[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]



 
        THE FUTURE OF CFTC: PERSPECTIVES ON CUSTOMER PROTECTIONS
=======================================================================


                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON

                        GENERAL FARM COMMODITIES

                          AND RISK MANAGEMENT

                                 OF THE

                        COMMITTEE ON AGRICULTURE

                        HOUSE OF REPRESENTATIVES

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                               __________

                            OCTOBER 2, 2013

                               __________

                            Serial No. 113-8


          Printed for the use of the Committee on Agriculture

                         agriculture.house.gov




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                        COMMITTEE ON AGRICULTURE

                   FRANK D. LUCAS, Oklahoma, Chairman

BOB GOODLATTE, Virginia,             COLLIN C. PETERSON, Minnesota, 
    Vice Chairman                    Ranking Minority Member
STEVE KING, Iowa                     MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas              DAVID SCOTT, Georgia
MIKE ROGERS, Alabama                 JIM COSTA, California
K. MICHAEL CONAWAY, Texas            TIMOTHY J. WALZ, Minnesota
GLENN THOMPSON, Pennsylvania         KURT SCHRADER, Oregon
BOB GIBBS, Ohio                      MARCIA L. FUDGE, Ohio
AUSTIN SCOTT, Georgia                JAMES P. McGOVERN, Massachusetts
SCOTT R. TIPTON, Colorado            SUZAN K. DelBENE, Washington
ERIC A. ``RICK'' CRAWFORD, Arkansas  GLORIA NEGRETE McLEOD, California
MARTHA ROBY, Alabama                 FILEMON VELA, Texas
SCOTT DesJARLAIS, Tennessee          MICHELLE LUJAN GRISHAM, New Mexico
CHRISTOPHER P. GIBSON, New York      ANN M. KUSTER, New Hampshire
VICKY HARTZLER, Missouri             RICHARD M. NOLAN, Minnesota
REID J. RIBBLE, Wisconsin            PETE P. GALLEGO, Texas
KRISTI L. NOEM, South Dakota         WILLIAM L. ENYART, Illinois
DAN BENISHEK, Michigan               JUAN VARGAS, California
JEFF DENHAM, California              CHERI BUSTOS, Illinois
STEPHEN LEE FINCHER, Tennessee       SEAN PATRICK MALONEY, New York
DOUG LaMALFA, California             JOE COURTNEY, Connecticut
RICHARD HUDSON, North Carolina       JOHN GARAMENDI, California
RODNEY DAVIS, Illinois
CHRIS COLLINS, New York
TED S. YOHO, Florida

                                 ______

                      Nicole Scott, Staff Director

                     Kevin J. Kramp, Chief Counsel

                 Tamara Hinton, Communications Director

                Robert L. Larew, Minority Staff Director

                                 ______

      Subcommittee on General Farm Commodities and Risk Management

                  K. MICHAEL CONAWAY, Texas, Chairman

RANDY NEUGEBAUER, Texas              DAVID SCOTT, Georgia, Ranking 
MIKE ROGERS, Alabama                 Minority Member
BOB GIBBS, Ohio                      FILEMON VELA, Texas
AUSTIN SCOTT, Georgia                PETE P. GALLEGO, Texas
ERIC A. ``RICK'' CRAWFORD, Arkansas  WILLIAM L. ENYART, Illinois
MARTHA ROBY, Alabama                 JUAN VARGAS, California
CHRISTOPHER P. GIBSON, New York      CHERI BUSTOS, Illinois
VICKY HARTZLER, Missouri             SEAN PATRICK MALONEY, New York
KRISTI L. NOEM, South Dakota         TIMOTHY J. WALZ, Minnesota
DAN BENISHEK, Michigan               GLORIA NEGRETE McLEOD, California
DOUG LaMALFA, California             JIM COSTA, California
RICHARD HUDSON, North Carolina       JOHN GARAMENDI, California
RODNEY DAVIS, Illinois               ----
CHRIS COLLINS, New York

                                  (ii)


                             C O N T E N T S

                              ----------                              
                                                                   Page
Conaway, Hon. K. Michael, a Representative in Congress from 
  Texas, opening statement.......................................     1
    Prepared statement...........................................     2
    Submitted statments on behalf of:
        Managed Funds Association................................    61
        State Street Global Exchange.............................    66
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma, 
  submitted letter...............................................    61
Scott, Hon. David, a Representative in Congress from Georgia, 
  opening statement..............................................     3

                               Witnesses

Duffy, Hon. Terrence A., Executive Chairman and President, CME 
  Group, Inc., Chicago, IL.......................................     5
    Prepared statement...........................................     6
    Submitted questions..........................................    67
Roth, Daniel J., President and Chief Executive Officer, National 
  Futures Association, Chicago, IL...............................     8
    Prepared statement...........................................    10
Culp, Ph.D., Christopher L., Senior Advisor, Compass Lexecon, 
  Chicago, IL....................................................    13
    Prepared statement...........................................    15
    Submitted questions..........................................    69
Anderson, Michael J., Regional Sales Manager, The Andersons Inc., 
  Union City, TN; on behalf of National Grain and Feed 
  Association....................................................    23
    Prepared statement...........................................    25
    Submitted questions..........................................    71
Koutoulas, Esq., James L., President and Co-Founder, Commodity 
  Customer Coalition, Inc., Chicago, IL..........................    30
    Prepared statement...........................................    32
Johnson, Theodore L., President, Frontier Futures, Inc., Cedar 
  Rapids, IA.....................................................    35
    Prepared statement...........................................    37


        THE FUTURE OF CFTC: PERSPECTIVES ON CUSTOMER PROTECTIONS

                              ----------                              


                       WEDNESDAY, OCTOBER 2, 2013

                  House of Representatives,
         Subcommittee on General Farm Commodities and Risk 
                                                Management,
                                  Committee on Agriculture,
                                                   Washington, D.C.
    The Subcommittee met, pursuant to call, at 9 a.m., in Room 
1300, Longworth House Office Building, Hon. K. Michael Conaway 
[Chairman of the Subcommittee] presiding.
    Members present: Representatives Conaway, Neugebauer, 
Austin Scott of Georgia, Crawford, Roby, Hartzler, Noem, 
Benishek, LaMalfa, Hudson, Davis, Lucas (ex officio), David 
Scott of Georgia, Vela, Enyart, Vargas, Walz, Negrete McLeod, 
and Costa.
    Staff present: Debbie Smith, Jason Goggins, Kevin Kramp, 
Mary Nowak, Pete Thomson, Tamara Hinton, John Konya, and C. 
Clark Ogilvie.

OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE 
                     IN CONGRESS FROM TEXAS

    The Chairman. Good morning. Well, thank you for joining us 
this morning as we continue our series of hearings on the 
future of the Commodity Futures Trading Commission. Today's 
hearing is focused on how to better protect customers in the 
futures marketplace.
    I would like to extend a warm welcome to all our witnesses 
today, and your participation in today's hearing is invaluable 
as we work toward the reauthorization of the Commission and 
improving how it operates.
    Constituents in Texas and Americans across the nation 
depend on well functioning financial markets to manage their 
businesses. In an increasingly globalized world, these markets 
provide access to financial tools that enable even the smallest 
firm to compete in any market. Therein, these markets, in 
particular, are essential to agricultural producers and 
manufacturers across the country as they use products, such as 
interest rate swaps and commodity hedges, to protect themselves 
from risk.
    Yet, today, there is uncertainty across the commodities 
market in the wake of the collapse of two futures commission 
merchants, MF Global and PFG Best. In both cases, customers who 
thought their funds were held in safe segregated accounts 
suffered loss, financial losses. Since the failures of MF 
Global and the PFG Best, the futures industry has taken several 
important concrete steps to improve the strength of the system 
overseeing segregated accounts. Among the most noteworthy of 
these changes is the daily electronic monitoring of customer 
account balances, a simple step that actually led to uncovering 
the fraud occurring at Peregrine Financial. Yet despite these 
improvements, no surveillance system is fool proof. There will 
always be risks inherent in trusting another person with your 
money. Honest people make mistakes, and bad people commit 
crimes. As mistakes occur, Members on this Committee must 
continue to refine the market surveillance systems, but when 
crimes occur, it is essential that our justice system acts 
deliberately and decisively to punish those who harm others and 
cast doubt on the safety of financial markets.
    Our challenge is to put in place systems and processes to 
ensure mistakes are caught swiftly and wrongdoing is made 
exceptionally difficult. As we do so, we must examine whether 
the cost of new regulations outweigh the benefits to the 
marketplace. In particular, I know that Members of this 
Committee are interested in testimony about the CFTC's proposed 
rule on customer protections. Many of the farmers and ranchers 
who are supposed to be protected by this rule have expressed 
deep skepticism of it, which I share with them, because they 
believe the CFTC's proposal would significantly increase their 
hedging costs and ultimately limit their ability to manage 
their risks.
    Improving customer protections in futures markets is a 
topic that Members on both sides of the aisle have been eager 
to explore for some time.
    For many of our constituents, the failure of MF Global and 
PFG Best added a new worry to their already overcrowded plate 
of concerns. An essential part of our job as lawmakers is to 
figure out the best way to restore confidence in investors that 
funds will always be safe no matter what happens to other 
market participants.
    I look forward to the testimony from our witnesses today, 
and some good conversation about what the industry has fixed so 
far, what problems still remain, and what legislative role this 
Committee will play in addressing those issues.
    Again, I would like to thank our witnesses for their 
willingness to share their expertise with us. As well, I would 
like to thank all the Members of the Subcommittee for their 
continued diligence in these hearings to reauthorize the CFTC. 
We will produce a better legislative product because of our 
collective engagement on these issues.
    [The prepared statement of Mr. Conaway follows:]

  Prepared Statement of Hon. K. Michael Conaway, a Representative in 
                          Congress from Texas
    Good morning, thank you all for joining us as we continue our 
series of hearings on the future of the Commodity Futures Trading 
Commission. Today's hearing is focused on how to better protect 
customers of the futures marketplace.
    I would like to extend a warm welcome to all of our witnesses 
today; your participation in today's hearing is invaluable as we work 
toward reauthorizing the Commission and improving how it operates.
    My constituents in Texas, and Americans across the nation, depend 
on well-functioning financial markets to manage their businesses. In an 
increasingly globalized world, these markets provide access to 
financial tools that enable even the smallest firm to compete in any 
market. Derivatives markets, in particular, are essential to 
agricultural producers and manufacturers across the country, as they 
use products such as interest rate swaps and commodity hedges to 
protect themselves from unknown risks.
    Yet today, there is uncertainty across the commodities markets in 
the wake of the collapse of two futures commission merchants--MF Global 
and PFG Best. In both cases, customers who thought their funds were 
held in safe, segregated accounts suffered devastating financial 
losses.
    Since the failures of MF Global and PFG Best, the futures industry 
has taken several important, concrete steps to improve the strength of 
the system overseeing segregated accounts. Among the most notable of 
these changes is the daily electronic monitoring of customer account 
balances--a simple step that actually led to the uncovering of the 
fraud occurring at Peregrine Financial.
    Yet, despite these improvements, no surveillance system is 
foolproof. There will always be risks inherent in trusting another 
person with your money--honest people make mistakes and bad people 
commit crimes. As mistakes occur, regulators and this Committee must 
continue to refine the market surveillance systems. But, when crimes 
occur, it is essential that our justice system acts deliberately and 
decisively to punish those who harm others and cast doubt on the safety 
of financial markets.
    Our challenge is to put in place systems and processes that ensure 
mistakes are caught swiftly and wrongdoing is made exceptionally 
difficult. As we do so, we must examine whether the costs of new 
regulations outweigh the benefits to the marketplace.
    In particular, I know that Members of this Committee are interested 
in testimony about the CFTC's proposed rule on customer protections. 
Many of the farmers and ranchers who are supposed to be protected by 
this rule have expressed deep skepticism of it--which I share with 
them--because they believe the CFTC's proposal could significantly 
increase their hedging costs and ultimately limit their ability to 
manage risk.
    Improving customer protections in futures markets is a topic that 
Members on both sides of the aisle have been eager to explore for some 
time. For many of our constituents, the failure of MF Global and PFG 
Best added a new worry to their already overcrowded plate of concerns. 
An essential part of our job as lawmakers is to figure out the best way 
to restore confidence that an investor's funds will always be safe, no 
matter what happens to other market participants.
    I look forward to the testimony from our witnesses today and a good 
conversation about what the industry has fixed so far, what problems 
still remain, and what legislative role this Committee will play in 
addressing those issues.
    I'd like to again thank our witness panel for their willingness to 
share their expertise with us. As well, I'd like to thank all the 
Members of this Subcommittee for their continued diligence in these 
hearings to reauthorize the CFTC. We will produce a better legislative 
product because of our collective engagement on these issues.
    With that, I'll turn it over to my friend and partner in these 
issues, Ranking Member Scott, for his opening remarks.

    The Chairman. With that, I will turn to my friend and 
partner in these issues, Ranking Member David Scott for his 
opening remarks. David.

  OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN 
                     CONGRESS FROM GEORGIA

    Mr. David Scott of Georgia. Thank you, Chairman Conaway.
    As always, I would like to join you and--first, turning on 
the mike. First, I would like to join you in warmly welcoming 
our distinguished witnesses and guests to our Subcommittee.
    Today's hearing is one of the final pieces in our effort to 
prepare for the coming Commodities Exchange Act 
Reauthorization, and I look forward to a robust exchange of 
information regarding the protection of customers of futures 
commission merchants.
    Of course, protection of market participants is one of the 
core functions of the CFTC. Unfortunately, it is in an area in 
which we have seen several startling lapses in oversight 
recently. Whether it is MF Global, Peregrine Financial, or most 
recently, the fines against Vision Financial, which ironically, 
absorbed much of the portfolio of Peregrine upon its collapse, 
one has to ask questions about the structure of the current 
oversight system and its appropriateness for the way the 
markets currently operate.
    That is not to say that the CFTC isn't working hard. They 
are working hard to ensure that customer funds are not 
commingled with company funds. However, the CFTC is being asked 
to provide oversight for markets that have grown exponentially, 
extraordinarily much larger over the last 10 years, and all the 
while attempting to implement a very complex and complicated 
new financial regulatory regime in Dodd-Frank, without a 
sufficient increase in the resources and funds and staff that 
they need to be made available to them to do the job. This is 
so important. We have to stress the appropriate appropriations 
level if we are going to put these demands on the CFTC. If the 
markets have grown as they have grown, then we have to grow 
their budget to match and make sure they have the resources to 
do their job.
    And as such, the CFTC has been forced because of a lack of 
funds, because of a lack of standing, to become reliant on 
self-reporting and third-party auditing. That is not the way to 
go, because that only opens up room for error and outright 
criminal activity, and that is what we have seen.
    And, unfortunately, when we see problems with the futures 
commission merchants, it negatively affects their customers and 
our constituents, like our farmers, our co-ops, our 
corporations, like Delta and Coca-Cola in my district, and 
ultimately all of the American people are affected, which is 
what brings us here today.
    So, Mr. Chairman, again, I thank you for holding this 
important hearing. The perspectives of market participants and 
the CFTC's work in protecting customers in the FCMs will indeed 
be vital as we move forward. We must ensure that whatever 
regime the CFTC moves and puts into place works well with all 
involved in the market, reducing risk and protecting customer 
funds without significantly raising the price of doing 
business.
    So, our examination here today will help in that respect. 
Thank you, I yield back the balance of my time.
    The Chairman. I thank the gentleman.
    I also recognize that the full Committee Chairman, Mr. 
Frank D. Lucas, is with us this morning. And Frank will be 
participating in the inquisition of our witnesses shortly.
    The chair would request that other Members submit their 
opening statements for the record so that witnesses may begin 
their testimony and to ensure that there is ample time for 
questions.
    I would like to welcome our panel of witnesses. I will 
introduce all six of them, and then we will start with Mr. 
Duffy.
    Mr. Duffy is Executive Chairman and President of CME Group 
in Chicago, Illinois. We also have Mr. Daniel Roth, President 
and CEO with the National Futures Association from Chicago. We 
have Dr. Christopher Culp, Senior Advisor, Compass Lexecon from 
Chicago, Illinois. We have Michael J. Anderson, Regional Sales 
Manager of The Andersons, Inc., Union City, Tennessee, on 
behalf of National Grain and Feed Association, and we have 
James Koutoulas--is that close, James?
    Mr. Koutoulas. Pretty close.
    The Chairman. All right, Buddy. Esquire, President and 
Cofounder of the Commodity Customer Coalition, Chicago, 
Illinois, and Mr. Ted Johnson, the President of Frontier 
Futures, Inc., from Cedar Rapids, Iowa.
    So, with that, Mr. Duffy, please begin.

  STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND 
            PRESIDENT, CME GROUP, INC., CHICAGO, IL

    Mr. Duffy. Thank you. Good morning, Chairman Conaway, 
Ranking Member Scott. I want to thank you for the opportunity 
to testify regarding customer protection in the futures 
industry.
    CME, NFA, and others responded to the failures of MF Global 
and PFG by enhancing customer protections. These enhancements 
include: Daily segregated--segregation reporting by all FCMs; 
increased surprise reviews of segregation compliance; bimonthly 
reporting on investment of customer funds; periodic electronic 
confirmation of customer balances; daily feeds showing balances 
of cash and securities for all customer accounts at 
depositories; and CEO/CFO sign-offs on significant customer 
fund distributions.
    The CFTC's proposed rules codify many of these initiatives. 
In addition, the CFTC has required gross margining at the 
clearinghouse level. This further protects customers from the 
kind of losses caused by MF Global and PFG.
    Unfortunately, CFTC also has proposed a bad rule. This has 
justifiably raised concerns among participants in the 
agricultural markets and many Members of Congress. The rule 
would require FCMs to ensure that each customer's account is 
fully collateralized at all times. The problem is FCMs cannot 
accurately calculate customer margin requirements in real-time. 
Particularly, this means that--or practically, this means that 
customers will be required to double their margin requirements, 
or two, FCMs will be required to contribute very large sums as 
residual interest on behalf of their customers.
    This rule will make the marginally profitable FCM business 
unsustainable for many firms that serve the agricultural 
community. Further, it may deprive not just FCMs but their 
customers' access to futures markets.
    The residual interest rule is not necessary to protect 
customer funds. It's costs and the negative consequences 
outweigh any added protection. This over-collateralized--
collateralization is unwarranted from a risk-management 
standpoint. No regulatory risk model assumes that all customers 
with margin requirements will fail to meet them.
    The proposed ruled would drain liquidity and increase the 
cost of hedging financial and commodity risk, especially for 
farmers and ranchers using our markets. Unfortunately, the 
greatest impact of increased costs would be felt by the smaller 
and mid-sized firms that serve them. They may be driven out of 
business.
    The unintended consequences is that this would actually 
increase systemic risk by concentrating risk among fewer firms. 
Ironically, the proposal would force customers to place more 
collateral with their FCM at the very time they may be trying 
to avoid fellow-customer risk or FCM misconduct.
    We understand the Commission is considering phasing in the 
rule, possibly to mitigate the consequences I just described. A 
phase-in does not cure the problem, however. Instead, CME 
supports the FIA alternative. This approach would permit an FCM 
to calculate its required residual interest as of 6 p.m. on the 
first day after the trade date.
    Now I would like to comment on adopting an insurance 
regime. Professor Culp concludes that the only workable 
insurance is likely private insurance. This insurance would be 
provided through a company owned by participating FCMs. There 
seems to be no commercial interest in providing insurance to 
individual customers or specific FCMs. He also explains that it 
is not feasible to have universal futures insurance mandated by 
the government similar to SIPC. Professor Culp points out that 
its funding, based on the FCM's gross revenues, would be highly 
regressive. Large FCMs would pay a lopsided share while their 
customers would likely benefit the least from the $250,000 
coverage.
    He concludes that the first year of funding, estimated at 
$25 million would not grow fast enough to reach the target 
level of $2.5 billion, until more that 5 decades later. So, 
without a government backstop, the plan would significantly 
underfund relative to potential private solutions, and we 
certainly would not support imposing the burden on the 
taxpayers.
    Customer protection is the cornerstone of our industry. We 
have strengthened our approach, and we will continually 
consider ways to enhance the safety of customer property. At 
the same time, we strive to avoid unnecessary cost or change to 
market structure.
    This will serve customer needs by making certain that we 
have deep pools of liquidity that allows customers to mitigate 
their risk.
    I thank you, Mr. Chairman. I look forward to answering your 
questions.
    [The prepared statement of Mr. Duffy follows:]

 Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and 
                President, CME Group, Inc., Chicago, IL
    Good morning, Chairman Conaway, and Ranking Member Scott. I am 
Terry Duffy, Executive Chairman and President of CME Group.\1\ Thank 
you for the opportunity to testify today regarding the protection of 
customer property in the futures industry.
---------------------------------------------------------------------------
    \1\ CME Group Inc. is the holding company for five exchanges, CME, 
the Board of Trade of the City of Chicago Inc. (``CBOT''), the New York 
Mercantile Exchange, Inc. (``NYMEX''), the Commodity Exchange, Inc. 
(``COMEX'') and The Board of Trade of Kansas City Missouri, Inc. 
(``KCBT'') (collectively, the ``CME Group Exchanges''). The CME Group 
Exchanges offer a wide range of benchmark products across all major 
asset classes, including derivatives based on interest rates, equity 
indexes, foreign exchange, energy, metals, agricultural commodities, 
and alternative investment products. The CME Group Exchanges serve the 
hedging, risk management, and trading needs of our global customer base 
by facilitating transactions through the CME Group Globex electronic 
trading platform, our open outcry trading facilities in New York and 
Chicago, and through privately negotiated transactions subject to 
exchange rules.
---------------------------------------------------------------------------
    CME Group Exchanges, the National Futures Association (``NFA'') and 
other U.S. exchanges responded to failures at MF Global and Peregrine 
Financial Group (``PFG'') by enhancing the protection of customer 
property held by futures commission merchants (``FCM''). These 
enhancements include:

   Daily segregation reporting by all FCMs,

   Increased surprise reviews of segregation compliance,

   Bi-monthly reporting on investment of customer funds,

   Periodic electronic confirmation of customer balances,

   Daily feeds showing balances of cash and securities for all 
        customer accounts at depositories, and

   CEO/CFO signoffs on significant customer fund distributions.

    These programs and rules mitigate the risk of, and augment the 
early detection of, the improper transfer of customer funds and the 
improper reporting of customer asset balances, and improve our ability 
to check compliance with CFTC requirements for the investment of 
customer funds. Our efforts to enhance our monitoring continue today 
through the use of an account balance aggregation tool, which 
facilitates analysis of all of the firm's customer account balances 
across all of its reporting banks. Timely, including daily, access to 
this additional information is enabling us to better direct our 
regulatory resources at risk-based reviews of customer balances at 
clearing members and FCMs and their activity with respect to those 
balances.
    The CFTC's proposed rules codify many of these initiatives.\2\ In 
addition, the CFTC has required gross margining at the clearing house 
level. This further protects customers from the kind of losses caused 
by MF Global and PFG.
---------------------------------------------------------------------------
    \2\ NPR dated November 14, 2012 entitled, ``Enhancing Protection 
Afforded Customers and Customer Funds held by Futures Commission 
Merchants and Derivatives Clearing Organizations.'' 77 FR 67866.
---------------------------------------------------------------------------
Residual Interest
    CME remains fully committed to protecting customers against the 
full range of FCM conduct that may cause customer harm. But it is 
important to weigh the costs and consequences of each ``protective'' 
measure against the benefits to customers. We believe that the CFTC's 
proposal respecting the required residual interest that must be 
maintained by FCMs in the customer segregated account will adversely 
impact customers and fundamentally change the way in which futures 
markets operate.\3\ If a proposed ``protective'' measure is so 
expensive or its impact on market structure is so severe that customers 
cannot effectively use futures markets to mitigate risk or discover 
prices, there is no justification for implementing that measure. The 
proposal on ``residual interest'' fails this test. It has justifiably 
raised concerns among participants in the agricultural markets and many 
Members of Congress.
---------------------------------------------------------------------------
    \3\ CME Group filed comments to the CFTC's proposed rulemaking by 
letter dated February 15, 2013 from Kim Taylor, President, CME 
Clearing. (RIN 30-38-AD88).
---------------------------------------------------------------------------
    The rule would require FCMs to insure that each customer's account 
is fully collateralized ``at all times.'' \4\ FCMs cannot accurately 
calculate customer initial and variation margin requirements in real 
time. Practically, this means that customers will be required to double 
their margin requirements or FCMs will be required to contribute very 
large sums as ``residual interest'' on behalf of their customers. This 
rule will make the marginally profitable FCM business unsustainable for 
many firms that serve the agricultural community, and may deprive them 
and their customers of access to futures markets.
---------------------------------------------------------------------------
    \4\ It would require each FCM to maintain ``at all times'' residual 
interest in its customer accounts sufficient to exceed the sum of all 
customer margin deficits.
---------------------------------------------------------------------------
    The residual interest rule is not necessary to protect customer 
funds. Its costs and negative consequences outweigh any added 
protection. This over-collateralization is unwarranted from a risk 
management standpoint. No regulatory risk model assumes that all 
customers with margin requirements will fail promptly to meet them. The 
proposed rule will unnecessarily drain liquidity and increase the cost 
of hedging financial and commercial risk especially for farmers and 
ranchers using our markets. Smaller and mid-sized firms that serve them 
will suffer the greatest impact of these increased costs, and may be 
driven out of business, leaving farmers and ranchers with fewer FCMs to 
facilitate their risk management goals. This will actually increase 
systemic risk by concentrating risk among fewer firms. Ironically, the 
proposal would force customers to place more collateral with their 
FCM--when they may be trying to actively avoid fellow-customer risk or 
FCM misconduct.
    We understand the Commission is considering phasing in the rule, 
possibly to mitigate the consequences I just described. A phase-in does 
not cure the problem. Instead, CME supports the FIA alternative--that 
would permit an FCM to calculate its required residual interest as of 6 
p.m. on the first business day after the trade date.\5\
---------------------------------------------------------------------------
    \5\ Comment Letter dated February 15, 2013 from Walt Lukken, 
President, FIA re: RIN 3038-AD88 Enhancing Protections Afforded 
Customers and Customer Funds Held by Futures Commission Merchants and 
Derivatives Clearing Organizations, 77 Fed. Reg. 67866 (November 14, 
2012).
---------------------------------------------------------------------------
Bankruptcy Code
    We believe that Congress could further enhance customer protections 
through amendments to the Bankruptcy Code. Potential amendments range 
from fundamental changes that would facilitate individual segregation 
of customer property to narrower revisions that would enhance a 
clearinghouse's ability to promptly transfer positions of non-
defaulting customers. While amending the Bankruptcy Code is a 
significant undertaking, CME Group believes that modification to the 
bankruptcy regime in light of recent experience would benefit customers 
and the market as a whole.
Insurance
    In the wake of MF Global and PFG, some have advocated establishing 
an insurance scheme to further protect futures customers and restore 
their confidence in our markets. Like other ``protective measures,'' an 
insurance proposal must be analyzed in light of the costs and 
potentially limited benefits of such an approach.
    To that end, CME Group, the Futures Industry Association (``FIA''), 
the Institute for Financial Markets (``IFM'') and NFA engaged Compass 
Lexecon to study the costs and benefits of adopting an insurance regime 
for the U.S. futures industry.
    It's notable that Professor Culp's written testimony concludes that 
the only possible workable insurance is likely private insurance 
provided through a company owned by FCMs that choose to participate. 
There seems to be no commercial interest to provide insurance to 
individual customers or on a FCM specific basis.
    He also explains that a government-mandated universal futures 
insurance, similar to SIPC for securities is not feasible. Professor 
Culp points out that its funding--based on an FCM's gross revenues--
would be regressive with large FCMs paying a lop-sided share, while 
their customers would likely benefit the least from the $250,000 
coverage. He concludes that first year funding estimated at $25 million 
could barely cover an average loss caused by a default of small and 
medium FCMs.
    Without a government backstop, the plan would be significantly 
under-funded relative to potential private solutions. And we certainly 
would not support imposing this burden on the taxpayers.
Conclusion
    Customer protection is the cornerstone of our industry. We've 
strengthened our approach, and we will continually consider ways to 
enhance the safety of customer property. At the same time, we strive to 
avoid unnecessary cost or changes to market structure that would 
negatively impact the deep pools of liquidity our customers rely on to 
mitigate their risks.

    The Chairman. Thank you, Mr. Duffy.
     Mr. Roth.

        STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CHIEF
  EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, IL

    Mr. Roth. Thank you, Mr. Chairman.
    I certainly think it is appropriate that the focus of 
today's hearing is customer protection issues, and certainly at 
NFA, that is what we focus on every day.
    And as both the Chairman and Ranking Member pointed out in 
their opening statements, over the last 2 years, the failures, 
first at MF Global and then at Peregrine, certainly highlighted 
the need to strengthen the overall regulatory structure, and 
over the last 2 years, that is exactly what we have been 
working on. We have worked very closely with the CFTC and with 
the CME and with the entire industry. And just as Mr. Duffy 
reviewed, we have implemented--developed and implemented a wide 
range of regulatory enhancements that are described in my 
written testimony. And they are all important. They are all 
significant, but if I could focus your attention on one, it 
would be one that Mr. Duffy mentioned as well, and that is the 
daily confirmation of segregated balances.
    So, for years and years, we have required FCMs to issue 
daily reports with either the NFA or CME regarding the amount 
of customer funds that they are holding. And then what we would 
do is, among other things, we would confirm those balances 
reported by the FCMs. We confirm those balances to outside 
sources, to the banks holding those funds as part of the annual 
examination process.
    Well, clearly, that wasn't good enough. We had to find a 
better way to do this, and that is exactly what we have done. 
We have partnered with the CME, and together we developed this 
system that provides for the daily confirmation of segregated 
balances so that we receive reports from over 2,000 bank 
accounts confirming the balances that those banks are holding 
for customer segregated funds, and then we perform an automated 
comparison between the reports from the FCM and the reports 
from the bank to identify any sort of suspicious discrepancies.
    So that daily confirmation process, along with all the 
other regulatory enhancements that we have made, clearly make 
the regulatory structure now significantly stronger than it was 
2 years ago. And we are very gratified, really, that so many of 
the changes that we developed were incorporated into the CFTC's 
rule proposal, and we support so much of what is in the CFTC's 
rule proposal.
    But as Mr. Duffy mentioned, there are other aspects of that 
rule that are very, very troubling. And let me just add a few 
points with respect to residual interest. What the Commission 
basically is proposing would require every FCM to assume that 
every customer is going to default on every margin call, and 
then there--make sure that they always have enough funds on 
hand to cover that possibility.
    Well, let me make four quick points. Number one, this rule 
proposal on residual interest has absolutely nothing to do with 
either MF Global or Peregrine. Neither one of those cases had 
anything to do with customers not meeting margin calls.
    Number two, this is first time in its 39 year history that 
the Commission has taken this position, that somehow the Act 
requires FCMs to assume that all customers will default on all 
margin calls. They have never taken that position before.
    Number three, there is underlying assumption under this 
rule that all customers meet their margin calls with wire 
transfers and that nobody writes checks anymore, and that 
assumption is just not right, particularly in the ag sector, 
where the--both ag end-users and the FCMs that service them 
regularly accept checks as margin payment.
    And fourth, just as Mr. Duffy mentioned, this proposal 
could have a devastating impact on both end-users and the FCMs 
that service the ag industry.
    Like Terry said, either the customers have to put up a lot 
more money or the FCMs have to put up a lot more money or both, 
and the net effect is that, you are going to have fewer farmers 
using the futures markets to hedge their risk and fewer FCMs to 
service those customers. It is a bad idea and it shouldn't go 
forward.
    Finally, Mr. Chairman, let me just mention the Griffin 
Trading case again. I have testified about it before. Over 30 
years ago, the CFTC adopted a rule which provides that if an 
FCM bankruptcy proceeding, that if there is a shortfall in 
customer segregated funds, the term customer property includes 
all of the assets of the FCM until the customers have been made 
whole, and I think that is a really good rule. It has been on 
the books a long time. It gives customer the--customers the 
priority and the protection they deserve.
    But several years ago, a Federal district court cast some 
doubt about the validity of that rule. They issued a decision, 
which was later vacated, which questioned the Commission's 
authority to adopt that rule that they did.
    Well, I think we have to address that and we have to 
eliminate that doubt. We have to eliminate that cloud of 
uncertainty. And I don't think that requires us to amend the 
Bankruptcy Code. And I don't think that requires us to have 
FCMs run around and get a multitude of subordination agreements 
from various creditors. Section 20 of the Act deals with FCM 
bankruptcy proceedings. I think we can amend section 20 of the 
Commodity Exchange Act to make very clear the Commission's 
authority to adopt the rule that it adopted, and we would be 
happy to work with staff to develop that language.
    Mr. Chairman, thank you very much for the opportunity to 
testify, and I look forward to answering any questions.
    [The prepared statement of Mr. Roth follows:]

  Prepared Statement of Daniel J. Roth, President and Chief Executive 
           Officer, National Futures Association, Chicago, IL
    Chairman Conaway, Ranking Member Scott, Members of the Committee, 
thank you for the opportunity to testify at this important hearing. My 
name is Daniel Roth and I am the President of National Futures 
Association. As Congress begins the reauthorization process, customer 
protection issues should be front and center in everybody's mind. 
Customer protection is the heart and soul of what we do at NFA, and for 
years the futures industry had an impeccable reputation for 
safeguarding customer funds. Since Congress last considered 
reauthorization, though, that reputation has taken a serious hit. First 
at MF Global and then at PFG, customers suffered very real harm from 
shortfalls in customer segregated funds, the kind of harm that all 
regulators seek to prevent. Clearly, dramatic improvements had to be 
made. In the wake of MF Global and PFG, NFA has worked very closely 
with the CME, other self-regulatory organizations and the CFTC to bring 
about those improvements. In my testimony today I would like to 
describe some of the improvements that have already been made, discuss 
the CFTC's proposed customer protection rules and suggest changes to 
the Commodity Exchange Act that would strengthen customer protections 
in any FCM bankruptcy proceeding.
Regulatory Improvements
Daily Confirmation of Segregated Account Balances
    For years, NFA and other SROs confirmed FCM reports regarding the 
customer segregated funds held by the FCM through traditional paper 
confirmations mailed to the banks holding those funds. These 
confirmations were done as part of the annual examination process. In 
early 2012 NFA began confirming bank balances electronically through an 
e-confirm process. That change led to the discovery of the fraud at 
PFG, but e-confirms were still done as part of the annual examination. 
We had to find a better way and we did.
    We partnered with the CME and developed a process by which NFA and 
the CME confirm all balances in all customer segregated bank accounts 
on a daily basis. FCMs file daily reports with NFA and the CME, 
reflecting the amount of customer funds the FCM is holding. Through a 
third-party vendor, NFA and CME get daily reports from banks for the 
over 2,000 customer segregated bank accounts maintained by FCMs. We 
then perform an automated comparison of the reports from the FCMs and 
the reports from the banks to identify any suspicious discrepancies. In 
short, Mr. Chairman, the process by which we monitor FCMs for 
segregated fund compliance is now far ahead of where it was just 1 year 
ago.
    We have recently expanded this system to also obtain daily 
confirmations from clearing firms and will expand it again by the end 
of the year to include clearinghouses as well.
FCM Transparency
    One of the lessons we learned from MF Global is that customers 
should not have to study the footnotes to an FCM financial statement to 
find out how their segregated funds are invested or other financial 
information about their FCMs. We had to make it easier for customers to 
do their due diligence on financial information regarding FCMs. For 
years, NFA required FCMs to file certain basic financial information 
with NFA, and that information is now posted on NFA's website for 
customer review. The information includes data on the FCM's capital 
requirement, excess capital, segregated funds requirement, excess 
segregated funds and how the firm invests customer segregated funds. 
This information is displayed for each FCM and includes historical 
information in addition to the most current data. The display of FCM 
financial information on NFA's website began in November 2012 and so 
far these web pages have received over 25,000 hits.
MF Global Rule
    All FCMs maintain excess segregated funds. These are funds 
deposited by the FCM into customer segregated accounts to act as a 
buffer in the event of customer defaults. Because these funds belong to 
the FCM, the FCM is free to withdraw the excess funds, but after MF 
Global, NFA and the CME adopted rules to ensure notice to regulators 
and accountability within the firm. Now all FCMs must provide 
regulators with immediate notification if they draw down their excess 
segregated funds by 25% in any given day. Such withdrawals must be 
approved by the CEO, CFO or a financial principal of the firm and the 
principal must certify that the firm remains in compliance with 
segregation requirements. This rule became effective on September 1, 
2012.
FCM Internal Controls
    NFA, CME and other SROs developed more specific and stringent 
standards for the internal controls that FCMs must follow to monitor 
their own compliance with regulatory requirements. In May 2013, NFA's 
Board approved an interpretive notice that contains specific guidance 
and identifies the required standards in areas such as separation of 
duties; procedures for complying with customer segregated funds 
requirements; establishing appropriate risk management and trading 
practices; restrictions on access to communication and information 
systems; and monitoring for capital compliance. NFA submitted the 
interpretive notice to the CFTC on May 22, 2013, for its review and 
approval.
Review of NFA Examination Procedures
    NFA's Special Committee for the Protection of Customer Funds--
consisting of all public directors--commissioned an independent review 
of NFA's examination procedures in light of the PFG fraud. The study 
was conducted by a team from the Berkeley Research Group (``BRG'') that 
included former SEC personnel who conducted that regulator's review of 
the SEC's practices after the Madoff fraud. BRG's report was completed 
in January 2013. The report stated that ``NFA's audits were conducted 
in a competent manner and the auditors dutifully implemented the 
appropriate modules that were required.'' The report, however, also 
included a number of recommendations designed to improve the operations 
of NFA's regulatory examinations in the areas of hiring, training, 
supervision, examination process, risk management, and continuing 
education. All of the recommendations of the BRG report have been 
addressed and, as a result, NFA has:

