Meet the Futures Industry: A Breakdown of Terminology, Roles and Responsibilities

Date: Wednesday, July 25, 2012
Author: Attain Capital Management

These days, the futures industry has been in the spotlight in a way we've never seen. Granted, we can think of better reasons to pay attention to our corner of the world, but the enhanced attention to our space has highlighted another issue- the fact that the public, at large, has little understanding of the futures industry in general. From reporters referring to FCMs as brokers, to the press using the term managed futures funds, to a seemingly never ending stream of questions related to what, exactly, an FCM does, it appears that the only thing that's clear is a desperate need for  clarity.

Understanding the distinctions between various actors in this space is important to both investors and media alike. It can help provide guidance on who to work with, and what to be thinking about when making investment decisions. It's also pretty critical to establishing wider spread understanding of the significance in what's been happening in our industry. So let's break it down- who the players are, who they answer to, and how those roles might be evolving in the coming months and years.

The Players 

In the futures industry, professionals can fall into a wide variety of buckets, but each category serves a unique function in the space.

Most of us are familiar with the idea of a stock exchange, like the New York Stock Exchange. The futures industry has their own futures exchanges, with some of the largest players in the space being the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE). There are also a wide variety of foreign exchanges out there, trading different (and sometimes similar) markets. The function of the exchanges is similar to what you see on the stocks side of things- the matching of buyers and sellers for products listed at the exchange, or quite simply – the facilitation of trades.  

But just as you cannot walk off the street into the New York Stock Exchange and buy some shares of Apple, you have to be working through the proper parties to trade in the futures markets. These parties are called Futures Commission Merchants, or FCMs. These agents are essentially vouching for you with the exchanges; they verify your identity, send over the required margin to place a trade, confirm that you have the funds to back up your trading behavior, and keep you informed of your account balances and needed action.

There are two types of FCMs- clearing and non-clearing. A clearing FCM holds a membership with an exchange, and, as such, is responsible for posting the required amount of money to hold any futures positions to the various futures exchanges they have memberships with. However, the cost of maintaining a seat on an exchange and the operational support for the necessary transactions gave birth to non-clearing FCMs. These firms will work with a clearing entity which helps direct the movement of customer cash for trading purposes alone, leaving the remainder of the FCM duties on the non-clearing FCM in question. For context, MFGlobal was a clearing FCM, while PFGBest was a non-clearing FCM that worked with Jeffries as their clearing FCM.  

What are the differences between the two? Clearing FCMs are generally a little lower cost, as there's only one entity involved in the clearing process. However, many of these firms will focus on larger investors, while non-clearing FCMs, in our experience, tend to do a better job with client relations. Moreover, non-clearing FCMs have the ability to move their book of business if the clearing party's integrity is somehow compromised. Such moves, however, are rare, with only a few that we can recollect in recent times.

Some people like professional traders, commercial hedgers, and large institutional investors may trade enough that an FCM is all they need to conduct their business. Especially since the dawn of electronic trading platforms, more and more investors will simply trade through whichever FCM they've partnered with. That being said, many investors seeking futures markets access will work through another actor-  an Introducing Broker. 

Broadly speaking, an introducing broker is the person or firm most futures market participants have a relationship with. They are the people you call to talk about what Corn might do next week, about which managed futures program is doing well in the current environment, or which electronic trading platform provides the bells and whistles you are looking for.  As alluded to, most of these brokers will specialize in specific types of access points, be they retail trading brokers, facilitating the trading of individuals who like to place their own trades either over the phone or via an online platform;  hedging transaction brokers for farmers and commodity consumers; or folks like us, who specialize in managed futures recommendations (more on that in a moment). What kind of firm you work with will depend on the type of business you're looking to do.

There are also distinctions to be drawn in broker affiliation. For instance, an Independent Introducing Broker has the ability to establish a clearing relationship with any firm they choose, and can move that business as they see fit. In contrast, a Guaranteed Introducing Broker, or GIB, is affiliated with one clearing firm alone. They will align themselves with an FCM in order to avoid having to meet certain net capital requirements, relying instead on the capitalization of the FCMs from a compliance perspective. However, should that FCM go down in flames, they're sinking with them. Again, using a broad brush, this is part of the reason we always recommend investors seek out independent brokers.

