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This chapter is from the book

Commodity Brokers Boom and Bust Too

In the late 2000s, the commodity markets made history, but in the early 2010s, it was commodity brokerage firms that were grabbing headlines. More specifically, the epic failure of two prominent players, MF Global and PFGBEST, showcased insolvency plagued by a lack of integrity. As Warren Buffett said, “Only when the tide goes out do you discover who has been swimming naked.”

Brokerage Firm Business Models Break Down

For years, futures brokerage firms had operated within a business model in which revenues were generated by trading commission in conjunction with interest earned on the deposits made by clients to meet margin requirements. Simply put, if a client wires $10,000 to a futures broker to fund a trading account, the brokerage firm is free to invest that money in regulatory-approved interest-bearing securities such as Treasuries, bank deposits, and CDs. Historically, the interest generated from such investments accounted for a rather significant percentage of a brokerage firm’s income. Yet federal programs forcing interest rates to near-zero levels eliminated the capability of firms to benefit from client deposits; accordingly, profitability was hindered and exclusive to the generation of commissions and fees.

Before the Federal Reserve’s never-ending quest for near-zero interest rates, futures brokerage firms enjoyed returns on client deposits between 3% and 5%. Accordingly, as technology improved trading execution, many firms traveled the path of discounting commissions to attract client funds and, in turn, relied on earning somewhere near 4% interest on client deposits. They knew that carrying large profit margins on commission wasn’t necessary if they could earn “the float,” which is the industry term for interest earned on client money. However, this business plan didn’t account for unfathomably low interest rates and eventually proved to be highly flawed.

Unfortunately, the practice of discounting commission to attract new clients is a slippery slope that eventually results in cannibalism of the industry. Firms went from competing on service, to competing on price; ultimately, profit margins shrank to levels at which brokers simply couldn’t operate profitably in a low-interest-rate environment.

In addition to low interest rates and lower commissions, the financial collapse of 2008 tightened the purse strings of many speculators. This dealt another blow to the commodity brokerage industry causing many brokerage firms to fold their hands.

I entered the commodity industry in early 2004; during that time, I’ve witnessed the number of registered Futures Commission Merchants (also known as futures brokers) fall from about 90 firms to fewer than 50. Simply put, nearly half of all commodity brokerage firms in operation when I stepped into the business are no longer in operation. Regretfully, I worked as a broker for one failed firm and operated as an Introducing Broker for another. Chapter 5, “Choosing A Brokerage Firm,” covers the definition of an Introducing Broker and a Futures Commission Merchant.

Through no fault of my own, or any of the other hard-working employees and brokers of these collapsed firms, I faced significant challenges in regrouping my life and business. Ensuring the most efficient transition to new brokerage arrangements possible for my firm and, more importantly, my clients was a difficult task. Part of the process involved establishing new relationships with the risk management departments of our new trade-clearing arrangements to make sure each of our clients had the opportunities and leeway they needed to better their odds of success. Additionally, we faced the burden of matching our clients with new trading platforms appropriate to their strategies, ensuring favorable margining and fee structures, and much more. On the bright side, the commodity industry is known as the “last bastion of capitalism”; therefore, survival of the fittest is in play. As difficult as it is for a broker and its clients to migrate to a new brokerage firm in the wake of the collapse of another, I can attest that the odds are in favor of an overall improvement in service and quality simply because only the strongest and most efficient survive.

Hard Times and Desperate Measures

The difficult futures brokerage environment led some to turn to highly questionable and illegal practices to stay afloat. Specifically, at least two firms violated longstanding, and previously concrete, safeguards of client funds by using customer margin deposits for business operations or, worse, personal embezzlement.

In fall 2011, MF Global, a mammoth commodity brokerage house, went down in dramatic fashion while misappropriating client funds to finance a “trade gone bad” on its proprietary desk in a fast and furious demise. Less than a year later, it was learned that the owner of PFGBEST, one of the ten largest privately held commodity brokerage firms, had been secretly pilfering funds from client accounts to finance operations, pay regulator fines, and fund a comfortable lifestyle for himself. As you are probably aware, the top executive at PFGBEST was reporting false customer segregated funds figures to the overseeing bodies and using falsified bank statements to deter regulators from detecting the fraud. In a letter written before an attempted suicide, he pleaded, “I had no access to additional capital and I was forced into a difficult decision: Should I go out of business or cheat? I guess my ego was too big to admit failure. So I cheated, I falsified the very core of the financial documents of PFGBEST, the Bank Statements.”