   Revised and beefed up its examination modules regarding 
        segregated funds, capital compliance, internal controls and the 
        exam planning process;

   Made staffing changes so that experienced managers and 
        directors spend more time in the field for every examination;

   Increased its recruiting and hiring of more experienced 
        examiners; and

   Made further improvements to its training programs.
Certified Fraud Examiner Training
    At the end of the day, the examinations performed by SROs in the 
futures industry are not about crossing ``T''s and dotting ``I''s--they 
are about detecting violations of SRO rules--including anti-fraud 
rules. That is why we have greatly expanded our use of the training 
programs of the Association of Certified Fraud Examiners. Becoming 
certified as a fraud examiner involves extensive training, testing and 
continuing education requirements. In the last year over half of our 
staff has obtained the certification and we are now requiring all of 
our compliance staff to obtain that certification.
Strengthening Customer Protections in FCM Bankruptcy Proceedings
    Both the PFG and MF Global bankruptcies highlighted the need for 
greater customer protections to not only guard against the loss of 
customer funds but also in the event of an FCM's insolvency. As 
discussed above, NFA has made and continues to implement changes to 
enhance the safety of customer segregated funds and guard against a 
shortfall in customer funds in the event of any future FCM failures.
    NFA believes, however, that Congress should consider a statutory 
change to strengthen customer protections and priorities in the event 
of a future FCM bankruptcy. Over 30 years ago the CFTC adopted rules 
regarding FCM bankruptcies. Among other things, those rules provided 
that if there was a shortfall in customer segregated funds, the term 
``customer funds'' would include all assets of the FCM until customers 
had been made whole. Several years ago, a district court decision cast 
doubt on the validity of the CFTC's rule. That decision was 
subsequently vacated but a cloud of doubt lingers. Congress can and 
should remove that doubt about the priority customers should received 
if there is a shortfall in segregated funds and can do so by amending 
Section 20 of the Act. Section 20 gives the CFTC authority to adopt 
regulations regarding commodity brokers that are debtors under Chapter 
7 of Title 11 of the United States Code. We would suggest an amendment 
to clarify the CFTC's authority to adopt the rule that it did. We 
believe there is a broad base of industry support for this approach and 
would be happy to work with Congress on specific proposed language.
CFTC's Proposed Customer Protection Rules
    NFA worked closely with the CFTC staff in developing many of the 
regulatory improvements described above. The Commission also proposed 
its own changes to customer protection rules in a 107 page Federal 
Register release last year. Certain parts of the Commission's proposals 
have provoked strong opposition both from the industry and from end-
users of the markets, particularly in the agricultural sector. As 
described below, NFA shares many of the concerns raised by others, but 
we fully support many of the Commission's proposals. For example, the 
Commission's proposed rules would:

   Require SROs to expand their testing of FCM internal 
        controls and develop more sophisticated measures of the risks 
        posed by each FCM;

   Require that FCM certified annual financial reports and 
        reports from the chief compliance officer be filed within 60 
        days of the firm's fiscal year end;

   Require that an FCM that is undercapitalized provide 
        immediate notice to the Commission and its DSRO; and

   Require each FCM to establish a risk management program 
        designed to monitor and manage the risks associated with the 
        FCM's activities.

    Other provisions of the Commission's proposals, however, raise 
serious concerns, particularly with regard to the so-called ``residual 
interest'' issue. FCMs have always maintained an amount of its own 
capital in customer segregated accounts to act as a buffer for 
customers who fail to meet their margin obligations in a timely manner. 
This amount is often referred to as the FCM's ``residual interest'' in 
the segregated account. The Commission has now proposed that all FCMs 
must maintain at all times a residual interest sufficient to exceed the 
sum of all margin deficits that the customers in each account class 
have. Essentially, FCMs would have to assume that every customer will 
default on every margin call and maintain capital in the segregated 
account to cover that possibility.
    Several points need to be made on this proposal. First, it has 
absolutely nothing to do with the problems encountered at either MF 
Global or PFG. Neither of those cases had anything to do with customers 
failing to meet margin calls. Second, this is the first time in the 
Commission's 39 year history that it has ever taken the position that 
the Act requires FCMs to assume that all customers will default on all 
margin calls. Third, the underlying assumption that in this day and age 
no customers meet margin calls by writing checks is wrong. Agricultural 
hedgers frequently meet their margin calls with checks. Fourth, the 
impact of this proposal could be devastating for both agricultural end-
users and the relative handful of FCMs that service those customers. 
Customers will have to post much more margin funds with their FCMs or 
the FCMs will have to maintain much more capital in their business. 
Either way, there will be fewer customers using futures markets to 
hedge and fewer FCMs handling their accounts. This proposal does not 
just fix something that is not broken, it threatens to do real harm to 
a longstanding system that has worked well for both customers and the 
markets.
    The Commission has also proposed new requirements for SROs, most of 
which we support. However, the Commission's proposals blur important 
distinctions between the annual examinations of FCMs performed by CPAs 
and those performed by SROs. Each year an FCM must have a certified 
financial audit performed by a CPA. The CPA issues a report expressing 
an opinion with respect to the FCM's financial statements or issues an 
Accountant's Report on Material Inadequacies. The SRO examination, on 
the other hand, focuses on FCM compliance with the rules of the CFTC 
and the SRO. Certainly, there are areas of overlap between the two 
examinations but there are also marked differences in focus and 
purpose. The Commission proposes that an SRO apply Generally Accepted 
Auditing Standards to every aspect of its FCM examination, not just in 
those areas where the SRO and CPA exams overlap. This is overbroad and 
will add unnecessary costs and burdens to the examination process.
Customer Account Insurance Study
    The failures of MF Global and PFG have generated renewed calls for 
some form of customer account insurance. Abstract discussions of this 
question do not help answer the two key questions: what type of 
insurance would be available and what would it cost. To answer those 
questions NFA joined with FIA, CME and the Institute for Financial 
Markets to sponsor the study being conducted by Dr. Christopher Culp, 
who is also a witness at today's hearing. Dr. Culp is awaiting pricing 
proposals from London reinsurance companies that would be part of a 
private sector solution.
    Dr. Culp's research on this issue has been thorough and methodical. 
Based on his data, we would agree with his preliminary conclusions that 
for the vast majority of customers at the larger FCMs various forms of 
customer account insurance would be of little or no interest and that, 
given the size of these larger customers, the cost of a mandatory 
insurance program for all customers of all FCMs would be cost 
prohibitive, whether sponsored by the government or by the private 
sector. Dr. Culp's research thus far, though, indicates that for 
smaller FCMs with customers who maintain smaller balances there may be 
a voluntary private sector solution. Ultimately, the viability of that 
option will depend on the price quotes for reinsurance and on the 
demand for the product among smaller FCMs and their customers. We look 
forward to Dr. Culp's final report.
Conclusion
    Detecting and combating fraud is central to our mission. No system 
of regulation can ever completely eliminate fraud, but we must always 
strive for that goal. The process of refining and improving regulatory 
protections is ongoing and the initiatives outlined above do not mark 
the end of our efforts. We look forward to working with Congress, the 
CFTC, SROs and the industry to ensure that customers have justified 
confidence in the integrity of the U.S. futures markets.

    The Chairman. Thank you, Mr. Roth.
    Dr. Culp.

STATEMENT OF CHRISTOPHER L. CULP, Ph.D. SENIOR ADVISOR, COMPASS 
                      LEXECON, CHICAGO, IL

    Dr. Culp. Excuse me, Chairman Conaway, Ranking Member 
Scott, other Members of the Committee, thank you very much for 
the opportunity to appear here today.
    In December 2012, Compass Lexecon was engaged by CME, 
Futures Industry Association, NFA, and the Institute for 
Financial Markets to conduct an analysis of the potential 
benefits and costs of a customer asset protection insurance 
scheme of some kind that would apply to customers of U.S. 
futures commission merchants. I was the director and am the 
director of the study, and I am pleased to give you a progress 
report today on where we stand with the study, as well as offer 
some preliminary conclusions based on what the data and our 
discussions with market participants have thus far 
demonstrated.
    Just to be clear, the risk that we are contemplating would 
be potentially covered by customer asset insurance is the risk 
that an FCM failure would result in losses of customer assets 
if the FCM is undersegregated when it fails. In other words, 
the customer assets actually at the FCM are below the 
liabilities to customers of the FCM. That can occur for two 
reasons. One would be the misfeasance or malfeasance, as 
occurred, for example with MF Global and Peregrine. Another 
concern of some market participants is that so-called fellow-
customer risk could impose undersegregation related losses. 
Fellow-customer risk occurs when one or more customers of the 
FCM face significant losses, miss a margin call, and that 
results in a deficiency in customer funds, that, in turn, 
results in asset losses for the other non-defaulting customers.
    When evaluating the potential benefits of any kind of 
customer insurance regime, you have to keep in mind two things: 
The insurance doesn't exist in isolation, so the benefit of 
insurance has to be considered both with respect to the cost 
and to the probability that the underlying risk event will 
actually occur. I am not here to discuss these various other 
enhanced protections that have occurred since MF Global, but 
these protections that the other panelists are all discussing 
are relevant because, to the extent these additional 
protections are working to reduce the risk that there is an 
undersegregation at the time of an FCM failure, the value of 
insurance becomes potentially less with respect to its 
potential cost.
    A significant objective of our study has been to try to 
estimate or quantify the cost of alternative insurance 
scenarios. Specifically, we considered four scenarios. Three 
private scenarios. First, direct provision of customer 
insurance by primary insurance companies. Second, direct 
provision of customer insurance to FCMs, on FCM-by-FCM basis. 
The third scenario is an industry risk retention group in which 
a group of FCMs collectively capitalize an insurance company 
that provides insurance to the customers of the participating 
FCMs. Those FCMs would retain and bear some of the first loss 
exposure in the event that there is an FCM failure, but 
reinsurance would then provide the primary source of capital on 
top of that first loss layer.
    The final scenario we considered is a mandated, government 
mandated universal SIPC-like structure, in which every customer 
of U.S. futures commission merchant would receive up to 
$250,000 in insurance coverage. In return, that coverage would 
be funded by a SIPC-like investor protection fund for futures 
that is paid for by, under the current proposal, 0.5 percent of 
the previous year's gross annual revenues from futures of each 
and every U.S. FCM on a mandatory basis, and that would be a 
target funding level for the fund of $2.5 billion.
    To facilitate the analysis of the three private scenarios, 
we have engaged for the better part of a year in a 
comprehensive data collection and analysis and empirical 
exercise, in which case we obtained customer level data from 
FCMs. We contacted a number of FCMs and received responses from 
six, two large, two medium, two small. We consider these 
broadly representative. We then worked with CME Group to 
conduct stress tests of this information and data so that we 
could examine what kind of customer assets might be at risk if 
an FCM happened to file during catastrophic market conditions.
    We then showed summary analyses from those results to about 
ten potential interested insurance and reinsurance companies. 
All of them remain interested at this point. We do not have 
quotes or indicative cost estimates from any of them, but we 
are awaiting those and will provide them with the final study 
to this Committee when it is completed.
    We can, however, offer several preliminary observations. 
First, as Mr. Duffy mentioned, we received no indication of 
interest in the direct provision of the FCM level or customer 
level insurance from insurance market participants. We have, 
however, received interest in the reinsurance aspect for a 
voluntary opt-in risk retention group. Our analysis also 
suggests that a government mandated universal coverage scheme 
could potentially suffer from significant drawbacks and 
concerns, one of which is that the vast bulk of the benefit of 
retail-oriented kind of investor protection fund would accrue 
benefits to the customers that are not bearing a proportional 
amount of the cost.
    For example, in 2012, the average amount of assets on 
deposit at small and medium FCMs was about $100,000 in our data 
sample, as compared to about $25 million at large FCMs, and yet 
the large FCMs would be responsible for bearing a 
disproportionate amount of the cost. In addition, the fund 
would accrue money over time very slowly at about $25 million a 
year, using 2012 numbers, and it would virtually necessitate a 
government backstop to close the gap to the $2.5 billion 
funding level.
    Finally, it would crowd out and discourage innovative 
market solutions, like the retention group, and it would 
essentially freeze a mandated structure in place and complicate 
the ability of voluntary solutions to close the gap. And I will 
be happy to cover any additional materials you have during the 
questions. Thank you for your time.
    [The prepared statement of Dr. Culp follows:]