Now, as we pointed out above – not all futures trading is done via a trader placing trades on their own or via their broker. In fact, we don't recommend investors trade futures on their own, at all. Futures trading is complex, and presents the risk of substantial losses, as the NFA likes us to say. In our experience, most people who trade futures on their own end up losing more often than they win. This is why we work in the managed futures space; where we believe that professional money managers can do a better job than a trading amateur when it comes to harnessing the potential value of futures markets. These money managers are called Commodity Trading Advisors, or CTAs, even though the press frequently refers to them as Commodity trading funds or commodity hedge funds, or the like.

Essentially, a CTA  will trade on behalf of client in identified markets according to a specifically outlined strategy. They may be systematically driven, or trade on a discretionary basis, but the structure of the programs is outlined, along with past performance, in a disclosure document that investors must sign off on before investing. Investors sign a limited power of attorney which gives trading authority in a specific account, and that account only, to the program manager, who then trades on their behalf according to the agreed upon strategy.   

Assuming you're operating in the futures markets and not forex (we'll get to that in a second), those investing with a CTA have their money held in a segregated account which has been introduced to a FCM by an Introducing Broker. Assuming said FCM is not PFGBest or MFGlobal and no fraud is taking place, that money cannot be touched, and is the property of the investor. The CTA will trade each clients' individual account, and with that separation of funds comes the ability for daily transparency and liquidity; after all, it is your account which you can view as often as you like and take mo alone.

Now, many CTAs are also registered as a Commodity Pool Operator, or CPO, which is similar to a CTA in essentially every way except how the investors access the strategy of the manager.  Unlike a CTA where the manager places trades directly in the client’s own account, a commodity pool, or Fund run by a CPO, pools together investor money and places trades in a single account owned by the Fund. Because an investors money is invested in the name of the fund, not the name of the investor, this leads to slightly lower levels of liquidity and transparency. The tarde off is that such funds, CPOs, tend to offer lower minimum investment thresholds than are available for individually managed accounts, as they rely on the pooled funds and not individual account balances to trade. You can’t trade 1/8 of a contract, but you can get 1/8 of what’s needed to trade 1 contract from 8 people in order to trade one contract.

Both CTAs and CPOs require accounts at clearing firms to trade the products of different futures exchanges on behalf of clients, or the fund;  while some CTAs will work with introducing brokers to expand their distribution.

The Referees

So we know who the players are and the board on which they play, but who's monitoring the game and enforcing the rules? Well, we've made our thoughts on how well they do their job pretty clear by this point, but understanding what they should be doing is pretty important when it comes to comprehending recent developments.

In 1974, Congress passed the Commodity Futures Trading Commission Act of 1974, which President Ford signed into law. It had become clear, as trading increased in frequency, that there was a need for legal oversight. The passing of the bill overhauled the Commodity Exchange Act and created the Commodity Futures Trading Commission (CFTC or Commission), an independent agency with far more authority over futures trading than its predecessor, the Commodity Exchange Authority.

The bill also allowed for the development of a self-regulatory body for the industry that would complement the actions of the CFTC. In 1976, a group of industry participants, lead by the then Chairman of the CME Leo Melamed, formed the National Futures Association Organizing Committee. The goal was to reflect a large cross-section of business and regional interests, because without full cooperation across the industry, the efforts would not be a success. The process was a slow one, but in 1982, Robert K. Wilmouth, former president of the Chicago Board of Trade, became the NFA’s first president. The rest, as they say, is history. The NFA became a self-regulating body operating under the authority of the CFTC.

What are the differences? The answer, it turns out, was not exactly easy to track down. Our past research had indicated that the CFTC writes the rules and enforces them for non-NFA members (think exchanges), and the NFA enforces the rules for its members unless the infraction is a large one.

Essentially, the NFA has a long list of compliance rules which members must abide by. Included in these rules are all of the CFTC regulations, while others are derived from the industry in order to uphold the highest levels of integrity among members- in theory, at least. As the NFA website explains, “With certain exceptions, all persons and organizations that intend to do business as futures professionals must register under the Commodity Exchange Act.” The NFA will then conduct audits of its members and generally monitor their behavior. If they find something out of line, they will issue a reprimand that can range from a letter of warning to expulsion from the organization and hundreds of thousands of dollars in fines. Again, in theory. 

When does the CFTC step up to the plate? Legally, they could get involved in any case alleging an infraction of their regulations, but in practice, they usually only get involved in the punitive process if the offender is not an NFA member (meaning the NFA has no jurisdiction), or if the violation was severe. While it is possible that someone could be punished by the CFTC and NFA, it doesn’t often happen that way.

