights, protection and advocacy. This is oversimplifying the subject matter as there is so much more to learn in this industry, but it is hopefully a way to bring attention to how important knowledge is to commodity traders on different levels. The days of the heads of large firms being above the law are gone. The days of too big to fail are gone. It is now the day to question everything, to run through worst-case scenarios and to trust in your own knowledge quest!

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Topic: PFGBest Client Funds Recovery
Date: Wednesday January 15, 2014
Time: 3:00pm Eastern Time

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