   Prepared Statement of Christopher L. Culp, Ph.D., Senior Advisor, 
                      Compass Lexecon, Chicago, IL
    Chairman Conaway, Ranking Member Scott, and other Members of the 
Committee, thank you for inviting me to appear today. My name is 
Christopher Culp. I am a Senior Advisor with Compass Lexecon (a 
consulting firm that applies the principles of economic analysis to 
legal and regulatory issues), an Adjunct Professor of Finance at The 
University of Chicago's Booth School of Business (where I have taught 
MBA courses since 1998 on subjects including derivatives and 
insurance), and a Professor for Insurance at the University of Bern in 
Switzerland. I have a Ph.D. in finance, have authored four books and 
coedited two books on derivatives, insurance, structured finance, and 
risk management, have published numerous articles on those same topics, 
and have provided consulting services in these areas for the last 19 
years.
    In December 2012, Compass Lexecon was engaged by the CME Group 
(``CME''), Futures Industry Association (``FIA''), Institute for 
Financial Markets (``IFM''), and National Futures Association (``NFA'') 
(collectively, the ``Sponsors'') to conduct a study of how customer 
asset protection insurance (``CAPI'') might work in the U.S. futures 
industry and to evaluate the economic benefits and costs of alternative 
CAPI approaches (the ``Study''). Before I give you a report on our 
progress, I begin by providing some background and context for the 
Study.
Background
    The U.S. futures industry has been in the business of providing 
risk-management products and solutions to customers since the mid-19th 
Century. Typical futures customers include commercial entities like 
grain elevators, cooperative associations of farmers, non-financial 
multinationals, asset managers, commodity pool operators, proprietary 
trading firms, and retail traders. Many of these futures market 
customers use futures and options to manage the risks that they face in 
their primary businesses in order to stabilize their costs and insulate 
themselves from swings in market prices that could give rise to 
catastrophic losses.
    Futures customers execute their transactions through futures 
commission merchants (``FCMs''). Those transactions are cleared by 
central counterparties (``CCPs'') like CME. CCPs function as the 
counterparty of record for all futures transactions and guarantee the 
performance on all trades. CCPs manage their risk exposures to trading 
counterparties in part by limiting their direct credit exposures only 
to ``clearing members.'' Although all futures customers execute their 
transactions through FCMs, only some FCMs are CCP clearing members. Any 
trades executed by non-clearing FCMs must be guaranteed by a clearing 
FCM.
    In order to provide trustworthy and safe risk-management solutions 
to customers, FCMs and CCPs must manage their own risks, preserve the 
integrity of the marketplace, and offer a risk-management solution in 
which market participants have confidence. In that regard, the U.S. 
futures industry has a long track record of successfully navigating a 
wide variety of market disruptions and high-profile defaults like 
Drexel Burnham Lambert, Refco, and Lehman Brothers.\1\ The 
effectiveness of the futures trading risk-management system is largely 
attributable to several guiding principles that have been in place 
since the turn of the 19th century.
---------------------------------------------------------------------------
    \1\ All of these firms failed for reasons unrelated to their U.S. 
futures businesses, and their customer funds remained properly 
segregated at all times.
---------------------------------------------------------------------------
    The first guiding risk-management principle in futures markets is 
that all trading participants must post a performance bond before 
entering into a new position and must maintain a required minimum 
margin amount throughout the life of an open trade. These minimum 
``initial margin'' requirements are generally set to cover 99 percent 
of potential price changes over the time the CCP expects it would take 
to close out or hedge a losing position, which, for most products, is a 
day or less. Customers must deposit margin with their FCM(s), non-
clearing FCMs must deposit margin with their clearing FCMs, and 
clearing FCMs must deposit margin with CCPs. Customer margin required 
by FCMs must be at least equal to and is usually higher than margin 
required by CCPs from FCMs.
    The second guiding risk-management principle is that all open 
positions are marked to market twice daily. Depending on the direction 
of market movements, the process of marking open positions to market 
may create an obligation for customers to provide additional margin to 
FCMs or CCPs or may result in a credit to customers for their trading 
profits. Customers with gains may withdraw their profits daily. As a 
practical matter, however, many customers and non-clearing FCMs choose 
instead to leave their profits on deposit in order to maintain excess 
assets above margin requirements as a buffer to avoid the risk of being 
under-margined in the future, to reduce the hassle and cost of frequent 
funds transfers, or because they lack the operational capabilities to 
engage in daily account sweeps.
    In the event that a clearing FCM cannot cover its payment 
obligations to a CCP, the defaulting FCM's margin and other eligible 
financial assets are used by the CCP to cover any losses resulting from 
the liquidation of the defaulting FCM's open positions and the 
liquidation or transfer of the FCM's customer positions. Any additional 
losses are absorbed by other financial safeguards, such as the 
mutualized clearing default guaranty funds maintained by CCPs. No FCM 
default to date has ever resulted in any losses to a U.S. CCP's 
clearing default fund.
    A third risk-management principle underlying U.S. futures markets 
is the protection of customer assets held by FCMs, which include assets 
on deposit to satisfy customer margin requirements and any excess 
assets. Since 1974, Commodity Futures Trading Commission (``CFTC'') 
regulations (and Commodity Exchange Authority regulations before that) 
have required FCMs to segregate customer assets from FCMs' own funds 
and to recognize those segregated assets as the customers' property.
    Although customer assets are segregated from an FCM's assets, most 
customer assets are legally and operationally commingled in customer 
pools or omnibus accounts--one for customers trading futures and 
options on U.S. exchanges (i.e., segregated or  4d accounts), and 
another for customers trading on foreign boards of trade (i.e., 
foreign-secured or  30.7 accounts).\2\ For both types of customer 
pools, FCMs must maintain sufficient funds to cover all of their 
customer obligations. In other words, assets in an FCM's customer pools 
must equal or exceed the customer liabilities in those pools. When that 
does not occur in either or both pools of customer funds, the FCM is 
said to be ``under-segregated.''
---------------------------------------------------------------------------
    \2\ Customer assets on deposit to support cleared over-the-counter 
derivatives are subject to a different segregation regime in which 
customer collateral is legally segregated but operationally commingled.
---------------------------------------------------------------------------
    One of the main benefits that segregation requirements provide is 
to make it easier for CCPs to manage the defaults of clearing FCMs that 
fail as a result of losses in their house trading accounts or for 
reasons unrelated to their futures trading activity. In those 
situations, the customer accounts \3\ of the defaulting FCM can be 
transferred very quickly to non-defaulting FCMs or liquidated with no 
resulting loss to customers, and no significant ongoing disruption to 
customers' trading activities. This approach has worked well in 
practice over time.
---------------------------------------------------------------------------
    \3\ I henceforth use the term ``customer accounts'' to refer 
collectively to both segregated  4d and foreign-secured  30.7 
accounts.
---------------------------------------------------------------------------
Customer Assets at Risk
    U.S. futures CCPs have a solid track record of managing FCM 
defaults with regard to the risk exposures of non-defaulting clearing 
members and mutualized CCP default funds. Nevertheless, customers have 
in the past several years experienced major losses arising from 
defaults of individual FCMs. Such losses can occur for two different 
reasons.
    First, customer losses can arise if an FCM defaults as a result of 
misfeasance or malfeasance (e.g., fraud, embezzlement, misappropriation 
of customer funds, and operational failures). Prior to 2007, such 
losses were generally small. For example, a study of customer asset 
risk conducted by NFA in 1986 found that between 1938 and 1985, less 
than $10 million of customer assets were lost as a result of defaults 
by FCMs that were under-segregated.\4\ The failures of MF Global in 
October 2011 and Peregrine Financial Group in July 2012, however, 
involved substantial amounts of under-segregation losses realized by 
the customers of those firms.\5\ In particular, the failure of MF 
Global has heightened customers' awareness of their exposure to under-
segregation risk. Those concerns were a significant reason that the 
Sponsors commissioned the Study.
---------------------------------------------------------------------------
    \4\ National Futures Association, Customer Account Protection Study 
(November 20, 1986).
    \5\ The failure of Sentinel Management Group in August 2007 also 
involved losses of customer funds. Sentinel, however, was not a 
traditional FCM but rather was registered as a FCM so that it could 
hold other FCMs' customer funds. Sentinel thus was more similar in its 
operations to an investment company than a FCM.
---------------------------------------------------------------------------
    Second, futures customers are exposed to ``fellow-customer risk.'' 
If one or more customers of an FCM incur significant losses and fail to 
honor their margin calls, a shortfall in customer segregated funds may 
result, in which case non-defaulting customers may not receive all of 
their funds back. Such fellow-customer losses arise when several 
situations occur at the same time: (i) one or more customers of the FCM 
must experience losses in excess of the margin they have already 
deposited--i.e., market conditions must be so severe that the resulting 
losses exceed the target 99 percent coverage level underpinning initial 
margin requirements; (ii) some of those customers with large losses 
must be financially unable to honor their resulting payment obligations 
to the FCM; and (iii) the FCM must lack the financial resources to 
cover the defaulting customer payment(s), thereby forcing the FCM into 
default. The simultaneous occurrence of all three of these situations 
is highly unlikely.
    In more than a century of U.S. futures trading, only one situation 
has arisen in which customers actually lost money as a result of 
fellow-customer risk exposures. In December 1998, a customer of Griffin 
Trading entered into positions on Eurex that generated a $10 million 
loss overnight. Griffin transferred funds to its clearing FCM from its 
foreign-secured customer accounts to cover the customer's losses. But 
those losses grew larger later the same day, and, when Griffin could 
not cover the margin calls arising from those additional losses, it 
filed for bankruptcy. As a result, Griffin's non-defaulting customers 
experienced losses resulting from Griffin's inability to cover the 
losses of its defaulting customer.\6\ All of the fellow-customer losses 
at Griffin arose from its foreign-secured customer accounts (i.e., 
customer assets related to trading on foreign boards of trade). The 
U.S. futures customer segregated accounts were transferred intact, and 
no Griffin customer trading only U.S. futures experienced any fellow-
customer losses.
---------------------------------------------------------------------------
    \6\ See, e.g., In Re: Griffin Trading Company, 245 B.R. 291 (Bankr. 
N.D. Ill. 2000), and In Re: Griffin Trading Company (7th Federal 
District, Northern Illinois), No. 10-3607 (June 25, 2012).
---------------------------------------------------------------------------
    A handful of other situations have occurred in which a failure of 
one or more customers of an FCM to meet margin calls has resulted in 
the FCM's under-segregation and forced it into default. Other than 
Griffin Trading, however, none of these other defaults resulted in 
actual fellow-customer losses. For example, three customers failed to 
meet a total of $26 million in margin calls made by Volume Investors 
Corp. (``Volume'') in 1985. Volume could not cover the payment 
obligation and thus defaulted to its CCP, The Commodities Exchange 
(``COMEX''). As a result of other assets held by Volume, recoveries by 
Volume's receiver from the original defaulting customers, and a payment 
by Volume's chief executive, none of the non-defaulting customers of 
Volume realized any losses.\7\
---------------------------------------------------------------------------
    \7\ CFTC, Release 2586-86, Docket #85-25 (July 29, 1986), at http:/
/www.nfa.futures.org/BasicNet/Case.aspx?entityid=0002121&case=85-
25&contrib=CFTC.
---------------------------------------------------------------------------
    Nevertheless, fellow-customer risk remains a concern amongst many 
futures trading customers. Such concerns persist in part because 
customers do not feel that they can monitor the risk to which they are 
exposed through their fellow-customers' trading activities. Customers 
are, of course, free to choose their FCM(s) based on reputation and 
their customer risk monitoring capabilities. As a practical matter, 
however, only very large customers tend to do so.
Customer Asset Protection Insurance
    Following the customer asset losses at MF Global and Peregrine, 
market participants and the CFTC have implemented numerous changes in 
how customer assets are protected. I am not here to discuss those 
changes today, but I do urge the Committee to take them into account 
when considering the issue that I am here to discuss today (i.e., 
CAPI).\8\ The net value of CAPI depends on the other protections in 
place to reduce the risk of customer asset losses. To the extent those 
other safeguards are working properly, insurable customer asset losses 
should be extremely rare occurrences, which, all else equal, reduces 
the value of CAPI.
---------------------------------------------------------------------------
    \8\ Our Study will include an Appendix that summarizes the recent 
changes in detail.
---------------------------------------------------------------------------
    The benefit and value of CAPI--like any other form of insurance--
must be carefully weighed against its costs. In general, the price or 
premium that insurance companies charge policy holders in a competitive 
marketplace is the sum of (i) the average amount of claims the insurer 
expects to pay, (ii) the cost to the insurer of providing the coverage 
(including the cost of any reinsurance), and (iii) the insurer's profit 
margin. As such, a typical purchaser of virtually any kind of insurance 
should expect to lose money on average. Even if the customer's actual 
losses and claims payments are exactly equal to the customer's expected 
loss, the customer still has to pay the total premium, which, as noted, 
includes provisions to cover the insurer's costs, the cost of 
reinsurance, and the like.
    That insurance purchasers have an expectation of losing money does 
not mean insurance has no value to purchasers. The policy limit, after 
all, is much higher than the expected or average claim. Insurance 
purchasers thus are willing to incur relatively small costs (i.e., 
premium based on expected or average losses) in states of the world 
when an insured loss has not occurred in order to eliminate or reduce 
much larger potential losses in states of the world when an insured 
loss has occurred. The value of CAPI to customers thus depends both on 
the cost of the coverage and the amount of coverage relative to 
expected or average losses.
    Another important determinant of the value of insurance is the 
amount of the deductible, or what insurers call the ``first-loss 
retention.'' Insurance and reinsurance companies consider a first-loss 
retention of critical importance because it helps align the risk-
management incentives of the policy holder with the insurance provider. 
Because the insurance company cannot perfectly observe the risk-
management decisions and activities of policy holders, the first-loss 
retention gives policy holders an incentive to manage their own risks 
in order to avoid high-frequency, low-severity losses below the 
deductible. Naturally, the lower the first-loss retention, the higher 
is the policy premium.
    In the context of CAPI, the first-loss retention is a challenge 
because the potential customer beneficiaries of CAPI do not directly 
control the process by which under-segregation and fellow-customer risk 
are managed. Forcing customers to bear the first-loss through a 
deductible is highly unlikely to influence the risk-management 
decisions of the FCMs that actually monitor and control those risks.\9\
---------------------------------------------------------------------------
    \9\ True, the existence of CAPI with no customer deductible will 
make customers indifferent about the risk-management practices of their 
FCMs, but, as I noted earlier, that is essentially already the case 
even in the absence of CAPI.
---------------------------------------------------------------------------
The Insurance Scenarios
    After Compass Lexecon was engaged by the Sponsors in December 2012, 
we first worked with the Sponsors to articulate several different CAPI 
scenarios that could then be shown to various insurance and reinsurance 
industry participants for the purpose of estimating the costs of 
privately provided CAPI under those different scenarios.\10\ We 
articulated three private, voluntary, opt-in CAPI scenarios, and we 
also have considered a fourth scenario involving mandated, universal 
CAPI coverage.
---------------------------------------------------------------------------
    \10\ We realize that possibilities for CAPI exist beyond the 
scenarios we defined. Nevertheless, we had to define several specific 
scenarios in order to facilitate consistent comparisons of costs 
provided by (re-)insurers. Otherwise, too many specific solutions might 
have been proposed that would have rendered cost comparisons 
impossible.
---------------------------------------------------------------------------
    The first private, market-based CAPI scenario we defined is CAPI 
provided directly by primary insurance carriers to individual futures 
customers. Yet, no insurance market participant with whom we have 
spoken has expressed any interest in underwriting CAPI directly to end 
customers because customers seem unlikely to agree to a deductible, 
which is incompatible with virtually all traditional insurance markets. 
In addition, a customer-level deductible would not serve its usual 
purpose in mitigating moral hazard.\11\ Insurers also indicated that, 
apart from the deductible issue, direct customer-by-customer CAPI 
likely would be very costly to administer and underwrite, which would 
lead to higher premiums than many futures customers might be willing to 
pay.
---------------------------------------------------------------------------
    \11\ If there is an alternative solution that does not expose FCMs 
to first-loss risks, we would recommend skepticism and suspicion for 
the aforementioned reasons.
---------------------------------------------------------------------------
    In the second scenario, FCMs could attempt to procure insurance on 
a one-off, FCM-by-FCM basis. For example, if a sole FCM wishes to 
provide $250,000 of CAPI to all of its 1,000 customers, the FCM would 
want to buy a total of $250 million in insurance with its customers as 
the named beneficiaries. Suppose an insurer agreed to provide $200 
million in coverage in excess of a $50 million first-loss retention or 
deductible. The CAPI only would be triggered when the FCM fails, 
however, in which case the FCM would not have unencumbered access to 
the funds it would need to pay the first $50 million in customer CAPI 
claims. So, for this scheme to work, the FCM would have to pre-fund the 
$50 million deductible in a manner that insulates those funds from the 
general assets of the bankrupt estate so that the $50 million is 
available solely to fund the first $50 million in CAPI payments (with 
the insurance covering the next $200 million in CAPI claims). It is 
possible to do this (e.g., through the use of captives or protected 
cell companies), but most insurance market participants with whom we 
spoke viewed such alternatives as cumbersome, unlikely to be profitable 
on an FCM-by-FCM basis, and, hence, unattractive.\12\
---------------------------------------------------------------------------
    \12\ This does not preclude the possibility that some insurers and 
FCMs eventually could structure such a CAPI program. For purposes of 
the Study, however, interest in this scenario was too limited for us to 
get any meaningful feedback from insurers on costs and pricing.
---------------------------------------------------------------------------
    Our third scenario is an industry risk retention group (``RRG'') in 
which a licensed primary insurance company is capitalized and owned by 
FCMs that wish to participate. Customers of the participating FCMs 
would be eligible for CAPI coverage that would be provided directly by 
the RRG. The participating FCMs would contribute capital that, together 
with CAPI premiums paid by customers, would fund a first-loss retention 
for the aggregate risk exposure of all customers across all 
participating FCMs arising from under-segregation or fellow-customer 
risk. The RRG would then purchase reinsurance for any CAPI payments in 
excess of the RRG's first-loss retention.
    For example, a RRG might be formed by five or six FCMs to provide 
CAPI coverage to all customers of those participating FCMs. If the 
expected or average loss of the RRG based on the under-segregation and 
fellow-customer risks of the participating FCMs is $50 million, the 
participating FCMs would be required to deposit sufficient capital such 
that the paid-in capital plus premiums received from customers for 
their CAPI coverage would total $50 million. The RRG then could secure 
about $250 million of reinsurance in excess of the first-loss layer of 
$50 million. Customers of the participating FCMs thus would have up to 
$300 million available to cover under-segregation or fellow-customer 
losses. The first $50 million of customer claims would be paid out of 
the RRG's assets (including FCM-contributed capital and customer-paid 
premiums), and the next $250 million would be paid by the reinsurers of 
the RRG. Such a structure could also involve sub-limits for customers 
based on their size--e.g., small customers would be covered for losses 
up to $50,000, whereas large customers would have claims limited to 
payments of up to $500,000.
    In addition to providing CAPI protection to customers, the RRG 
provides a mechanism by which customers could be reimbursed for some or 
all of their indemnified losses very quickly even if their actual 
assets were frozen in the defaulted FCM's bankruptcy estate. For 
example, the RRG could obtain a line of credit to cover some or all of 
the payments owed to customers of a defaulting participating FCM that 
would be secured by the RRG's capital and the reinsurance receivable. 
Customers would thus receive a very rapid payment, and the eventual 
reinsurance payment to the RRG would be used to pay down the line of 
credit.
    The industry RRG scenario is very similar in many important 
respects to the proposal put forth by the Commodities Customer 
Coalition (``CCC''), a nonprofit organization formed in response to the 
bankruptcy of MF Global.\13\ There are a few exceptions, however, 
between the RRG proposal we presented to reinsurers and the CCC 
proposal. For example, the RRG scenario we are reviewing with 
reinsurers is based solely on FCMs as owners, capital providers, and 
absorbents of losses in the first-loss layer. The CCC proposal, by 
contrast, contemplates that the RRG would also be owned and capitalized 
by commodity trading advisors, commodity pool operators, and 
introducing brokers.
---------------------------------------------------------------------------
    \13\ See J. Roe, ``Commodity Insurance Corporation: A Proposal for 
a Captive Insurance Company Servicing Customers of Introducing Brokers, 
Commodity Trading Advisors and Commodity Pools,'' Presentation of the 
CCC (December 17, 2012) http://commoditycustomercoalition.org/ccc-plan-
for-private-commodity-customer-insurance/ (last visited September 25, 
2013).
---------------------------------------------------------------------------
Progress of the Study
    In order to provide (re-)insurers with sufficient information for 
them to respond with meaningful indicative premium quotations for the 
three private, voluntary opt-in CAPI scenarios, we undertook a 
comprehensive empirical analysis of customer assets exposed to under-
segregation or fellow-customer risk. Although aggregate data on 
customer assets reported on an FCM-by-FCM basis was readily available 
through the CFTC and the two Designated Self-Regulatory Organizations 
(``DSROs'')--i.e., CME and NFA, both of which are Sponsors of this 
Study--these data alone are not sufficient because FCM-level data only 
reveal total customer assets of the FCM and do not indicate customer-
specific assets at risk. So, in February 2013, we contacted ten U.S. 
FCMs (ranging from very large banking institutions to smaller, 
specialized FCMs) and asked them to provide customer-level position and 
asset data for each month-end in 2012.\14\ Of those ten FCMs, six (the 
``Contributing FCMs'') provided usable data.
---------------------------------------------------------------------------
    \14\ We limited our request to 2012 both because recent regulatory 
changes make earlier time periods less representative of the market, 
going forward, and because of the demanding nature of our data request 
on the voluntary FCM contributors.
---------------------------------------------------------------------------
    The six Contributing FCMs that responded to our request are broadly 
representative of the U.S. futures industry. Two of the FCMs were 
``Large FCMs'' with $5 billion or more in customer assets and $1 
billion or more in Adjusted Net Capital at year-end 2012. Another two 
of the Contributing FCMs were ``Small FCMs'' with less than $1 billion 
in customer assets and less than $100 million in Adjusted Net Capital 
at year-end 2012. The other two FCMs were ``Medium FCMs'' with between 
$1 and $5 billion in customer assets and between $100 million and $1 
billion of Adjusted Net Capital. We completed our collection and 
preparation for subsequent analyses of the data that we received from 
the six Contributing FCMs in June 2013.
    To analyze assets at risk as a result of under-segregation arising 
from misfeasance or malfeasance, the above data alone was sufficient. 
Under-segregation losses arising from fraud, embezzlement, unauthorized 
conversions of customer funds, and the like, after all, need not and 
historically have not occurred on days when markets themselves are 
experiencing catastrophic price volatility. Fellow-customer losses, by 
contrast, are more likely to occur in highly stressed market conditions 
that cause market prices to exceed the price movements used to compute 
initial margin requirements.
    So, to analyze and quantify potential fellow-customer losses, we 
worked with the Clearing division of CME to perform stressed 
simulations of potential fellow-customer losses using a model similar 
to the one used by CME Clearing to measure its exposure to potential 
defaults by clearing FCMs. Specifically, we assumed that the prices of 
all futures contracts change by an amount that averages the worst 0.1% 
of all historical price changes dating back generally to 1987.\15\ To 
be conservative in our analysis, we assumed that all products within 
each commodity type experienced losses at the same time, and then 
ranked the losses of all customers at each Contributing FCM and 
calculated the ``hole'' in customer funds that resulted from a failure 
to meet a margin call by all customers from the 98th largest net margin 
payment obligation up to the 99.5th largest net margin payment 
obligation. Finally, we assumed that defaulting FCMs contributed none 
of their own financial resources to cover the unmet customer payment 
obligations, another conservative assumption.\16\ We completed our 
stressed analyses of potential fellow-customer losses in late August 
2013. The completed Study will summarize and present all of the 
relevant loss estimates that were computed for under-segregation and 
fellow-customer risk.
---------------------------------------------------------------------------
    \15\ For more recently listed products, we used data back to the 
inception of the products or the first date on which the data was 
clean. For some older products (e.g., gold and some interest rate 
products), we use historical data back to the early 1980s.
    \16\ We adopted the assumption that FCMs contribute nothing to 
cover losses arising from customer defaults purely for conservatism and 
not because it is realistic.
---------------------------------------------------------------------------
    We then provided various loss exposure analyses to ten potential 
CAPI 
(re-)insurers. We also have participated in various meetings and calls 
with the potential CAPI (re-)insurers since providing our loss exposure 
analyses. Most of the (re-)insurers have expressed interest exclusively 
in the industry RRG scenario and have not indicated any intention to 
provide us with indicative pricing for the first (CAPI provided 
directly to customers) or second (CAPI provided to individual FCMs) 
scenarios. As of today, we are waiting for indicative premium 
quotations from the interested (re-)insurers regarding the cost of 
providing CAPI coverage. When we have that information, we will provide 
the completed Study to this Committee.
Mandatory CAPI Coverage
    The fourth scenario we analyzed involves the mandatory and 
universal CAPI coverage of U.S. futures customers. Specifically, the 
Futures Investor and Customer Protection Act would establish the 
Futures Investor and Customer Protection Corporation (``FICPC'').\17\ 
The proposed customer asset protection scheme would be mandatory, 
universal, and would essentially mimic the protections afforded to 
securities investors by the Securities Investor Protection Corporation 
(``SIPC''). Unlike the scenarios described previously, the FICPC 
scenario would not give FCMs or customers a choice regarding their 
participation in the CAPI scheme--all FCMs and their customers would be 
required to participate.
---------------------------------------------------------------------------
    \17\ Statement of CFTC Commissioner Bart Chilton (August 9, 2012).
---------------------------------------------------------------------------
    A FICPC designed along the lines of SIPC would provide up to 
$250,000 to all FCM customers as reimbursement for losses sustained 
from the failure of an FCM (apart from losses arising purely as the 
result of financial market downturns). Following an FCM's insolvency, 
its customers would file claims with a FICPC trustee (analogous to a 
SIPC trustee). The trustee would have the authority to transfer 
customer accounts to non-defaulting FCMs or to liquidate those 
accounts.
    Under this proposal, the FICPC would be funded by mandatory 
payments from FCMs of up to 0.5 percent of each FCM's previous annual 
gross revenues related to futures trading until reaching a target 
funding level of not more than $2.5 billion. FICPC would be governed by 
a board of directors to be confirmed by a majority vote of the U.S. 
Senate. In the FICPC, there is no retained first-loss layer by either 
customers or any other market participants.
    Several potential concerns can be identified in the FICPC scenario. 
In particular, the proposed funding scheme for the FICPC is highly 
regressive--i.e., FCMs whose customers benefit the least from FICPC 
coverage would provide a disproportionately high amount of the funding. 
In 2012, a total of 70 FCMs reported positive annual gross revenues 
from commodities to CME and NFA in their capacities as DSROs. The ten 
FCMs with the highest amounts of customer assets at year-end 2012 would 
have accounted for 44 percent of the FICPC funding. Yet, the median 
value of customer assets on deposit at Large FCMs in 2012 (based on 
data from the Contributing FCMs) was roughly $1.4 million, as compared 
to median customer assets on deposit at Small and Medium FCMs in 2012 
of $4,434 and $5,089, respectively.
    In addition to the regressive nature of the proposed funding 
scheme, another concern with FICPC is the total amount of funding that 
the proposed plan would generate over time. In 2012, the 70 FCMs 
reporting positive annual gross revenues from commodities to CME and 
NFA had average annual gross revenues of $72.9 million, and the total 
annual gross revenue for all FCMs was $5.1 billion. In the first year, 
FICPC would receive (based on 2012 gross revenue numbers) an average of 
$364,591 from each FCM for a total across all FCMs of $25,521,370.
    If no losses and CAPI claims occur in the first year of the FICPC, 
its assets would grow over time. Yet, the growth rate of FICPC's assets 
would be incredibly slow vis-a-vis the target funding level of $2.5 
billion. For example, assuming a two percent return on FICPC's assets 
each year and an annual contribution by FCMs of $25,521,389 (i.e., 
assuming gross revenues for futures remains at 2012 levels), the FICPC 
would not reach its target $2.5 billion funding level for 55 years. 
Figure 1 below shows the assets of a FICPC Fund under those assumptions 
and further assuming that the first $25.5 million was paid in during 
2013 based on 2012 gross revenue numbers and that no claims payments 
are made. The FICPC Fund would cross the $1 billion asset threshold in 
2041 (i.e., 27 years after its inception).
Figure 1: FICPC Fund Projected Asset Levels


