In the wake of MF Global, it can be tempting to suggest myriad rules, which, if followed, would protect investors from similar debacles in the future. Of course, the key words here are: if followed. As Ananda Radhakrishnan, the CFTC’s Director of the Division of Clearing and Intermediary Oversight, put it, “If people are determined to misuse customer funds, they will misuse them.”
No matter how numerous the rules, they can still be broken. And in my experience, the more complex the rules are, the easier it is to break them without detection. Complexity itself gives moral weight to the details of the rules, rather than their spirit.
Instead of creating a maze of regulations, let’s at least start by equipping investors with the tools to know exactly where their assets are going and what might happen while assets are in the custody of a particular third party. Investors need to be crystal clear on the following points:
Contracting Entity – The contracting party should be clearly identified. This identification affects who can use assets and the purposes for which the assets may be used. For example, dealing with “affiliates” nudges the door of ambiguity ajar, and it could swing wide open later. The same goes for allowing the use of sub-custodians. If sub-custodians are used, the issues discussed below will also apply to assets left with them and need to be understood just as completely as they are for assets left directly with the custodian.
Location – In which jurisdiction(s) are the investor’s assets being held? Not all jurisdictions provide the same protection for custodied assets. An investor should be clear on where assets are being held and which regulatory authority has oversight of the legal entity that is holding its assets. Without this knowledge, the investor can’t answer the key questions discussed below.
Use of custodied assets – Knowing the legal entity a custodian uses and how that entity is regulated allows the investor to determine meaningful answers to the following questions: Can the investor’s assets be comingled with those of the custodian or of other customers? If so, what protection is afforded by local law? Who bears the loss if investments decline in value – the investor or the custodian? (History has shown that while the custodian makes the decisions on permitted investments, customers are left to deal with the results if there is a shortfall.) These questions shouldn’t be riddles for a potential investor to solve on its own. Each custodian should be prepared to address these matters with its customers and prospective customers in a clear and concise manner.
Third party creditors – A related set of questions involve whether, and in what circumstances, the custodian’s third-party creditors can gain access to the investor’s assets. What happens in the event of the custodian’s insolvency? How quickly can the investor reach its funds? Will the local regulatory authorities seek to “ring-fence” all assets to protect local creditors before assets are released generally to other creditors? An investor should be clear on its ability to access assets so that it can make contingency plans if access will be delayed.
The contract – Legal rules are the baseline for the relationship between an investor and its custodian, but a contract does not have to merely meet minimum legal requirements. It can set a different standard. An investor might consider an agreement that limits custodian control of its assets. One with enough bargaining position might even consider a more active way to monitor its positions.
The clearing process – Funds and financial assets are rarely left statically with a custodian; funds are used to purchase financial assets and financial assets are sold for funds. If this process occurs through a clearing house, the precise transaction details will differ depending on the country, the instrument traded, and the specific clearing house used. Many customers of MF Global had a rude awakening to the fact that clearing houses are focused on protecting trade performance between their direct members, not access to assets by customers of their members. Unfortunately, it is difficult to master the rules in this area and the associated risks they might pose to investors. For this reason, each clearing and settlement organization should be proactive in communicating to third-party users exactly how its practices impact access to assets. If transparency is required any place in the financial services industry, it is certainly sorely needed to help investors understand the clearing and settlement process and the risks they run in this regard.
Only once investors understand the legal framework surrounding their custodians and the clearing and settlement process can they make meaningful decisions about how to manage risks. Let’s help them get there before the next “surprise” occurs.
