Friday, August 01, 2014

Bi-Partisan Senate Legislation Would End Prefunding of Margins in Commodities Trades

Senators Pat Roberts (R-Kan.) and Heidi Heitkamp (D-ND) introduced a bill to enhance customer protections for futures end users such as farmers and ranchers who hedge risk by preventing regulations from the CFTC from being overly laborious. Following the collapses of MF Global and Peregrine Financial Group, the CFTC adopted customer protection rules to help regulators better recognize trouble in firms before they occur. While some changes to the regulations are beneficial, noted the Senators, the rules enacted by the CFTC could overly burden those who rely on futures markets to hedge risks, such as local farmers and ranchers, grain merchants, and futures brokers.

The Risk Hedging Protection Act, S. 2601, provides futures customers with an additional day to get their needed payments to brokers to meet the margin call, while still protecting customers and the financial markets. Companion legislation, H.R. 4413, was earlier approved by the House Agriculture Committee and the full House of Representatives.

The CFTC residual interest rule will eventually require futures customers to deposit the cash required to fully cover the margin of their futures contracts by the morning of the day following a trade. Unfortunately, many customers and end users will not be able to transfer funds to their Futures Commission Merchant (FCM) in time to meet this requirement, which will likely lead to FCM’s requiring the prefunding of margin accounts. The Senators fear that the final result may drive some end users out of the futures markets due to increased costs, leaving them without a market-based tool to manage their risk.

Further, the prefunding of margins will restrict capital that could otherwise be used to hire, make capital improvements, and other critical investments. Prefunding margin accounts will require customers to send significantly more money to their FCM in advance of market moves that may never occur. Customers would be required to pay their initial margin as well as a maintenance margin that assumes price swings in the market. In some circumstances, customers may be required to prefund twice the margin to maintain their accounts.

Additionally, in the event of an FCM insolvency similar to MF Global, the CFTC residual interest rule could mean twice as much customer funds at risk. The residual interest rule will also put additional financial pressure on the smaller to mid-sized FCMs that serve agriculture. These relatively smaller FCMs do not have the large balance sheets that other FCMs may have at their disposal. A likely outcome will be consolidation among FCMs that will result in increased concentration in the FCM sector and greater concentration of risk.

The Roberts-Heitkamp bill would strengthen customer protections in a way that does not needlessly increase the costs to end users. The legislation requires futures customers to deliver sufficient funds to their FCM to cover their margin requirement by the end of business on the day following a trade, rather than the morning following a trade. Roberts-Heitkamp tightens the time frame futures customers had prior to the residual interest rule (3 days), but will prevent prefunding of margins and its unintended adverse consequence.

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