        Notes: Assumes constant annual contributions to FICPC of 
        $25,521,389 (i.e., 0.5% of 2012 gross revenues from commodities 
        for all FCMs that reported positive gross revenues in 2012) and 
        that FICPC assets are invested in government bonds earning 2% 
        per annum.

    The SIPC Fund faced the same problem when it was created by 
Congress in 1970. Figure 2 below shows that the Fund grew sluggishly 
over time and did not exceed $1 billion until 1996 (i.e., 25 years 
after its inception). SIPC, however, is an entity in which the U.S. 
Government is the equivalent of a reinsurer of up to $2.5 billion. 
Specifically, if the SIPC Fund is or appears to be insufficient to 
cover claims, the Securities and Exchange Commission can make loans to 
SIPC (backed by notes issued to the U.S. Treasury) in an aggregate 
amount not to exceed $2.5 billion.
Figure 2: SIPC Fund from Inception to December 31, 2012


        Source: Securities Investor Protection Corporation, 2012 Annual 
        Report, p. 29.

    So, FICPC might not provide much short-term comfort to futures 
customers given the slow growth rate in the assets available to cover 
any eligible customer claims. Without a government backstop (and the 
corresponding taxpayer-financed contingent liability), the program 
would be significantly under-funded both in absolute terms and relative 
to the potential voluntary, private market-based solutions that we have 
identified.
    Because of its mandatory and universal nature, moreover, FICPC 
likely would result in new costs for U.S. futures trading participants. 
Those additional costs could deter customers from using futures markets 
to satisfy their risk-management needs and depress market liquidity, 
thereby potentially further raising costs for customers.
Conclusion
    For nearly a year, we have been researching and studying the 
potential benefits and costs of alternative CAPI programs. Our 
discussions to date with various 
(re-)insurers suggest a willingness and ability to provide capital to 
underwrite a private, voluntary CAPI program along the lines of an 
industry RRG in which FCMs bear the first-loss exposure to losses 
arising from FCM under-segregation or fellow-customer risk. In other 
words, the supply seems to be available to cover these risks, but we 
remain uncertain at this date as to the cost of that risk capital and 
the resulting demand for privately provided CAPI given those as-yet-
unknown costs. Yet, if there is sufficient demand for CAPI amongst FCMs 
and customers at the price that the reinsurance market charges and a 
willingness of FCMs to contribute their own capital to cover the first-
loss layer, then those willing FCMs and customers could have access to 
customer funds protection through a non-mandated, market-based 
solution.
    If it turns out, however, that there is limited demand for private 
CAPI solutions at the market price, then a mandated CAPI solution may 
be even more unrealistic. In other words, to the extent that a subset 
of market participants are unwilling to pay for voluntary CAPI, it is 
very likely that requiring all market participants to purchase CAPI at 
the mandated expense of the industry will be undesirable. A mandated 
CAPI solution, moreover, would likely be feasible only with either 
implicit or explicit taxpayer-backed government support. In addition, 
the added transaction costs that such a solution could ultimately 
impose on customers might simply cause some customers to stop relying 
on U.S. futures markets for their risk-management needs, which could 
reduce market liquidity and give rise to even higher transaction costs 
for remaining market participants.

    The Chairman. Thank you, Dr. Culp.
    Mr. Anderson.

 STATEMENT OF MICHAEL J. ANDERSON, REGIONAL SALES MANAGER, THE 
               ANDERSONS INC., UNION CITY, TN; ON
         BEHALF OF NATIONAL GRAIN AND FEED ASSOCIATION

    Mr. Anderson. Thank you. Good morning, Chairman Conaway, 
Ranking Member Scott, and Members of the Subcommittee.
    I work at The Andersons, Incorporated. I live in northwest 
Tennessee and run a series of elevators there. The Andersons is 
a diversified company rooted in agriculture. We were founded in 
Maumee, Ohio, in 1947, and we conduct business across North 
America in grain, ethanol, plan nutrient sectors, railcar 
leasing, turf and cob products, and consumer retailing. Today, 
I am here representing the National Grain and Feed Association. 
I serve on the NGFA's risk management committee, and I am 
NGFA's representative to the CFTC Ag Advisory Committee.
    In my written testimony, I have detailed several areas that 
we believe are important for Congress to consider during the 
CFTC reauthorization. I am going to focus today on the rule 
proposed by CFTC last November that would radically change the 
way business is done in the futures industry. We believe 
strongly that despite CFTC's goal of enhancing customer 
protections, that these two provisions of the rule will 
actually cause a dramatic increase in customer risk.
    The first provision would decrease the time in which 
customer margin calls must arrive to their futures commission 
merchant, or FCM, from the current 3 days to just 1. Otherwise, 
the FCM would have to take a capital charge for this 
undermargined account. Even in today's environment, of money 
moving electronically, 1 day is not sufficient for all 
customers to make their margin calls. We are urging CFTC to 
maintain the current 3 day timeline; otherwise, we fear some 
FCMs would require customers to pre-margin these hedge 
accounts, potentially putting more customers' funds at risk in 
another FCM insolvency.
    The second provision of concern, and maybe more troubling 
than the first, would change the timing of the FCM's 
calculation of residual interest, which are the funds the FCM 
contributes of its own money to top up customer accounts until 
margin calls are received. For decades, this provision of the 
Commodity Exchange Act has been interpreted by the Commission 
as allowing some period of time for the FCMs to do this. The 
CFTC proposal would change that consistent historical 
interpretation to require that every customer be fully margined 
on a 24/7 basis. It may sound like a good idea, but in the real 
world, it causes major problems. Future Industry Association 
has estimated this provision alone would cost as much as $100 
billion per day to be contributed to hedge accounts either by 
FCMs or by futures customers. This would severely stress FCM's 
liquidity, especially the smaller and mid-sized FCMs that we 
rely on to serve the ag industry, again, leading us to believe 
that pre-margining would be a likely conclusion.
    An unintended consequence could be further consolidation in 
the FCM world as smaller firms cannot compete with larger firms 
who are able to top up these hedge accounts. To bring this down 
to the everyday world, I am going to repeat an example that has 
been given before, so apologies if you have heard it.
    Consider an average Midwestern grain elevator that handles 
5 million bushels of grain every year. Before harvest, this 
elevator may have 40 percent of its annual grain volume 
purchased from its farmer customers through forward contracts, 
and assuming a crop mix of 60 percent corn, 30 percent soybeans 
and ten percent wheat, that elevator would have to hedge 300 
contracts of grain. Today, that would result in a minimum of 
$920,000 that that country elevator has to send to the FCM just 
to establish its hedged positions, and recall, this is just one 
country elevator.
    Now, if we look at the additional financial requirements, 
if the CFTC proposal was put into effect, we will assume that 
the elevator's FCM is going to require pre-margining of the 
customer to cover a 1 day limit move, which is a reasonable 
precaution, that country elevator would then have to send an 
additional $1 million more to the FCM for the possibility of 
this limit move that may or may not occur. If MF Global had 
been requiring pre-margining of this fashion, that country 
elevator is now exposed more than two times what it would have 
been originally, about $1.9 million as opposed to the original 
$900,000 it had to send to established positions.
    Further, we continue to be confused as to why the meaning 
of the Commodity Exchange Act has been changed after decades of 
consistent interpretation. We believe that the Act provides 
plenty of flexibility for the CFTC's historical interpretation, 
and we would be happy to discuss that in more detail. We are 
also mystified as to why the CFTC apparently has not undertaken 
serious cost-benefit analysis before implementing such a major 
change in the way the futures industry does business. An 
indication of the serious problems this proposal would cause 
for U.S. agriculture, 21 national organizations signed a letter 
to the Commission on September 18th detailing consequences and 
urging serious analysis by the CFTC before moving forward on 
these two provisions.
    And Mr. Chairman, I request that this letter be included in 
the hearing record, if that is all right.*
---------------------------------------------------------------------------
    * The document referred to follows Mr. Anderson's prepared 
statement and is entitled Attachment.
---------------------------------------------------------------------------
    The Chairman. Without objection.
    Mr. Anderson. We would prefer to work with CFTC to resolve 
these problems, but there may be a need for legislative action 
to clarify the interpretation that the futures industry has 
relied on for so long. I thank you sincerely for taking the 
time to hear from our industry today, and I would be happy to 
respond to any questions.
    [The prepared statement of Mr. Anderson follows:]

Prepared Statement of Michael J. Anderson, Regional Sales Manager, The 
  Andersons Inc., Union City, TN; on Behalf of National Grain and Feed
                              Association
    Good morning, Chairman Conaway, Ranking Member Scott, and Members 
of the Subcommittee. I am M.J. Anderson, Regional Sales Manager of The 
Andersons Inc. in Union City, Tennessee. The Andersons Inc. is a 
diversified company rooted in agriculture. Founded in Maumee, Ohio, in 
1947, the company conducts business across North America in the grain, 
ethanol and plan nutrient sectors, railcar leasing, turf and cob 
products, and consumer retailing.
    Today, I am testifying on behalf of the National Grain and Feed 
Association (NGFA), the national trade association representing more 
than 1,000 companies including grain elevators, feed manufacturers, 
processors and other commercial businesses that utilize exchange-traded 
futures contracts to hedge their risk and assist producers in their 
marketing and risk management strategies. We appreciate the opportunity 
to testify before the Subcommittee today.
CFTC's Customer Protection Proposal--Customer Protection and Customer 
        Risk
    For many years, grain hedgers and the futures commission merchants 
(FCMs) with whom they work to manage their risk have relied on a 
consistent interpretation of the Commodity Exchange Act by the 
Commodity Futures Trading Commission (CFTC) with regard to posting 
margin funds to their hedge accounts. Unfortunately, in the name of 
customer protection, that interpretation recently has been thrown into 
question by a new proposal from the CFTC that we believe would 
dramatically increase customer risk.
    We understand that CFTC Commissioners currently are evaluating a 
final staff draft of this rule, with the goal of voting on a final rule 
later this month. The rule seeks to bolster futures customer 
protections--a laudable goal that the NGFA supports fully. However, two 
very troublesome provisions would have the perverse effect of 
significantly increasing financial risk to futures customers--and in 
the process, dramatically changing the way business has been conducted 
in futures markets for decades.
    One provision concerns the timing of when an FCM is required to 
take a capital charge for undermargined accounts. Currently, customers 
have 3 days to make margin calls to their FCMs before the FCM is 
required to take a capital charge. As we read the CFTC proposal, that 3 
day period would be shortened to just 1 day. Even in today's 
environment of money moving electronically, a single day is not 
sufficient for all customers to make margin calls that quickly. We fear 
this provision would compel FCMs to require that customers pre-margin 
their accounts--especially the smaller and mid-size FCMs that are so 
important in providing service to futures customers in the agribusiness 
and production agriculture spaces.
    The second provision potentially is even more troublesome and more 
expensive to futures customers. It would change the timing of FCMs' 
calculation of residual interest for futures accounts--in other words, 
it appears the proposal would require all customers to be fully 
margined at all times. While this may sound like common sense, it is a 
huge departure from the CFTC's interpretation for decades that FCMs be 
allowed a certain period of time to ``top up'' hedge accounts while 
they wait for customers to make margin calls. This new proposal would 
lead to one of two outcomes: either the FCM would have to move more of 
its own funds (i.e., residual interest) into customers' hedge accounts; 
or FCMs would be forced to require pre-margining and, perhaps, intra-
day margining, to ensure that each individual customer is fully 
margined at any moment.
    The practical end result would be that futures customers would be 
required to send much more money to their FCMs in advance in 
anticipation of futures market moves that might never happen. Some 
customers likely would exit futures markets in favor of lower-cost risk 
management alternatives. We believe this potential exodus from futures 
markets would be most clearly seen among agricultural producers who 
utilize futures for risk management purposes and among smaller grain-
hedging firms.
    Taken to its logical conclusion, we believe strongly that neither 
proposal accomplishes the Commission's stated goal of enhancing 
customer protection. To the contrary, customers would be sending much 
larger amounts to their FCMs, leading to much greater volume of funds 
at risk if another MF Global situation occurs. If this rule had been in 
place when MF Global failed, perhaps twice as much customer money would 
have been missing and a correspondingly larger amount still would not 
be returned to customers.
    Much has been said about the meaning of the Commodity Exchange Act 
with regard to residual interest. Some at the CFTC have seized on a 
single sentence of the act in Section 4d(a)(2) to contend that the CEA 
prohibits one customer's funds from being used to cover another 
customer's margin calls. We believe strongly that the Commission's 
recent public stance is an overly aggressive interpretation that 
overturns decades of consistent administration of the regulations by 
the Commission, Congress and the futures industry. As a recent legal 
review by the Futures Industry Association has shown, there is ample 
flexibility in the Act to justify the manner in which residual interest 
rules historically have been implemented. Specifically, we believe the 
first of three ``Provided, however,'' clauses immediately following the 
limits in Section 4d(a)(2) give clear authority for the historical 
interpretation.
    Perhaps most troubling about this entire issue is that, to our 
knowledge, the Commission has performed no credible cost-benefit 
analysis relative to these specific provisions of the proposal. We 
believe strongly that this fundamental change of direction by the 
Commission--after decades of consistent interpretation--deserves a 
serious effort to quantify benefits relative to the enormous costs and 
risks imposed on futures customers. We respectfully urge the Commission 
to undertake a serious and thorough review prior to any action on the 
capital charge and residual interest provisions of the referenced 
rulemaking.
    On that note, we would like to thank you, Chairman Conaway and 
Ranking Member Scott and others, for sponsoring H.R. 1003, legislation 
that would require the Commission to perform both qualitative and 
quantitative cost-benefit analysis of potential regulations before 
issuing them. Such analysis likely would have provided the Commission 
with important and helpful information prior to publication of the 
customer protection rule. The NGFA supports inclusion of H.R. 1003 in 
legislation reauthorizing the CFTC.
    Discussions with the Commission have not resolved these issues to 
date, and we continue to be mystified about how the meaning of the 
Commodity Exchange Act, interpreted consistently on this matter for 
decades, suddenly has changed. It is difficult to understand the reason 
for such a dramatic change in the CFTC's stance after decades of 
consistent interpretation. We continue to believe that the Act provides 
sufficient flexibility. However, if the Commission continues to contend 
that its hands are tied due to provisions of the Commodity Exchange 
Act, Congressional action may be needed to clarify the matter.
Widespread Concern in U.S. Agriculture and Agribusiness
    The proposed changes in capital charge and residual interest 
provisions have provoked very deep concerns among a broad swath of U.S. 
farmers, ranchers and agribusiness firms who utilize futures markets to 
manage risk in their businesses. On September 18, twenty-one national 
organizations wrote to CFTC Commissioners warning of the following 
consequences if these provisions are finalized:

   ``FCMs will be forced either to use their own funds to `top 
        up' residual interest--not feasible given the huge amounts 
        involved--or, most likely, require that customers pre-margin 
        hedge accounts.

   Many producers who use futures directly will be discouraged 
        from using futures markets to hedge their production risk.

   Due to the significantly increased funding requirements of 
        pre-margining--perhaps nearly double the amounts currently 
        required--many small agribusiness hedgers will be forced to 
        consider alternative risk management tools or be forced out of 
        the market.

