JPMorgan takes another step towards dismantling the traditional Futures customer account model

A smart article in Bloomberg yesterday discussed JPMorgan’s now well-known announcement that it would let clients store excess collateral at an account within the custodian bank rather than leaving the assets with a Futures clearer. This is both a logical business move – clients want the option of where to hold excess cash – and also a competitive salvo against the clearinghouses that want to develop their own plans for excess collateral (see an article in our Asset Ops and Strategy blog, “CME is considering holding customer accounts,” from July 24 2012). Excerpts from the Bloomberg article follow along with our comments.
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JPMorgan Chase & Co. (JPM) will allow customers to house excess swaps and futures collateral in a separate bank account as it seeks to reassure investors after losses at MF Global Holdings Ltd. (MFGLQ) and Peregrine Financial Group Inc.

The new service will allow clients to automatically aggregate excess margin at JPMorgan Chase Bank N.A., the firm’s insured deposit-taking unit, Emily Portney, head of agency clearing, collateral and execution at the New York-based bank, said in a telephone interview.

Under Attack
JPMorgan’s decision shows how the brokerage model is under attack, said Craig Pirrong, a finance professor at the University of Houston. Benchmark interest rates near zero since 2008 had already put earnings pressure on the firms, also known as futures commission merchants, or FCMs, and the missing money at MF Global and Peregrine has jarred investors who thought their assets were protected by segregation requirements under the Commodity Exchange Act, he said.

“It’s another illustration of the impending end of the FCM model,” Pirrong said. Futures brokerages earn money on customer collateral by lending it out at higher rates than they pay to the investor or by buying securities with it. “Everything is tilting against that old model,” Pirrong said.

[Dr. Pirrong has gotten to the heart of the matter – the recent losses at MF Global and Peregrine has changed the rules of the game for FCMs and their clients. A breakdown of confidence means that banks like JPM and clearinghouses like CME have an opportunity to win business.]

At MF Global and Peregrine, the excess customer money held at the brokerages is what disappeared. Collateral backing trades of MF Global customers that was held by CME Group Inc. (CME), as well as Peregrine customer assets maintained by Jefferies Group Inc., were protected.

Margin Calls
Investors who trade futures or clear swaps often leave extra collateral in their accounts to have it available if needed for a margin call. This money exceeds what the clearinghouse and the brokerage demand to keep the trades active.

The JPMorgan service will draw unneeded money and securities from however many clearing brokers an investor uses, Portney said. “It’s clearing-broker agnostic,” she said.

[This is reminiscent of Prime Custody, where a custodian bank draws the excess long-only assets of a hedge fund for safekeeping against the potential default of a Prime Broker. In a sense, the new JPM model is a repurposing of this same asset sweeping function.]

The new collateral treatment will also allow investors to choose how to invest their excess margin because it’s held in a depository bank account that the client will control, Portney said. That’s different than in the current futures model, where investment decisions are made by the brokerage and not the investor, Pirrong said.

[And there’s the money shot. Ka-ching.]

CME Group, the world’s largest futures market, said last month it’s considering a plan to hold all customer funds at clearinghouses or other depositories in response to MF Global and Peregrine. The exchange operator and clearinghouse owner said any interest earned by the customer money would be returned to the futures brokerages to maintain a key feature of how the firms earn revenue, according to a letter to customers from Executive Chairman Terrence Duffy and Chief Executive Officer Phupinder Gill.

Duffy, testifying before Congress after the idea was announced, said it “will be controversial and perhaps have disruptive consequences.” He later said the proposal wasn’t meant to disrupt how the futures industry works.

[Except that any change of excess holdings whether provided by CME or JPM will disrupt some parts of how the futures industry works, especially the part where FCMs have been able to profit from the excess balances left by their clients. We think it is unlikely that the JPM model will allow FCMs to continue to earn interest on their clients’ balances. The models here are that the CME is going to the FCMs whereas JPM can go to the FCMs or directly to their clients. JPM has the clients’ ears already so it isn’t as beholden to the FCMs as the CME is.]

The full Bloomberg article is here.

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