Futures Broker Due Diligence Notes post PFG
|July 12th, 2012, 05:37 PM||#1 (permalink)|
Identify Evaluate Execute
Mercer Island WA
Futures Experience: Advanced
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Futures Broker Due Diligence Notes post PFG
After the PFG collapse I've been evaluating my futures brokers to determine whether my capital is adequately protected. I'm certainly not panicking but it is clear regulation is poor and the required legislation to protect my capital is some time off. In any case it is prudent to review and take action if appropriate. I thought I'd share my own personal due diligence notes so it may provide some information to others who may be concerned.
Note, prior to opening my existing accounts I'd done a fair amount of due diligence. For this round of due diligence I'm only considering brokers that offer both equities AND futures as they are the only ones able to piggy back their existing equities SIPC coverage.
I've broken the analysis down into; invested capital, proceeds from sales/ initial margin, overnight margin and proceeds of overnight margins and sales. The most important aspect for me is capital protection so that is my ultimate focus. The three candidates chosen were Interactive Brokers, Tradestation and TD Ameritrade/Think or Swim. I only use IB for futures right now but am considering TD/TOS (already use for equities) and Tradestation. I will still evaluate IB to confirm that I have adequate protection.
To conduct due diligence I spoke to the following people:
1. TD- Manager of the trade desk,
2. IB - Manager of the margin desk
3. Tradestation - Senior account rep.
Basically I kept asking for someone else to speak to until I got someone who knew what they were talking about. This in itself was a long drawn out process. I was lucky with tradestation as the first person I spoke to was very knowledgeable.
Disclaimer: The following table and notes are based on telephone discussions. I could have misunderstood some areas and have nothing at all in writing apart from what is on their websites which may also be factually inaccurate. In other words these are personal notes so traders should conduct their own due diligence. If you believe anything I have written is factually incorrect and have specific knowledge in this area please provide any views so I can provide an update to the table.
Here is a summary table:
Notes to Table (Table updated in post below):
1. Interactive brokers
Note 1. If you open up a futures account without an equities account and deposit cash with IB it is covered by the SIPC as futures cash and equities cash is commingled. Because this is a cash account and not an insured deposit account it is covered by SIPC and not FDIC.
Note 2. Once you make a futures trade and then liquidate by the end of the day the initial margin and profit cash stays in the commodities accounts unless you choose the option to sweep to the securities account. Make sure you have this option selected. The commodities account falls under normal segregation rules and there is no SIPC coverage.
Note 3. If you make an overnight trade the overnight margin is transferred to the segregated account there is no coverage. IB calculate the margin on the total of the position. So if you are short -$1m ES and long $1m TF then the entire margin is transferred to the account. Again, if you liquidate, make sure the securities option is checked or the cash will stay in the commodities account.
2. TD Ameritrade/Think or Swim
Note 4. If you open a futures account and deposit cash with TD it is covered by the FDIC for institutional failure as the account is classified as an insured account. If you want to be covered for fraud, open a securities cash account and choose to sweep to that account and be covered by SIPC.
Note 5. If you make a futures trade and liquidate by the end of the day the initial margin cash is automatically transferred back to your preferred sweep account at the end of the day.
Note 6. TD Ameritrade operates an omnibus fund which deals with margin on overnight trades. This means they only transfer to the clearing firm the net position of their total client funds. This means if the clients are long $100m and short $90m then they only transfer overnight margin for the net $10m based on the pro-rata of accounts. They still segregate the cash in total for the required margin but only $10m is transferred out of the TD umbrella. According to them only when the cash leaves TD Ameritrade and deposited with the clearing firm does it become uninsured. Note I spoke to Interactive Brokers about this and they said that wasn't within the rules and the margin on the gross position had to be transferred.
If you liquidate a swing position then you don't need to do anything as the cash is automatically transferred back to the FDIC insured deposit account.
Note 7. If you open a futures only account at tradestation there is no SIPC coverage on your capital. The cash between futures and equities is kept in entirely separate accounts. There are two solutions to this:
Firstly open an equities account as well as a futures account and keep the cash in the equities cash account which is insured by the SIPC. Transfer only what you need to cover any initial and overnight margins into your futures accounts. Transfers take 24 hours to process.