   Futures customers will be compelled to send excess margin to 
        their FCMs in anticipation of future market movement on 
        existing positions--many billions of dollars more than needed 
        to cover existing positions--the last thing customers want to 
        do now, in the wake of MF Global and Peregrine Financial Group.

   Much more customer money--maybe twice as much--will be at 
        risk in the event of another FCM insolvency.

   Futures customers will be compelled to borrow more money 
        just to post margin on potential market moves--difficult for 
        both lending banks and for customers to predict, and 
        potentially difficult for smaller local banks. This increased 
        borrowing requirement negatively affects a customer's ability 
        to invest in their own business.

   The entire hedging process will be made less cost-efficient, 
        thereby discouraging use of futures markets.''

    It is very important to note again that these organizations are not 
investors or speculators. They represent farmers, ranchers and the 
agribusinesses that work with production agriculture to hedge their 
business risk. We believe it should be of deep concern to the 
Commission that many of the affected individuals and firms may be 
forced by the huge added expense of using futures to find other, less-
costly forms of risk management--and that the smaller and mid-sized 
FCMs that provide such important service to U.S. agriculture stand to 
be disproportionately disadvantaged. It is in no one's interest to 
cause consolidation among FCMs, thereby concentrating risk in a smaller 
number of firms.
Reforms to the U.S. Bankruptcy Code
    Nearly 2 years after the implosion of MF Global, companies and 
individuals that were customers of that FCM continue to deal with the 
aftermath of parent company MF Global Holdings' bankruptcy and misuse 
of futures customer funds. Most U.S. futures customers so far have 
received distributions from the trustee of about 97% of their funds--
funds that were supposed to have been segregated and protected. Recent 
developments have made it increasingly likely that 100% of customer 
funds will be returned to customers, but the NGFA believes strongly 
that statutory reforms are needed with the twin goals of preventing 
similar occurrences in the future and enhancing the rights and 
protections of futures customers in the event of a future FCM 
insolvency.
    Among those changes, we believe that reforming the U.S. bankruptcy 
is the single most important step essential to preserving and codifying 
customers' rights and protecting customers' assets. To that end, the 
NGFA recommends the following statutory changes:

   The Bankruptcy Code should state clearly that customers 
        always are first in line for distribution of funds, ahead of 
        creditors, and that all proprietary assets including those of 
        affiliates must go to customers first. This would provide 
        clarity to regulators and to the courts in terms of 
        prioritization of claims, an area in which precedent has not 
        been established.

   Part 190 regulations of the CFTC should be incorporated into 
        Subchapter IV of Chapter 7 of the Bankruptcy Code to harmonize 
        the statutes and remove any interpretative inconsistencies. 
        Generally, the Bankruptcy Code provides a limited description 
        of the liquidation process of a commodity futures broker. The 
        Commodity Exchange Act and bankruptcy regulations drafted by 
        the CFTC provide much greater and more detailed guidance for 
        the liquidation of a commodity broker or FCM.

   Under current bankruptcy law, powers of a trustee to recover 
        customer funds are limited under so-called ``safe harbor'' 
        provisions unless actual intent to defraud customers/creditors 
        can be shown. The NGFA strongly recommends that any transaction 
        involving the misappropriation of an FCM's customer property 
        should not be protected under safe harbor provisions, 
        regardless of the intent behind a fund transfer.

   To strengthen commodity customer protection, the CFTC should 
        have a specifically identifiable role in the liquidation of an 
        FCM. The CFTC should have the authority to appoint its own 
        trustee to represent exclusively the interests of commodities 
        customers. In a case like MF Global, in which over 95% of the 
        assets and accounts affected were those of commodities 
        customers, we believe the CFTC's authority should be 
        strengthened and clarified.

   In the MF Global situation, creditor committees were 
        established under the MF Global Holdings Chapter 7 proceeding, 
        but there was no statutory provision under the SIPA liquidation 
        of the MF Global Inc. for establishment of customer committees. 
        The NGFA recommends that the Bankruptcy Code expressly should 
        authorize the establishment of customer committees to represent 
        FCM customer interests.

    We are aware that other organizations also are working toward 
specific recommendations for changes in the Bankruptcy Code that will 
enhance customer protections. The NGFA intends to work cooperatively 
with such groups to develop consensus reforms that can be moved by 
Congress expeditiously.
    Insurance or Liquidity Protection for Commodity Futures Customers--
The NGFA recommends that insurance or insurance-like products should be 
available to commodity futures customers. Customers and their lenders 
who finance hedging in commodity markets must have confidence that 
their funds are safe and protected. We are aware that the Futures 
Industry Association and others currently are finalizing a 
comprehensive analysis of potential products and costs, and we consider 
it prudent to see that study before recommending a particular 
structure. We also are aware that the Commodity Customer Coalition 
recently has completed an online survey of commodity futures customers 
to gauge interest and input on insurance products. This data also could 
prove useful in crafting appropriate solutions.
    Since the NGFA began working on potential customer protection 
enhancements early last year, we have been very mindful that most new 
customer protections will come at a cost--and that, eventually, the 
cost most likely will be borne by the customer. For that reason, we 
have taken a deliberate approach to recommending specific new 
protections, and we respectfully suggest that Congress and all 
stakeholders adopt a similarly cautious view. On the bright side, since 
the collapse of MF Global, significant new operational safeguards that 
should enhance the safety of customer funds have been put in place on 
commodity futures accounts by exchanges and regulators. These 
enhancements, already in place, should help mitigate costs of insurance 
or other customer protection efforts.
    It is important to note that the solution on insurance to protect 
customers is not necessarily a government solution or a legislated 
solution. It may be that some form of privately provided product is 
more cost-effective and more appropriate. The NGFA has taken no formal 
view at this point on any specific structure. We advise strongly that 
data from the above-referenced efforts should be carefully considered 
prior to making such an important decision.
    Fully Segregated Customer Accounts/Pilot Program--Currently, the 
Commodity Exchange Act and U.S. Bankruptcy Code provide for pro rata 
distribution of all customer property that was held by a failed futures 
commission merchant (FCM). Almost 2 years after the fact, former 
customers of MF Global still have not received back 100% of their 
supposedly safe segregated funds. This is unacceptable. Restoring the 
confidence not only of customers, but also of their lenders, is 
critically important. To that end, the NGFA has recommended 
establishment of an optional fully-segregated account structure to be 
offered and utilized by mutual agreement of customers and their FCMs.
    Creation of a fully-segregated account structure necessarily would 
result in some additional costs that likely would be borne by customers 
that utilize such accounts. It is likely that some customers would opt 
for the added protections despite extra costs, while other customers 
might be unwilling or unable to bear those extra costs. For that 
reason, we propose that the full-segregation option be utilized on a 
voluntary basis at the agreement of an FCM and its individual 
customers.
    We suggest that a pilot program involving a limited number of 
commodity futures customers, FCMs, and lenders, along with regulators, 
would be a useful means of testing the mechanics and identifying the 
viability and true costs of a full-segregation structure. It is our 
understanding that similar structures already are in place in the swaps 
marketplace, and perhaps that can offer insights into similar accounts 
for futures customers who may desire the same kind of protection. The 
NGFA does not recommend legislative action to establish a full-
segregation account structure, but support for a pilot to test concepts 
would be constructive.
High Frequency Trading
    Increasingly, traditional customers of agricultural futures markets 
are concerned about the impacts of high-frequency trading. Especially 
immediately preceding and following release of important crop and 
stocks reports by the U.S. Department of Agriculture, we believe high-
frequency trading has caused and magnified volatile market swings. 
These disruptions have led many hedgers to avoid futures markets at 
such times, leading the NGFA to recommend a short pause in trading 
around releases of key USDA reports. Concerns also have been raised 
about the impact of high-frequency trading on order fills for 
traditional hedgers and about timely access to USDA reports, especially 
for those without mega-high speed connections.
    It may be that regulatory action by the CFTC is the more 
appropriate way to address high-frequency trading issues. Should high-
frequency traders be required to register with the Commission? Should 
such traders be required to post margin even if no positions are held 
at day's end? Are there other measures that should be considered to 
help ensure that high-frequency trading does not disrupt futures 
markets in ways that render them less useful to hedgers managing 
business risk? The NGFA suggests that these kinds of questions should 
be part of the conversation during reauthorization.
    We look forward to working with the Committee on these and other 
matters during the reauthorization process. Please do not hesitate to 
contact the NGFA with any questions.
                               Attachment
September 18, 2013

  Hon. Gary Gensler,
  Chairman,
  Commodity Futures Trading Commission,
  Washington, D.C.

RE: RIN 3038-AD88: Enhancing Protections Afforded Customers and 
            Customer Funds Held by Futures Commission Merchants and 
            Derivatives Clearing Organizations, 77 Fed. Reg. 67866 
            (November 14, 2012)

    Dear Chairman Gensler:

    The undersigned organizations represent a very broad swath of 
agricultural futures market participants, including crop and livestock 
producers who use futures directly to manage their risk; agribusiness 
firms who rely on futures markets as they assist producers with risk 
management plans and in their own risk management programs; as well as 
lenders that support the industry's risk management activities.
    We support strongly the Commission's efforts to enhance futures 
customer protections. However, the capital charge and residual interest 
provisions of this rule will have the opposite impact--if adopted, 
customers will be exposed to significantly greater financial risk.
    If adopted as proposed, these provisions likely will have the 
following impacts:

   FCMs will be forced either to use their own funds to ``top 
        up'' residual interest--not feasible given the huge amounts 
        involved--or, most likely, require that customers pre-margin 
        hedge accounts.

   Many producers who use futures directly will be discouraged 
        from using futures markets to hedge their production risk.

   Due to the significantly increased funding requirements of 
        pre-margining--perhaps nearly double the amounts currently 
        required--many small agribusiness hedgers will be forced to 
        consider alternative risk management tools or be forced out of 
        the market.

   Futures customers will be compelled to send excess margin to 
        their FCMs in anticipation of future market movement on 
        existing positions--many billions of dollars more than needed 
        to cover existing positions--the last thing customers want to 
        do now, in the wake of MF Global and Peregrine Financial Group.

   Much more customer money--maybe twice as much--will be at 
        risk in the event of another FCM insolvency.

   Futures customers will be compelled to borrow more money 
        just to post margin on potential market moves--difficult for 
        both lending banks and for customers to predict, and 
        potentially difficult for smaller local banks. This increased 
        borrowing requirement negatively affects a customer's ability 
        to invest in their own business.

   The entire hedging process will be made less cost-efficient, 
        thereby discouraging use of futures markets.

    Much has been said about the meaning of the Commodity Exchange Act, 
particularly with regard to the timing of residual interest 
calculations and FCMs' receipt of customers' margin. With respect, we 
believe strongly that the Commission's recent public stance is an 
overly aggressive interpretation that overturns decades of consistent 
administration of the regulations by the Commission, Congress and the 
futures industry. As a recent legal review by the Futures Industry 
Association has shown, there is ample flexibility in the Act to justify 
the manner in which both capital charge and residual interest rules 
historically have been implemented.
    Clearly, the proposed rules are a huge change to the way the 
futures industry does business. However, by its own admission, the 
Commission has performed no credible cost-benefit analysis relative to 
these specific provisions of the proposal. We believe strongly that 
this fundamental change of direction by the Commission--after decades 
of consistent interpretation--deserves a serious effort to quantify 
benefits relative to the enormous costs and risks imposed on futures 
customers. We respectfully urge the Commission to undertake a serious 
and thorough review prior to any action on the capital charge and 
residual interest provisions of the referenced rulemaking.
            Sincerely,

  AMCOT
  American Cotton Shippers Association
  American Farm Bureau Federation
  American Feed Industry Association
  American Soybean Association
  CoBank
  Commodity Markets Council
  National Association of Wheat Growers
  National Barley Growers Association
  National Cattlemen's Beef Association
  National Corn Growers Association
  National Cotton Council
  National Council of Farmer Cooperatives
  National Grain and Feed Association
  National Pork Producers Council
  National Sorghum Producers
  National Sunflower Association
  North American Millers Association
  USA Rice Federation
  U.S. Canola Association
  U.S. Dry Bean Council

CC:

  Hon. Bart Chilton,
  Hon. Scott O'Malia,
  Hon. Mark Wetjen,
  Members of Senate and House Agriculture Committees.

    The Chairman. Thank you, Mr. Anderson.
    Mr. Koutoulas.

    STATEMENT OF JAMES L. KOUTOULAS, ESQ., PRESIDENT AND CO-
    FOUNDER, COMMODITY CUSTOMER COALITION, INC., CHICAGO, IL

    Mr. Koutoulas. Chairman Conaway, Ranking Member Scott, 
Members of the Committee, thank you for the opportunity to 
testify at this important hearing. My name is James Koutoulas, 
and I am the President and Co-Founder of the Commodity Customer 
Coalition. While I also serve on the board of directors of the 
National Futures Association, my testimony does not necessarily 
represent the views of that organization. While I am deeply 
honored that our organization was invited to testify before 
this Committee before the 2 year anniversary of our creation, 
the fact that we exist at all is evident of the need to improve 
protections for commodity customers.
    For those unfamiliar with us, a lot of things had to go 
wrong for the CCC to be formed. With MF Global teetering on the 
bankruptcy, it's DSRO, CME Group had grave concerns about the 
sanctity of segregated accounts and, 4 days before FCM's global 
bankruptcy, instructed its management that no transfers were 
permitted without CME's express written consent. However, CME 
Group did not take the extra step of enforcing that instruction 
by requiring CME approval for wire transfers initiated from MF 
Global's customer accounts, and it did not require CME's 
approval in JP Morgan assets, its treasury software. That would 
have only taken a few minutes to configure. This oversight 
allowed MF Global staff to transfer customer funds to meet 
house margin calls at JP Morgan, creating a shortfall of over 
$1 billion, according to the MF Global, Inc., trustee's report.
    This occurred despite the fact that, per the trustee's 
report, JP Morgan's chief risk officer personally informed MF 
Global senior management that JP Morgan thought customer funds 
were at risk. JP Morgan sent MF Global management three 
variants of a comfort letter asking them to certify that no 
customer funds were transferred. And although none of these 
letters were signed and returned by MF Global management, JP 
Morgan did not return those customer assets for over 18 months 
after the bankruptcy.
    Once MF Global filed for bankruptcy, its counsel 
represented there was no shortfall in customer accounts, 
despite internal communication otherwise. On that basis, the 
bankruptcy judge permitted MF Global holdings to enter Chapter 
11 rather than Chapter 7 and appointed another trustee to 
oversee that reorganization. The appointed trustee permitted MF 
Global senior management to remain at the firm, even though 
well over a billion dollars of customer money was still 
unaccounted for and even went so far as to claim attorney/
client privilege on their behalf in his dealings with criminal 
investigators. This transpired in conjunction with the SIPA 
trustee's alarming initial plan to keep MF Global customers' 
cash frozen for a full 9 months after the bankruptcy and only 
then allow the release of 60 percent of the funds.
    In the face of this long list of obstacles delaying the 
return of their property, thousands of customers reached out to 
John Roe and myself and asked us to help them. We had farmers 
saying we are incapable of buying seed. Retirees couldn't 
withdraw their savings to buy medicine. We had a single mom who 
said she was in danger of losing her home, because of this we 
spent thousands of hours doing pro bono service to help recover 
this property.
    Now here we stand where the CFTC is asking customers to 
double down on this FCM system that they don't trust after MF 
Global, they really don't trust after PFG, and comply with this 
new residual interest rule. And this rule will definitely do 
more harm than good. We understand where the CFTC is coming 
from, wishing to protect customers from fellow-customer risk, 
which is a very valid concern, but asking that the hedge 
accounts, the farmers and ranchers, to go to $900,000 up to $2 
million and expose that to FCM malfeasance when the regulators 
have proven that they can't stop this, I think that is 
ridiculous.
    And I think that what the CFTC could do is to go and maybe 
enforce this residual interest rule on high frequency traders, 
on firms which, in a couple of minutes, with a rogue algorithm 
can blow up an FCM, but they shouldn't impose it on general 
commodity customers and upon hedge customers.
    And moving on to insurance. In testimony before the Senate 
Committee on Agriculture, Nutrition, and Forestry, the CCC 
advocated for the creation of a private insurance mechanism to 
cover FCM malfeasance, much like the one Dr. Culp delineated. 
We were the only group to advocate for such a plan before the 
PFG failure, and we still believe it is a good idea. We agree 
with Dr. Culp that private opt-in insurance is the only 
feasible method for implementation of that, and we urge your 
Committee to consider that.
    And again, thank you, Chairman Conaway, Ranking Member 
Scott, for having us here today. We are deeply honored and hope 
that our feedback is helpful.
    [The prepared statement of Mr. Koutoulas follows:]