Prior to this dramatic confession and the sudden unraveling of PFGBEST, the brokerage firm was considered to be well-respected and among the most compliant in the commodity industry. Regrettably, for these reasons I chose to use PFGBEST as the exclusive brokerage firm to clear my clients’ trades.

Customer Segregated Funds Violations

Before October 2011—more specifically, before the collapse of MF Global—few outside the futures industry were aware of the term customer segregated funds. In July 2012, the failure of PFGBEST to uphold the sanctity of customer segregated funds catapulted the phrase into daily usage in national media outlets, and maybe even the homes of many Americans.

Customer segregated funds are exactly what the name implies; they are monetary deposits made by clients that are segregated from the assets of the brokerage firm. Expressly, when a client wires funds to a brokerage account in his name, the money is sent to a bank account in the name of the broker but titled “Customer Segregated Fund.” All funds held within this account are to be client monies and are not to be commingled with firm money.

The requirement that brokerage firms hold client funds in segregated accounts is a safeguard against brokerage firm bankruptcies. In theory, if the FCM (Futures Commission Merchant, a fancy word for brokerage firm) suffers financial trouble and files for bankruptcy, any client funds on deposit will be unaffected. In fact, in such a case, it is common practice for the funds and open positions to simply be transferred to an alternative brokerage firm, leaving the insolvent FCM to deal with its issues. Before MF Global and PFGBEST, commodity brokerage bankruptcies, mergers, and acquisitions were perhaps an inconvenience to traders, but no client had ever lost a dime in the process; that changed in 2011.

The failure of MF Global and PFGBEST to avoid the commingling of firm and client money crudely reminded us that segregated funds rules are only as good as their followers—and enforcers. Both FCMs displayed a flagrant disregard to compliance stipulations intended to protect the very customers who had enabled their long-standing success as brokerage firms. Deplorably, in both cases, industry regulators weren’t able to detect the violations until after it was too late. Client funds had already been misappropriated and either spent or lost.

At the time this book was going to print, MF Global clients had recouped most of the money they had on deposit through liquidation of firm assets and other sources, but the process had taken approximately a year. PFGBEST clients hadn’t fared so well; it took nearly four months after the firm’s failure for the bankruptcy trustee to release 30% of the funds in what was a chaotic transfer of client assets to another brokerage firm. At the time of this writing, an uncertain amount of client funds would be recovered, but estimates ranged from 50 cents to about 80 cents on the dollar. Even with the most optimistic outcome, the burden of having funds unwillingly tied up and the emotional turmoil caused by the fiasco is substantial.

Collateral Damage

Brokerage clients are the obvious losers of the MF Global and PFGBEST breakdowns. However, other casualties are often overlooked, including the firm’s employees, its brokers, third-party vendors (platforms, trading systems, and money managers), floor traders, market makers, and more. When MF Global and, later, PFGBEST went under, not only did they nearly take their clients with them, but the situation devastated the lives of many hard-working industry participants. The trading pits in Chicago saw an immediate and dramatic decline in participation, and several hundred back-office employees were suddenly out of work.

Painfully, my trading firm, DeCarley Trading, worked exclusively with PFGBEST until its demise in July 2012. I’ll never forget July 9: A single email near the close of trading dashed all our hard work and dreams. Without any prior knowledge of troubles brewing at the firm, nor any reason to have suspected wrong doing, we were notified that PFGBEST’s assets and client funds had been frozen pending an FBI investigation into the fraud of its president, Russell Wasendorf.

The commodity brokerage business is extremely demanding; few brokers achieve financial success, and those who do spend years building their business to get there. DeCarley Trading opened its door four years before the failure of PFGBEST and worked tirelessly around the clock to build clients’ trust. Sadly, it was taken from us in the blink of an eye, through no culpability of our own. Fortunately, we were able to quickly recover by creating an even better trading environment for our brokerage clients; with some time and dedication, we are confident we will emerge as a “bigger and better” firm.

However, we were not alone in our hardship. Approximately 120 firms were engaging in a similar exclusive trade-clearing relationship with PFGBEST. As I was writing this, more than half of such firms had thrown in the towel and closed shop. After all, their ability to generate commission revenue stopped immediately; PFGBEST owed its brokers about a month and a half in commission, and the thought of starting from scratch to build a business in a nearly impossible environment for commodity brokers was a gut-wrenching task many weren’t willing to attempt.

Each of us doing business with PFGBEST chose the firm with careful consideration and due diligence; nonetheless, each of us also learned that even doing your homework and confirming with the data reported by regulators isn’t always enough. With that said, the industry and its regulatory bodies have gained insight and implemented practices that should successfully prevent a repeat of the PFGBEST and MF Global heartache.

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