Protecting clients’ money in MF Global’s wake

The collapse of MF Global in 2011 has highlighted the need for a renewed focus on how AFS licensees handle clients’ money and how that money is protected. The industry is also embarking on its own form of protection as certain industry players in the OTC derivatives market are engaging with ASIC positively and proactively to embrace, and even drive, reform. 

The collapse of MF Global worldwide on 31 October 2011 has highlighted the need for a renewed focus on how Australian financial services (AFS) licensees handle clients’ money and how that money is protected.

In the coming months, AFS licensees can expect to see changes to the legislative requirements around the permitted uses of client money under the Corporations Act, as well as a likely further tightening of policy by the Australian Securities and Investments Commission (ASIC). The industry is also embarking on its own form of protection as certain industry players in the over-the-counter (OTC) derivatives market are engaging with ASIC positively and proactively to embrace, and even drive, reform.

The ongoing MF Global saga

In 2010, MF Global used client money to invest in European bonds which subsequently failed and caused disastrous consequences for the company, its investors and clients. Liquidators suspect the loss from the failure of the bonds of around $1.2 billion is client money. Bankruptcy proceedings against MF Global’s US parent company are underway in the US, while the Australian subsidiary, MF Global Australia Limited, is under voluntary administration, with Deloitte working to recover lost funds and divide up the remains. The administrators of MF Global Australia have commenced proceedings in the Supreme Court of New South Wales seeking the determination of issues on the distribution and recovery of clients’ money out of MF Global Australia’s client money account.

The Australian regulatory framework

An established regulatory regime exists in Australia to protect clients’ money held by AFS licensees. Under the local regime, there are restrictions on how clients’ money may be handled. This covers the type of account that it must be paid into, the circumstances in which clients’ money may be withdrawn from the account and a requirement that the money is kept segregated from the AFS licensees’ own money. Clients’ money must be kept separate from the AFS licensee’s own funds and held in segregated accounts. These are typically pooled with other clients’ money and therefore expose clients to the risk of a shortfall in funds should other clients default. Further, when dealing in derivatives, clients’ money may be withdrawn by the AFS licensee and used in connection with margining, guaranteeing, securing, transferring, adjusting or settling the deal. This includes dealings on behalf of people other than the client.  AFS licensees may also make payments out of client money accounts, with the client’s written authorisation, and withdraw any client money to which it is entitled. 

As a result, many client agreements contain broad authorisations from clients to make withdrawals from client money for any purpose and to create an entitlement to withdraw funds when margin is due and payable. This means that, legally, AFS licensees dealing in derivatives can use client money for their own purposes, such as hedging their exposure to clients’ positions in derivatives. While most Australian providers of OTC products, such as contracts for difference (CFDs), do not use client money for their own purposes, the collapse of MF Global has revived an appetite for further regulatory reform in this area.

Regulatory response

In the United Kingdom, the Financial Services Authority (FSA) recently announced a plan to review how companies handle client money, following high-profile corporate collapses, including MF Global and Lehman. The key focus of the FSA’s review will be on inadequate record-keeping, ineffective segregation of clients’ assets and the low level of the relevant regulatory requirements.

Locally, the protection of clients’ money has been an area of focus for ASIC for some time. In July 2010 ASIC released Regulatory Guide 212: Client money relating to dealing in OTC derivatives which provided regulatory guidance to AFS licensees on their obligations when  holding clients’ money and which also imposed enhanced disclosure requirements in connection with clients’ money. In August 2011, ASIC released Regulatory Guide 227: Over-the-counter contracts for difference: Improving disclosure for retail investors (RG227), which sets out seven benchmarks against which OTC CFD (or similar product) providers must clearly detail their performance in their product disclosure statements. A key objective of RG 227 is to ensure that retail investors gain a better understanding of OTC CFD providers’ rights over client money, and the risks associated with the pooling of client money.

Treasury appears to be looking to go further, and is considering legislative reforms to bolster the existing client money regime in Australia. It released a Discussion Paper in November 2011 – Handling and use of client money in relation to over-the-counter derivatives transactions. Treasury sought submissions from industry on proposed legislative changes for permissible use of client money in OTC derivatives transactions. Using international comparisons, Treasury espoused four reform options: 

  • restrict or prohibit the ability of client money being used for margining or hedging transactions by the licensee
  • adopt the UK approach, where the licensee acts as a trustee in respect of client money
  • impose a statutory trust fund to prevent licensees from using client money to hedge their own position in derivatives, or
  • adopt segregated individual accounts for individual clients. 

Industry response

OTC CFD providers who represent the majority of the Australian market support the proposal for change. Several large OTC CFD providers submitted responses to Treasury’s Discussion Paper supporting the proposal to prohibit the use of client money by AFS licensees for their own purposes. 

Industry has also actively engaged with ASIC on the issue. Representatives of around 80% of the OTC CFD market in Australia have joined forces to create the Australian CFD Forum, to safeguard the reputation of OTC CFD providers in the wake of MF Global. The Australian CFD Forum has been consulting with ASIC on the adoption of voluntary industry standards. Using self regulation, OTC CFD providers have developed  a set of Best Practice Standards under which members must not access any clients’ money held in segregated accounts for any purposes, including using funds to hedge clients’ trades or for their own operational purposes. 

While the outcome of these discussions is pending, the industry and the regulator agree that restrictions on the use of client money by OTC CFD providers is needed. A change along these lines is therefore expected and would be consistent with offshore regulatory trends, in the UK and the United States. The FSA is looking to tighten its supervision of UK firms holding client money and the US industry showing support for the so-called ‘Corzine Rule’ (named after the former CEO of MF Global, Jon Corzine), which would require CEOs of futures firms to sign off on large transfers of client money. 

Regardless of the scope and extent of the reforms that are ultimately implemented in the context of better protecting clients’ money, it is encouraging to see the strong engagement between ASIC and industry, with industry proactively seeking to consult with ASIC.