   Prepared Statement of James L. Koutoulas, Esq., President and Co-
        Founder, Commodity Customer Coalition, Inc., Chicago, IL
    Chairman Conaway, Ranking Member Scott, Members of the Committee, 
thank you for the opportunity to testify at this important hearing. My 
name is James Koutoulas and I am the President and Co-Founder of the 
Commodity Customer Coalition. While I also serve on the Board of 
Directors of the National Futures Association, my testimony does not 
necessarily represent the views of that organization.
    While I am deeply honored that our organization was invited to 
testify before this Committee before the 2 year anniversary of our 
creation, the fact that we exist at all is evident of the need to 
improve protections for commodity customers. For those unfamiliar with 
us, a lot of things had to go wrong for the CCC to be formed.
Industry Failures Results in the Formation of the CCC
    With MF Global teetering on the brink of bankruptcy, its DSRO, CME 
Group, had grave concerns about the sanctity of segregated accounts 
and, 4 days before the bankruptcy, instructed MF Global management that 
no transfers were permitted without CME's express written consent. 
However, CME Group did not take the extra step of enforcing that 
instruction by requiring CME approval for wire transfers initiated via 
MF Global's treasury software, JP Morgan Access, something that would 
have only taken a few minutes to configure. This oversight allowed MF 
Global staff to transfer customer funds to meet house margin calls at 
JP Morgan, creating a shortfall of over $1 billion according to the 
MFGI trustee's MF Global Investigation Report. This occurred despite 
the fact that, per the trustee's report, JP Morgan's Chief Risk Officer 
personally informed MF Global management that they thought customer 
funds were at risk. JP Morgan sent MF Global management three variants 
of a comfort letter asking them to certify that no customer funds were 
transferred, and, although none of the three letters were signed and 
returned by MF Global management, JP Morgan did not return these 
customer assets for over 18 months after the bankruptcy.
    Once MF Global filed for bankruptcy, its counsel represented that 
there was no shortfall in customer accounts, despite internal 
communication by MF Global senior management to the contrary. On that 
basis, the bankruptcy judge permitted MF Global Holdings to enter 
Chapter 11 rather than Chapter 7, and appointed an additional trustee 
to oversee that ``reorganization.'' The appointed trustee permitted MF 
Global senior management to remain at the firm, even while over a 
billion dollars in customer money was still unaccounted for, and even 
went so far to claim attorney-client privilege on their behalf in his 
dealings with criminal investigators. This transpired in conjunction 
with the SIPA trustee's alarming initial plan to keep MF Global 
customers' cash frozen for a full 9 months, and then allow the release 
of only 60% of the funds.
    In the face of this long list of obstacles delaying the return of 
their property, thousands of customers reached out to John Roe and 
myself after we received early media attention for our efforts to 
expedite the return of our own customers' property. After hearing 
stories of farmers incapable of buying seed, retirees unable to 
withdraw their savings to buy medicine, and a single mother who was in 
danger of losing her home, John and I organized the CCC and each 
contributed thousands of hours of pro bono service to help expedite the 
return of the property throughout the estate.
Outcomes for MF Global Customers
    Thankfully, our advocacy and litigation efforts, helped by the 
indemnity that CME provided to the trustee, all customers received 72% 
of their property back that was in 4(d) designated accounts 7\1/2\ 
months ahead of the trustee's initial plan--although 30.7 customers had 
no such luck and only received a majority of their funds back 20 months 
after the bankruptcy. Now, thanks to the CFTC's proposed settlement 
with MF Global, Inc., all customers are expected to receive 100% of 
their property back roughly 2 years after the bankruptcy. While this 
outcome exceeds almost all of the expectations formed upon the 
realization that there was a shortfall of over a billion dollars in 
customer accounts, it is simply unacceptable that customers were 
deprived of their property for even 1 day. Worse still, they felt they 
had little choice other than to rely on a handful of volunteers, with 
no bankruptcy or litigation experience, to represent them against the 
country's biggest bank and a former FBI director.
    After MF Global's collapse, the industry has shown a renewed vigor 
towards protecting customer funds, and has implemented many thoughtful 
reforms, such as those delineated by Mr. Roth, namely: the ``MF Global 
Rule,'' more stringent standards for FCM internal controls, and the 
daily electronic confirmation of segregated account balances. 
Nevertheless, in the less than 2 years since MF Global's bankruptcies, 
eight FCMs have already been fined for failing to comply with various 
segregation regulations, PFGBest's transgressions the most grave 
amongst them.
Industry Failures Continue
    PFGBest's customers have fared far worse than MF Global customers. 
Despite entrusting their funds to segregated accounts held by a 
regulated entity that was audited annually by a SRO, last summer their 
customers were told that over $200 million of assets had been stolen 
over 20 years. At this time, their only hope to recover more than 50% 
of their property is for the CFTC to prevail in its litigation against 
US Bank, which allegedly allowed PFGBest to treat its segregated 
accounts as if they were commercial checking accounts.
Strengthening Protections through Bankruptcy Reform and Insurance
    While both governmental and private regulators have generally done 
a good job protecting customers historically, everyone makes mistakes. 
Unfortunately, customers have bared almost all of the consequences of 
both debacles, as no regulator has lost their job, JP Morgan has not 
faced an enforcement action for knowingly receiving customer funds, and 
no member of MF Global management has been charged with a crime or been 
investigated for the many potential misrepresentations they may have 
made before this, and other Congressional Committees. Thus, sole 
responsibility for the safety of customer property currently relies on 
a combination of public and private entities, none of whom have skin in 
the game, to maintain segregation at all times, which they have 
repeatedly failed to do.
    Despite declining to enforce many of the existing regulations we 
already have on the books, the CFTC has now proposed over 500 pages of 
new rules, some of which we think add real value to customer 
protections, such as the expanded testing of FCM internal controls, the 
implementation of improved risk management procedures, and the required 
filing of certified FCM annual reports. Unfortunately, these proposed 
new rules also contain the most onerous burden ever placed on 
customers: the new residual interest rules.
The Proposed Changes to Residual Interest Do More Than Good
    These rules would require customers whose faith in the segregated 
account system has been badly shaken by the failures of MF Global and 
PFGBest to double down on it, by almost literally requiring twice the 
amount of cash that is currently held in segregation industry-wide. The 
would-be Russ Wassendorfs of the world do not need access to more cash 
from farmers, ranchers, and investors should they wish to engage in 
future malfeasance. Moreover, the businesses of small-to-midsize 
agricultural users and traders have been severely strained over the 
last several years due to the difficulties of making money in a 
persistent zero interest rate environment and the loss of customer 
confidence due to the MF Global and PFGBest insolvencies. Requiring the 
industry to comply with hundreds of pages of new rules while also tying 
up additional capital could very well be the final straw that puts many 
out of business.
    Instead of implementing many of these new rules, especially the 
proposed residual interest change, the industry as a whole would be 
better protected by consistently enforcing the existing. With respect 
to criminal penalties, I would like to remind the Committee that any 
willful violation of the Commodity Exchange Act is a felony punishable 
by 10 years in prison. There are least a few cases where this law 
should have been enforced, but as of now, justice has yet to be 
pursued. On the civil side, penalties have generally been assessed in 
relatively fixed amounts, giving the regulatory regime the worst of 
both worlds--devastating small firms while failing to provide a 
meaningful deterrent to large firms.
It is Time to Finally Fix Griffin Trading and Restore Customer Priority
    That is not to say some additional rule changes are not necessary. 
A few pages of legislative language would go a long way towards 
preventing future commodity customers from waiting years to receive the 
return of their property should another FCM go bankrupt with a 
shortfall in customer funds. In 1999, a small FCM named Griffin Trading 
was in such a situation. In Griffin, customers wound up recovering all 
of their property after an eventual settlement. Before that happened, a 
District Court judge held that the CFTC overstepped its authority by 
regulating that customers had priority over assets needed to fill a 
shortfall in segregated accounts. While this ruling was vacated by the 
settlement, it has still been cited as precedent for denying customers 
the immediate return of their property. The industry has been well 
aware of the weakening of customer protections caused by Griffin for 14 
years. Nevertheless, it did not make an effort to address it as part of 
the 2005 revisions to the Bankruptcy Code, which would have mitigated 
much of the suffering of Sentinel, MF Global, and PFGBest customers, 
and reduced the massive fees charged to those respective estates by 
bankruptcy trustees.
Restoring Customer Priority Through Subordination
    It is time that we address this long-neglected issue and take this 
opportunity to modify the CEA to require FCMs to subordinate the claims 
of their affiliates and lending institutions to customer claims in the 
event of a shortfall in segregated accounts. This would allow future 
bankruptcy trustees to return funds to customers much more quickly, as 
they would not have to reserve and wrangle over dubious claims of 
preference made on customer assets. Some members of the industry 
complain this change would be burdensome for FCMs seeking funding; 
however, this provision would simply return the operation of the law to 
the way it was written in 1974.
Strengthen Customer Priority by Giving Proper Statutory Authority to 
        CFTC
    In addition to enacting this subordination provision, the CFTC's 
current regulation Section 190.08(a)(i)(J) should simply be codified in 
the CEA directly to invalidate the authority argument made by Griffin's 
judge. The regulation states that ``customer property'' includes . . . 
``cash, securities or other property of the debtor's estate, including 
the debtor's trading or operating accounts and commodities of the 
debtor held in inventory, but only to the extent that the property 
enumerated [above] is insufficient to satisfy in full all claims of 
public customers.'' Codifying that regulation in conjunction with 
enacting a subordination provision would leave no doubt as to the 
priority of customer funds in a bankruptcy without opening up the 
Bankruptcy Code, which we have been told is akin to a zombie 
apocalypse.
Customer Account Insurance
    In testimony before the Senate Committee on Agricultural, 
Nutrition, and Forestry, the CCC advocated for the creation of a 
private insurance mechanism to cover FCM malfeasance before the 
uncovering of the PFGBest fraud. We agree with our colleagues here that 
insurance for commodity accounts is a complicated matter which requires 
deliberative study. The type of insurance as well as its triggers and 
limits are just a few of the nuances which will drastically affect the 
costs and benefits of such insurance; however, you do not need a study 
to determine that there is a type of customer who would benefit from an 
insurance mechanism. As MFGI Trustee Giddens noted in his MF Global 
Investigation Report, 78% of MF Global customers could have been fully 
insured with a $200 million fund. That amount seems to be a much easier 
sum to raise than the billions required by the CFTC's Residual Interest 
proposal. Indeed, 91.5% of commodity customers surveyed by the CCC are 
in favor of some type of an insurance mechanism.
Ring-Fencing New Account Classes
    Finally, the addition of new, segregated account classes for retail 
FX customers and for safekeeping accounts is a simple legislative 
change that would improve customer protections for groups that are 
often neglected. Many in the industry view FX customers as the red-
headed stepchildren of the futures regulatory regime, and argue that 
they do not deserve the protections of segregation if they do not trade 
exchange-cleared products. We beg to differ, though, and if the futures 
industry is responsible for regulating retail FX, it should not expect 
retail customers, most of whom are also futures customers, to 
understand that nuanced argument. Rather, it should do its best to 
protect all customers by giving them segregation protections, so they 
do not end up as general creditors like PFGBest customers probably 
will, even though no theft occurred in the FX accounts there.
    There has also been significant demand for safekeeping accounts, 
especially from mutual funds, which would allow customers to hold their 
excess margin in an individually-segregated account at a custodial bank 
rather than in a commingled segregated account at a FCM. Currently, 
CFTC Interpretation 10 essentially prohibits that practice, stating 
that such an account would still suffer a pro rata loss during a FCM 
bankruptcy for which there was a shortfall in the general segregated 
pool. We recommend creating a separate account class for safekeeping 
accounts and repealing Interpretation 10 to make the implementation of 
such an account class viable.
    Thank you again Chairman Conaway, Ranking Member Scott, and Members 
of the Committee for inviting us here today. We are honored to be 
included in these important discussions as to how best protect 
commodity customers going forward.

    The Chairman. Thank you, Mr. Koutoulas.
    Mr. Johnson.

STATEMENT OF THEODORE L. JOHNSON, PRESIDENT, FRONTIER FUTURES, 
                     INC., CEDAR RAPIDS, IA

    Mr. Johnson. Chairman Conaway, Ranking Member Scott, and 
Members of the Subcommittee. Thank you for inviting me to 
provide testimony regarding the customer protection rules 
proposed by the CFTC. My name is Ted Johnson, and I am 
President of Frontier Futures, a small family-owned futures 
commission merchant based in Cedar Rapids, Iowa. It was started 
by my father nearly 30 years ago to provide low cost futures 
execution to people who want to make their own decisions 
regarding their trading needs.
    The vast majority of our customers are farmers or small 
agricultural firms who use futures markets to hedge their 
risks.
    Today, I am here to provide the views of a small FCM on the 
rule changes the CFTC has proposed to protect customer funds. 
There have been a number of highly publicized failures by 
futures commission merchants in the past several years 
involving substantial loss of funds and shaking the confidence 
of many users of the markets. I have had more conversations 
than I can count with customers who are worried about the 
safety of the funds they invest with us.
    All these recent failures have involved fraud or 
malfeasance on the part of the FCM and a failure to follow 
rules and regulations regarding keeping the proper amount of 
funds in segregation. The NFA, the CFTC, and other regulators 
should be applauded for the great strides they have made in the 
last few years using technology to verify information provided 
by FCMs. Prior to this, the only--we were required to report 
our funds in segregation to the NFA daily, but the only 
confirmation they received was when they came in for an annual 
audit. PFG showed even this could be subverted for a time. 
Today, our balances are independently confirmed daily, and if 
there is a discrepancy, I can tell you the NFA is following up 
on that quickly.
    We have also new reporting rules regarding withdrawing 
funds from segregation. I fully support the rules that seek to 
codify these changes and to give CFTC backing to them, and I 
believe they will enhance public confidence in the futures 
markets.
    The other issue is the co-customer risk that the other 
members of the panel here have talked about. If debit amounts 
from a certain customer exceed the capital of an FCM, the rest 
of the losses are made up by other customers of that FCM whose 
funds are held in these segregated accounts. To my knowledge, 
there has not been a case of a customer losing money due to 
another customer's debit since I have been in the futures 
industry for about 25 years.
    Commission and interest income is too small when compared 
to the risk incurred if customer accounts aren't properly 
monitored to avoid debit accounts. If any markets were going to 
cause a problem for FCMs, last summer's volatile ag markets 
would have. However, at least in our case, we don't have a 
single customer who is unable to meet their obligations. Many 
of the proposed rule changes address this issue. Requiring FCMs 
to increase risk management standards, increasing requirements 
for residual interest in segregation and reduction in days to 
collect margin calls before they become capital charges are all 
aimed at protecting an FCM's customer from losses incurred by 
other customers of the FCM. Most of these changes have 
significant costs associated with them.
    For an FCM--the requirement to maintain a separate risk 
management department is not only expensive for an FCM of our 
size but ignores the fact that our entire staff is, in effect, 
a risk management department. The requirement to maintain 
residual interest in segregated funds greater than all margin 
calls at all times would be very difficult for us to track and 
also will require us to choose between greatly increasing our 
capital or the funds we require customers to deposit. Smaller 
customers who are unable to meet their margin calls at a 
moment's notice would risk liquidation of their positions.
    For Frontier Futures as a firm, the option to increase our 
capital may not even be possible, and the increasing margins 
may cause many of our customers to either leave us for others 
firms or cease trading all together.
    The residual interest rule may also force consolidation in 
a number of small to mid-sized FCMs. Currently, FCMs charge 
margins based on requirements set by the exchanges. The new 
rules will create a competitive imbalance favoring firms with 
access to large amounts of capital, such as bank-owned FCMs, as 
these firms will be able to fund margin calls by their 
customers.
    Firms without this access would be forced to charge much 
higher rates and may result in migration of customers out of 
these firms. With fewer customers available, there is bound to 
be consolidation. This will mostly affect the small to mid-
sized FCMs who clear these small hedgers.
    In the end, all government regulation should meet a cost-
benefit analysis standard. Much of the discussion surrounding 
these rules is focused on the cost side of this equation.
    In the case of the rules which enhance the ability of 
regulators to ensure that existing rules are followed and to 
prevent fraud, the FCM failures at MF Global and PFG have made 
the benefits clear. However, the benefits of the new rules 
regarding risk management and residual interest are far less 
clear, and the cost to the industry and end-users of the 
markets are real and substantial, especially smaller firms, 
farmers, and ranchers.
    Thank you for this opportunity to comment on this issue. I 
look forward to answering any questions you might have.
    [The prepared statement of Mr. Johnson follows:]

Prepared Statement of Theodore L. Johnson, President, Frontier Futures, 
                         Inc., Cedar Rapids, IA
    Chairman Conway, Ranking Member Scott and Members of the 
Subcommittee, thank you for inviting me to provide testimony regarding 
the customer protection rules proposed by the CFTC. My name is Ted 
Johnson, and I am the President of Frontier Futures, Inc, a small 
family owned futures commission merchant based in Cedar Rapids, IA. 
Frontier Futures was started by my father nearly thirty years ago with 
the intent to provide low cost futures execution to people who want to 
make their own decisions regarding their trading needs. The vast 
majority of our customers are farmers or small agriculture firms who 
use the futures markets to hedge their risks.
    Today I am here to provide the views of a small FCM on the rule 
changes the CFTC has proposed to protect customer funds. From a broad 
perspective, there are two ways that customer funds can be put at risk. 
The first is when the FCM removes funds from segregation, leaving the 
customer accounts under-funded. This problem has manifested itself 
recently as a number of highly publicized failures by futures 
commission merchants in the past several years involving substantial 
loss of funds and shaking the confidence of the end-users of the 
derivatives markets. I have had more conversations than I can count 
with customers who are worried about the safety of the funds they 
invest with us. This was especially true following the failure of PFG, 
given the fact that they were located just up the road from us in Cedar 
Falls, IA, and the local news coverage of the case was extensive. Our 
firm was also directly affected by a less publicized FCM failure in 
2007 when Sentinel Management Group was discovered to have been 
illegally investing customer funds. In that case, the shortfall was 
made up by other FCMs, including Frontier Futures, who had invested 
customer funds with Sentinel. This cost my firm most of our capital and 
forced us to close one of our three offices.
    All of these recent failures have involved fraud or malfeasance on 
the part of the FCM and a failure to follow the rules and regulations 
regarding keeping the proper amount of funds in segregation. The NFA 
and the CFTC should be applauded for the great strides they have made 
in the last few years in using technology to verify information 
provided to them by FCMs. Prior to this, we as an FCM were required to 
report our funds in segregation to the NFA daily, but the only 
confirmation they received was when they came in for an annual audit. 
PFG showed that even this could be subverted. Today, our balances are 
independently confirmed daily, and if there is a discrepancy, the NFA 
seems to be following up quickly. We also have new reporting rules 
regarding withdrawing funds from segregation, although there is no 
independent confirmation mechanism for this yet. Many of these proposed 
rules seek to codify these changes and give CFTC support to them, and I 
fully support these rules. Most of them involve the use of technology 
and procedure to greatly increase the level of protection provided to 
customer funds from malfeasance by their FCMs, and should enhance 
public confidence in the futures markets.
    The second way customer funds in segregation can be jeopardized is 
the result of large losses by other customers of an FCM. Customers of 
an FCM that generate debits reduce the amount in segregation. An FCM is 
required to make up that debit out of its own capital until that debit 
is collected. This is a main reason for FCMs maintaining a residual 
interest in the funds in segregation. If the debit amounts are larger 
than the capital of the FCM, a shortfall in segregation occurs, and 
results in losses by other customers whose funds are held in these 
segregated accounts. To my knowledge, there has not been a case of a 
customer of an FCM losing money due to a customer debit since I have 
been in the futures industry. FCMs are already greatly incentivized to 
avoid this risk. Commission and interest income is simply too small of 
a percentage of the risk incurred if customer accounts aren't properly 
monitored and debit accounts avoided. If any markets were going to 
cause problems for FCMs, last summer's volatile ag markets would have. 
However, we did not have a single customer who was unable to meet their 
obligations.
    Many of the proposed rule changes address this issue while FCMs are 
already focused in this direction. Requiring FCMs to increase risk 
management standards, increasing the requirements for residual interest 
in segregation, and the reduction in days to collect margin calls 
before they become capital charges are all aimed at protecting an FCM's 
customer from losses incurred by other customers of the FCM. Most of 
these changes have significant costs associated with them. The 
requirement to maintain a separate risk management department is not 
only expensive for an FCM of our size, but ignores the fact that our 
entire staff is in effect a risk management department. The requirement 
to maintain residual interest in segregated funds greater than all 
margin calls at all times will not only be very difficult to track, but 
force us to choose between doubling or possibly tripling our capital, 
or greatly increasing the funds we require our customers to deposit to 
ensure they never have a margin call. For smaller customers, or those 
who can't follow the markets on a minute to minute basis, meeting 
margin calls on a moment's notice is a difficult thing to do. This is 
especially true of small hedge customers, who would then be faced with 
liquidation of hedges. For Frontier Futures as a firm, the option to 
increase our capital by that much may not be possible, and increasing 
margins may cause many of our customers to either leave us for other 
firms or cease trading altogether.
    The broader consequence of the residual interest rule may be to 
force a consolidation in the number of small to mid sized FCMs. 
Currently, FCMs charge margins based on margin requirements set by the 
exchanges. The new rules will create a competitive imbalance favoring 
firms with access to large amounts of capital, such as the bank owned 
FCMs, as these firms will be able to fund margin calls by their 
customers with this capital. Firms without this access will be forced 
to charge much higher margin rates to their customers, and may result 
in a migration of some customers out of these firms. With fewer 
customers available to some firms, there is bound to be consolidation. 
This will mostly affect small to mid sized FCMs who clear small hedgers 
as well as guarantee Introducing Brokers.
    In the end, all government regulation should meet a cost-benefit 
analysis standard. Much of the discussion surrounding these rules has 
focused on the cost side of this equation. In the case of the rules 
which enhance the ability of regulators to ensure that existing rules 
are followed and to prevent fraud, the FCM failures at MF Global and 
PFG have made the benefit clear. However, the benefits of the new rules 
regarding risk management and residual interest are far less clear and 
the costs to the industry and end-users of the markets are real and 
substantial, especially smaller firms, farmers and ranchers.
    Thank you for this opportunity to comment on this issue. I look 
forward to answering any questions you might have.