The futures industry is pretty large and sprawling, making the task of regulating the industry a difficult one. While the NFA may be tasked with being the frontline regulator on most issues, general surveillance of FCMs is largely conducted by a group of self-regulatory organizations who  hold designated responsibilities for a list of FCMs, known as DSROs. Outside of the NFA, each other DSRO is an exchange of some form, including the CME, ICE, Kansas City Board of Trade and Minneapolis Grain Exchange. Their job is to closely monitor the balances of segregated funds accounts.

At this point, it's important to understand the massive distinction between "segregated" and "secured" funds. Futures clients enjoy the benefits of having their funds "segregated." Barring out and out fraud at an FCM, these funds may not be touched for any purpose other than trading by or on behalf of the investor. The Refco bankruptcy is a recent example of the benefits derived from these protections; those with funds in segregated accounts didn't lose a penny, with their balances being transferred to new clearing firms.

Secured funds are a whole different ballgame. Typically, this is money for those trading forex- think currencies. Although it is also how US FCMs enable trading on foreign commodity exchanges. So if you want to trade some Euro Bund futures on Eurex, the FCM will convert some of your segregated account balance to a secured balance, and then transfer that secured money to the foreign exchange. This caused all sorts of problems in the MF Global case, as the UK regulators in particular have been stubborn about returning money posted in their country as margin, claiming the UK investors have priority on that money.  Secured funds, in the case of bankruptcy, essentially become part of the general creditor claims – although there is some precedent for customer funds to have prioritiy even if they aren’t segregated funds.  Should it be this way? In our opinion, no, but currently, it's where things stand.

At the end of the day, though, these regulators answer to the CFTC, which answers to Congress. Unfortunately, as we've seen in the MFGlobal and PFGBest cases, accountability among the regulatory bodies has been slim, and answers for investors are in short supply. We've outlined ways investors might be able to up their protection in light of these deficiencies, but in the long-term, we're hoping  the necessary reforms are put into place.

How These Concepts Might Evolve

Recent scandals have called into question the general infrastructure of the futures industry, forcing us to consider a wider universe of where things go from here. From a regulatory perspective, we've got a wide berth of changes we'd like to see made, but that's been covered by now (see here for more).

Right now, we're looking at what happens to the role of the FCM moving forward. There are two components to consider. Initially, the FCM business model has languished in an era of lower interest rates. Hedgeworld had a great article up on the subject, despite some terminology issues. The thrust of it (bracketed terms replaced for accuracy- to the authors, please note that a broker and FCM are not the same thing, and cannot be used interchangeably):

Long before Peregrine Financial Group's dramatic collapse last week, months before MF Global's meltdown triggered an industry-wide crisis of confidence, the world of the independently owned [FCM] was not a happy one.

Even as trading volumes handled by these relatively small futures commission merchants boomed over the past decade, profits were dwindling: electronic trading, the rise of the hedge fund and rapid-fire algorithmic trader, and the slump in interest rates had upended their century-old business model.

Some turned to speculating with their own money, trade finance or market research to bolster earnings; others have been sold, further depleting the ranks of an industry which saw market share halved in 10 years. Two, MF Global and Peregrine, allegedly looted their customers' money to try to stay afloat.

"The root cause of issues at both firms was the lack of profitability," said Gary DeWaal, general counsel of [FCM] Newedge, which is owned by two French banks and is one of the world's largest futures [FCMs].

"That caused the principals to do things that, in the end, were probably not such a good idea," he deadpanned.

But, really, the bigger concern is protection of client funds. Can the concepts exist in harmony? Perhaps... industry chatter is leaning toward the idea of having exchanges hold funds on behalf of FCMs, returning interest gained on funds back to them, and allowing them to focus on serving clients. The CME alluded to a similar idea in an email to clients this morning.

Generally speaking, we're not opposed to the idea, but there are some complications to consider. For instance, a big portion of futures trading takes place of foreign futures exchanges. While we might trust the CME with funds, for U.S. investors, the idea of entrusting custody of their funds to entities which do not answer to U.S. law is a tidbit unnerving. Further, not all investors fund their accounts in cash. In the past, many used treasury bills as collateral, and as the PFGBest bankruptcy hearing on specifically identifiable property (SIP) highlighted, others continue to fund their accounts with things like precious metals or blue chip stocks. How does this get handled in a world where FCMs aren't holding customer assets? We don't have the answers, but we think they need to be found before any decisions are made.

There's no way around it- this is a complex industry, and we face even more complex challenges on the horizon. But before we can tackle those issues, it's important that our discussion come from an informed place, and we hope these clarifications can help us get there. In the meantime, we'll keep on fighting, hoping that logic and reason prevail.