The second option is to have most of the cash in Tbills. So if you have a $100k account buy $90k in Tbills and then leave $10k in cash. The TBill is 95% marginable. If you blow through the $10k in cash then you can draw-down the Tbill by paying a $10 fee for each draw down.
Note 8 - If you liquidate a futures trade by the end of the day and are concerned then you must have the equities cash account setup so you can transfer the initial margin and profit cash back to the equities account, otherwise the cash will sit in the commodities account and be uninsured.
Note 9 - Same as above
4. Futures only Brokers
Note 10-Further investigation into broker proprietary trading revealed some significant risks to trader account equity. Proprietary trading is the brokerage trading in its on right. The additional risk to customer funds occurs through the brokerage using client assets to collateralize its positions. The is perfectly legal and is sanctioned by the fed as follows:
Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.
Of the three brokers mentioned above, only Interactive Brokers operates a prop trading desk and a very active one at that. In fact according to recent filings Interactive Brokers re-pledged or re-sold $7.9 billion of $16.7 billion of available client funds. In addition the customer through the IB Fully disclosed clearing agreement authorizes this. These big bets have helped IB make a staggering $850,000 pre-tax profit per employee. Compare this to Apple $400,000 per employee, Goldman Sachs $75,000 and Amazon $9,000.
Note Section D4 from this agreement which is basically a mirror image of MF Global:
4. To the extent allowed by the Laws and Regulations, Interactive and its affiliated
companies ("Affiliates") may engage in stock lending activity and the lending of
Customer collateral, securities or other property including, but not limited to, using
Customer collateral, securities or other property for their own accounts or for the
accounts of other Customers, and lending, either to themselves, to their Affiliates, or to
others, any Customer collateral, securities and other property held by Interactive in
Customers' Fully-Disclosed Accounts. Pursuant to applicable Laws and Regulations,
Interactive or its Affiliates may deposit collateral, securities and/or other Customer
property with third parties and may pledge, re-pledge, hypothecate or re-hypothecate
Customer collateral, securities and/or other Customer property, either separately or
together with other securities and/or other property of other Customers of Interactive
for any amount due to Interactive in any Interactive Fully-Disclosed Account in which
Customer has an interest. Interactive or its Affiliates, may so pledge, re-pledge,
hypothecate or re-hypothecate Customer collateral, securities and/or other property
without retaining in Interactive's or its Affiliate's possession or under its control for
delivery a like amount of similar collateral, securities and/or other property and
Interactive or its Affiliates may return to Customer collateral, securities and/or other
property other than the original, or original type of, collateral, securities and/or
property that Customer deposited with Interactive. Collateral that is registered with a
third party may not be in Customer's name.
Note: To get around the US Federal Reserve Board's Regulation T IB, Goldman Sachs and other investment banks use their UK affiliates to hypothecate assets. Whay are they using UK affiliates? The UK has no minimum formula for hypothecating assets so they are open to leveraging client funds many times over. MF Global did exactly this with the sovereign debt bet being many times the total of client funds.
Based on the information above the following conclusions can be drawn:
1. In the event of broker fraud/theft IB, TD and Tradestation appear to be a safer alternative to Futures only broker's because they are covered by SIPC insurance as opposed to futures brokers that have no coverage.
2. Although IB, TD and Tradestation are covered by the SIPC there may not be sufficient solvency to cover claims as the SIPC only has a net $200 million in assets due to the Madoff fraud (present and future claims) exhausting most of its funds. Furthermore the SIPC may simply deny payouts to futures only traders as SIPC is primarily intended to protect securities traders.
3. IB exposes the trader to additional business risks through its ability to hypothecate client assets to collateralize its positions. This is primarily what happened to MF Global. MF Global used client assets to collateralize its European sovereign debt bet that went wrong. IB has the legal right to do the same but in the event of failure could be more catastrophic as it can pledge equities portfolios as well.
4. The risks of futures only brokers have been clearly exposed with the recent demise of PFG due to officer theft. This exhibited significant control issues with the regulator over monitoring segregated funds. The public perception is the regulator does not have sufficient expertise to protect client accounts from dishonest FCMs.
5. If the regulator is able to exhibit in the future that its ability to monitor and control these segregated funds is flawless then FCMs without a prop business could be deemed a relatively safe second alternative to SIPC firms such as TD Ameritrade/Think or Swim or Tradestation (provided equities account in place as well).
Last edited by djkiwi; July 21st, 2012 at 04:50 PM.
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