Using client segregated account funds to hedge derivative broker risk
ASIC has voiced concern about the practice of derivative brokers deducting client money from a client segregated account to hedge broker risk (based on the broker’s own hedging policies and broker margins).
The regulator’s concern has emerged as a result of a number of high profile broker defaults, involving over the counter derivative brokers, in which client monies have been applied to hedge trading risk.
In the case of retail clients, the primary concern of the regulator is that, the client may not be aware of the counterparty risks involved in investing in derivatives and thus may not be in a position to assess the level of counterparty risk involved.
Current legal position
It is common practice for licensed derivative brokers to pool together funds received from clients for hedging to cover client positions. In effect, as a result of this pooling, one client's money could be used to pay margin calls for hedging positions taken out to cover derivative dealings conducted on behalf of another client.
One regulatory concern is that the application of pooled client funds for hedging broker risk does not prevent the derivatives broker from taking on excessive levels of risk of which a retail client may not be aware.
Treasury views
Treasury has suggested that if the pooling of client money, which is envisaged by the current legislation, is continued that “its application may nevertheless need clarification or amendment to better protect retail clients”.
The possible regulatory response may include tightening the laws to restrict or even impose a ban on pooling client money.
Sonray’s Case
An individual client’s entitlement to pooled monies held in a clients’ segregated account upon liquidation of a derivatives broker has been considered in the Sonray Capital Markets case [1].
Sonray traded in global equities, futures, margin foreign exchange and CFDs.
Client funds and assets were held on trust by Sonray in a number of client segregated accounts and were mixed from the outset and subject to thousands of unauthorised dealings resulting in a deficiency of $45.6 million.
As a consequence, there were insufficient funds in Sonray’s clients’ segregated accounts to meet the entitlements all Sonray’s clients represented by their account balances on various trading platforms.
The resulting segregated client account deficiency led to conflicting claims amongst Sonray’s clients as to their respective entitlements to the various trust funds and assets.
The Court found that the client funds were so thoroughly mixed that it was practically impossible to ascertain a particular client’s entitlements in each of the segregated accounts.
In the particular circumstances of Sonray, His Honour Gordon J held that if a client has paid money into a client segregated account where the balance is so thoroughly mixed with other client monies, then any particular client who has paid money into that client segregated account will be entitled to an equitable charge over the whole balance of the account.
Possible change to regulatory approach
As a result of the deficiencies in client segregated accounts arising on liquidation in cases like Sonray, the regulator may be prompted to potentially revisit:
- how monies held in a segregated client account may be used to hedge derivative broker and counterparty risk; and
- how client funds are pooled for use by derivative brokers in support of those hedging arrangements.
There is a possibility that Australia might follow the UK and the US where licensed brokers are:
a. restricted in their use of client money and prohibited from:
- treating client money as their own working capital;
- using it to hedge its own position in derivatives; and
b. required to:
- deposit each client’s money in a separate client bank account (in a statutory trust); and
- put sufficient capital aside to pay out a specific client’s open positions, that is, if a client’s equity position drops into negative territory then a broker cannot reduce the amount of capital it holds for that client.
Likely impact
The derivative broking industry is likely to see the imposition of additional risk disclosure requirements associated with the operation of their client segregated accounts.
There is also the possibility that, in the foreseeable future, specific restrictions may be imposed on client funds held by an OTC derivative broker in a client segregated account:
- to quarantine each individual client’s funds from that of other clients; and
- to tighten the conditions which apply to using client funds to hedge a derivative broker’s own position in derivatives.
If you require assistance in relation to derivative compliance, operating a segregated client account, derivative market rules or financial services please contact:
Michael Bracken
Partner
Phone: 61 2 9228 9231
Michael_Bracken@tresscox.com.au
[1] Georges v Seaborn International (Trustee) in the matter of Sonray Capital Markets Pty Ltd (in liq) [2012] FCA 75
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