    The Chairman. Thank you, Mr. Johnson.
    I also thank our panel for strict adherence to the 5 minute 
rule. I appreciate that discipline this morning.
    The chair will remind Members that they will be recognized 
for questioning in order of seniority for Members who were here 
at the start of the hearing. After that, Members will be 
recognized in order of arrival. I appreciate the Members' 
understanding, and I recognize myself for 5 minutes.
    Mr. Duffy or Mr. Roth--regarding the reinterpretation of 
the CEA by CFTC--they claim there is a sound legal basis for 
how they came to that new conclusion that they need to 
reinterpret the Act and change this longstanding 
interpretation. Can you give us your opinion as to whether or 
not the CFTC has a sound legal basis for that new 
interpretation?
    Mr. Roth. Mr. Chairman, I think the suggestion by the 
Commission that the statute ties their hands on this issue, 
that is their position, that their hands are tied because the 
statute provides what the statute provides. In my experience, 
regulators, including NFA, when they want to do something--or 
they don't want to do something, their hands are tied. When 
they do want to do something, they can untie knots quicker than 
a boy scout, so it strikes me as being odd that for 39 years, 
the Commission consistently misinterpreted the statute. And I 
think the suggestion that the current proposed rule is mandated 
by the statute flies in the face of logic to me.
    I don't think, as a matter of statutory interpretation, 
they are correct, and I think, further, the fact that for 39 
years the Commission took the other position undercuts their 
position.
    The Chairman. All right. Thank you.
    Terry, anything further?
    Mr. Duffy. I couldn't add to that metaphor, so I will leave 
that one alone.
    Mr. Conaway. All right.
    Mr. Johnson--or Mr. Anderson, I am sorry. Yes, Mr. 
Anderson.
    One of the issues that is of importance to family farmers 
is funding, financing and providing themselves with protection 
from market volatility by hedging in the commodity markets. We 
are concerned that the CFTC has nearly finalized its customer 
protection rules, but the very farmers and ranchers that it is 
supposed to help have recently come out opposed to it. In your 
opinion, is the staff of the CFTC ignoring the concerns of 
smaller agricultural customers, despite the overwhelming 
concern that Congress and the Administration has expressed for 
the financial well-being of family farms?
    Mr. Anderson. I am not sure if they are ignoring it, but we 
are all here today to make sure that that voice is getting 
heard. I think there is momentum. Obviously, the messages today 
are pretty similar, so we just want to make sure that is heard.
    The Chairman. All right. Dr. Culp, thank you for your work 
on this insurance study. Can you spend a little time walking us 
through the mechanics of how a $25 million fee will grow to 
$2.5 billion in 2067, and why that is not necessarily a viable 
option?
    Dr. Culp. Sure. In order to get to that particular number, 
there is a chart that is contained in my written testimony, 
made the assumption that there is no change in the gross 
revenues from the futures industry, from the FCMs from 2012 
levels; in other words, no increase nor no decrease. So using 
the 0.5 percent annual contribution rate for all 70 FCMs that 
reported in 2012, that gets us to a $25.5 million a year 
number. We then assume it is invested at two percent a year and 
that there are absolutely zero claims or losses. In that 
situation, the fund would grow to $2.5 billion after 55 years.
    The same thing happened with SIPC, and there is also a 
chart that is in my written testimony. If you look at the 
profile of SIPC when it was funded in the first place, the 
funds in SIPC grew very slowly, so had there been a very large 
loss early in the life of SIPC, the only thing that would have 
made the SIPC facility at all credible was the $2.5 billion 
line of credit that SIPC has with Treasury. That is why, to me, 
the idea of a universal government mandated fund along these 
lines just isn't a credible, viable option to provide capital 
and assurances to investors, unless it is including an implicit 
or explicit government backstop.
    The Chairman. All right. And in the time remaining, could 
you flesh out a little bit why the futures market may not be 
well served by a model that is designed for clients in a retail 
equity market.
    Dr. Culp. Sure. In fact, those are related issues. It is a 
good question. I mean, futures are risk-shifting markets. You 
have heard this from my other co-panelists already. Securities 
markets are markets for investment in capital formation. The 
historical role of participants in futures markets has not been 
of retail investors. There is a retail component, but the vast 
majority of futures trading participants are commercial hedgers 
that are managing the risks of their businesses, institutional 
investors, like pension funds, et cetera. Often, the sizes of 
the accounts held by these participants are relatively large, 
especially compared to a $250,000 policy limit.
    So, to some extent, having a retail-type government-backed 
fund for a wholesale sophisticated market is a bit like ramming 
a square peg into a round hole.
    The Chairman. All right. Thank you, gentlemen.
    I will have some other questions later.
    Mr. Scott, for 5 minutes.
    Mr. David Scott of Georgia. Thank you very much.
    Mr. Duffy, may I start with you?
    I listened to your testimony and you recommend the Future 
Industries Association's alternative proposal to residual 
interest, that is, to permit an FCM to calculate its required 
residual interest as of 6 p.m. On the first business day after 
the trade date.
    Mr. Duffy. Correct.
    Mr. David Scott of Georgia. So, as we do not have the FIA 
here to testify, can you explain to the Committee how this 
proposal accomplishes what the CFTC is aiming for in its 
proposed rule, without the cost that everyone here has 
testified to?
    Mr. Duffy. Well, without having FIA here, what we are--our 
understanding is, and what I have talked with our risk folks 
and our clearing folks is, in talking with all of our FCMs, 
they believe that they can calculate--or they can collect 
somewhere in the neighborhood of 80 to 90 percent of the margin 
that is due by the next day.
    Mr. Roth is correct. Everybody does not do wire transfers. 
Many still do checks, but for the most part, we can probably 
wire most of the money in by 6 p.m. the next day, but there is 
this still outstanding ten percent. So, that is really what the 
alternative calls for. I think what is important here, the 
Commission's interpretation of ``at all times,'' you heard the 
gentleman to my far left make a comment about how they can't 
complete--they cannot comply with such a requirement, and this 
is a compromise that makes complete sense.
    So that is really how they came up with it. We believe 
firmly that we can get most of the margin in by 6 p.m. the next 
day.
    Mr. David Scott of Georgia. Very good. Now, to you, Mr. 
Roth and actually, if we have time, I would like the whole 
panel to respond to this. Many of you highlight two particular 
risks to customer segregated accounts, those arising from the 
futures commission merchant itself and those arising from 
losses experienced by fellow-customers. Now, given the history 
of the futures market, which of these risks is greater and 
which risk should we be most worried about attempting to 
address in this CFTC reauthorization? And if I could get as 
many responses as we could.
    Mr. Roth. Thank you, sir. The--back in, I guess it was 
around 1986, NFA did a study of FCM insolvencies, going all the 
way back to 1938, and if you look at the whole history of FCM 
insolvencies, by far, the most frequent cause of an FCM 
insolvency is malfeasance. By far. So, the most--just in terms 
of frequency, the customer, or rather FCM malfeasance is the 
greatest risk.
    In terms of magnitude of the risk, if you did have these 
sort of cataclysmic market events that sparked a number of 
defaults by major institutional customers, the magnitude of 
those losses that could be caused by fellow-customer risk would 
be far greater than what happens through malfeasance. But as 
far as frequency, by far, would be the malfeasance by the FCM 
historically.
    Mr. David Scott of Georgia. Dr. Culp, would you comment on 
that?
    Dr. Culp. I think Mr. Roth is right. I would actually add 
one thing, though, that if you think about the fellow-customer 
risk, we actually have done analyses of these numbers, again, 
working with CME and the stress testing model. In order for the 
magnitude of fellow-customer risk to exceed the malfeasance/
misfeasance risk, you would not only have to have a truly 
catastrophic market move but you would actually have to have a 
fairly large number of the customers of the FCM fail to make 
their margin payments. If you look at just a few hundred for a 
large FCM, and we went through a number of iterations of this, 
but if you don't have widespread failures to pay, then even the 
magnitude of fellow-customer risk can actually be below the 
misfeasance or malfeasance risk. So, I agree, I think that is 
bang on.
    Mr. David Scott of Georgia. All right. Now, very quickly. 
In previous testimony, this Subcommittee has had calls for 
increased penalties for market manipulation, attempted 
manipulation, other violations in order to better protect 
customers by having stronger punishment for wrongdoers. Do you 
agree, or do you think current penalty levels are sufficient to 
dissuade wrongdoing in the derivatives market?
    Mr. Roth. I am sure everybody wants to talk about that, but 
I will jump in first because I was quickest with the button. 
You know, ultimately, the strongest deterrent you can have is 
criminal enforcement of rules. Civil penalties are fine. They 
are important. But nothing is more effective than vigorous 
prosecution of existing laws. And it is frustrating for 
everybody because there are always so many competing interests 
for the resources of the prosecutors as well as any other facet 
of government, but that is really where you are going to 
achieve the greatest deterrent impact, is vigorous criminal 
prosecution of the existing laws. Civil penalties are 
important. I don't mean to minimize them, but nothing is more 
important or effective than criminal prosecutions.
    Mr. David Scott of Georgia. Well, thank you so much. I see 
my time has expired. Maybe we will come back, and in a second 
round, I can get responses from others on that.
    The Chairman. All right. Thank you, Mr. Scott.
    Chairman Lucas, 5 minutes.
    Mr. Lucas. Thank you, Mr. Chairman. And I thank you and the 
Ranking Member for this hearing and all of the work you have 
done on this subject matter.
    And I certainly appreciate our witnesses appearing today to 
discuss an issue that has garnered a lot of attention.
    We have been discussing the CFTC's proposed rule that seeks 
to improve customer protections. However, I worry that the 
Commission has missed the mark with much of its proposal. As 
currently drafted, the futures commission merchants would be 
forced to use their own capital to cover all customers 
positions at all times of the day, in addition to farmers and 
ranchers that would have to meet 1 day margin requirements, and 
for many of our rural folks, our farmers and ranchers, a 1 day 
margin call is simply unrealistic.
    So, I ask the group: To anyone's knowledge, have there been 
conversations between USDA and CFTC about the impact this 
customer protection rule will have on farmers?
    That is what I was afraid of.
    Given the vocal outcry from producers in the ag 
marketplace, and I ask again this question generally to the 
group, are you optimistic that the Commission will repropose 
this rule or at least make meaningful changes?
    That is what I was afraid you would say. Let the record 
show that there was not any optimism on either question in that 
regard.
    I just would note that I wrote a letter to the CFTC last 
week with the leaders of both House and Senate Agriculture 
Committees asking the Commission to not ignore the concerns of 
the small ag players in the market.
    And Mr. Chairman, I would like to ask unanimous consent 
that the letter be entered into the record, written by myself, 
Ranking Member Peterson, Chairwoman Stabenow, and Ranking 
Member Cochran from the Senate Agriculture, Nutrition, and 
Forestry Committee.
    The Chairman. Without objection.
    [The letter referred to is located on p. 61.]
    Mr. Lucas. Thank you, Mr. Chairman.
    Finally, I will ask this question, Mr. Duffy, and of 
course, if anyone else would care to answer. If the proposed 
changes to the residual interest and 1 day margin are 
implemented by the CFTC, what will the futures commission 
merchant industry look like in 5 to 10 years, and what will 
happen with the farmers and ranchers who they have served for 
decades?
    Mr. Duffy. I will give you the 5 to 10 minute version first 
because that is what will happen in 5 to 10 minutes. We had a 
meeting in Chicago, the former Secretary of Agriculture, Mr. 
Glickman, and myself, held with all the ag producers and all 
the groups from around the country, and we had everybody from 
NCBA to the National Farm Bureau, and they said to a person, 
they would be out of the market instantaneously if that was to 
happen.
    So, I don't know what is going to happen in 5 to 10 years, 
Mr. Chairman, because that is a very difficult thing to try to 
look into the future, but I can tell you, this is a very 
serious issue for our farm community. We only have a handful of 
FCMs that they have the ability to go to today. If those FCMs 
are burdened with an additional cost, these participants will 
have nowhere to go in the marketplace except to do over-the-
counter type transactions or things of that nature due to risk 
management. That is exactly what Dodd-Frank called for them not 
to do. You want them on a listed exchange doing it in the 
clearinghouse.
    This is a critical issue for a good part of the average 
daily volume of liquidity for farmers and ranchers because not 
only does this impact farmers and ranchers, the people that 
create that liquidity, they will have nowhere else to go. What 
happens is, these spreads will widen dramatically, and when 
those spreads widen dramatically then the producers of 
agricultural products will have to pass on that cost of their 
risk management onto the American consumer. That is not a good 
outcome on a very bad rule, sir so, I cannot tell you where 5 
or 10 years will go. I can tell you what is going to happen in 
5 or 10 minutes once this passes, though.
    Mr. Lucas. Anyone else wish to comment?
    Sadly, Mr. Chairman, I think that sums it up. I yield back 
the balance of my time.
    The Chairman. Well, I thank the Chairman and appreciate 
your questions this morning.
    Let us now go to Gloria for 5 minutes.
    No questions.
    Mr. Costa for 5 minutes.
    No questions.
    Dr. Benishek for 5 minutes.
    Mr. Benishek. Thank you, Mr. Chairman.
    Have any of you had conversations with the CFTC about the--
what is the response to your concerns? I mean, it seems like 
you said that our hands are--they said our hands are tied. Is 
that the only response that you have gotten to your inquiry 
about this?
    Mr. Roth. The conversations that I and others have had, you 
do have the response that, one, our hands are tied; this is 
just mandated by the statute. I think there are times when 
certain members of the Commission staff proposed alternatives 
that would extend the time at which the funds had to be in 
place to the end of the clearing cycle, which is like 3 a.m., 
the next day, and which does really no good at all.
    Frankly, in response to the Chairman's question, I am kind 
of an optimistic guy by nature, and I think that there has been 
enough outcry on this that I am very hopeful that the 
Commission will ultimately adopt a rule that makes sense.
    It takes three votes up there--I am optimistic that reason 
will prevail. But in conversations, it has been largely again 
that their hands are tied, this is mandated by the statute, and 
that they are willing to extend it to some point but not as far 
as the FIA proposal, which NFA would certainly support.
    Mr. Benishek. Let me ask you, has there been a change? I am 
not familiar enough with the Commission to--has there been a 
change in the composition of the Commission or the staff that 
would result in loss of institutional knowledge or the fact 
that this has been interpreted one way for 39 years doesn't 
seem to bear any weight in the decision making process? Can you 
elaborate on that?
    Mr. Duffy. Yes. I think the only change, obviously, has 
been Commissioner Sommers, who has stepped down. The Commission 
has not filled that vacancy yet. They put up a nominee. The 
President has put up a nominee so far but yet to be confirmed, 
so we don't have a full complement of Commissioners. As far as 
staff goes, they have only made one announcement as of recently 
that was on the enforcement side.
    On this particular rule issue, again, you said it 
correctly, it has been 39 years of interpreting it one way, and 
I believe this is what Mr. Roth said in his testimony, this 
is--has nothing to do with what happened to protect customer 
funds under MF Global or PFG. This wouldn't have done anything 
to prevent what MF Global did to the marketplace. What MF 
Global did, we won't rehash all the things that they did, 
because I testified in front of this Committee and others, they 
committed a fraud, for the most part. And that goes with what 
Mr. Roth said earlier, we need to have penalties, more than 
civil, criminal penalties to make sure that these things don't 
happen again, but this rule, sir, makes absolutely no sense 
whatsoever from the Commission's standpoint.
    Mr. Benishek. Thank you.
    Mr. Anderson. I could add to that as well, though. Last Ag 
Advisory Committee meeting, they said the same thing, hands are 
tied. We have done a little bit of work, and it appears they 
are pulling one line out of the Commodity Exchange Act, and the 
very next line in there says, ``Provided, however,'' and goes 
on to have a list. I don't know exactly off the top of my head 
what that says, but we believe that ``Provided, however,'' 
phrase might have a little flexibility, and we included that in 
our written testimony as well.
    Mr. Benishek. Does anyone else want to comment?
    Well, I think I will yield back my time. Thank you.
    Mr. Duffy. Mr. Chairman, may I make one more comment, 
please?
    I think what is really important, sir, to recognize and not 
get lulled to sleep by the Commission or its proposal, as I 
said in my testimony, and others have also, it is a phased-in 
proposal, where sometimes that gets very attractive where the 
first year there is no change and so people feel, well, we will 
worry about in a year from now.
    This, even though it is a phased-in proposal, I assure you 
that people that are looking at this will not wait 1 year to 
see what year 2 and 3 and 4 are going to look like. They will 
be out of the market long before that, because what will happen 
is FCMs are going to have to set up business models. They can't 
have business models for 30 days. They have to put out a 2 or 3 
year or 5 year business model. This will impact that 2 or 3 or 
5 year business model if they try to implement it, so I would 
hope that the Congress would recognize that this 4 year 
implementation is no different in year 4 than it is today.
    Mr. Benishek. Thank you, sir. I will yield back.
    The Chairman. The gentleman yields back.
    Austin Scott for 5 minutes.
    Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
    We have heard a lot today about the things that are wrong 
in the proposed rule, and I am going to--Mr. Roth and Mr. 
Anderson, if the two of you would--what are the things in the 
rule that you think are right, if anything?
    Mr. Roth. There are a number of things, and we support most 
of the proposal. Certainly, to the extent that the Commission 
codifies the changes that have already been made by SROs, we 
are fully supportive of that. In addition, though, they 
require--they require FCMs to expand our test in FCM internal 
control. I think that is a good idea. They required FCM 
certified financial reports to be filed within 60 days of the 
firm's fiscal year-end instead of the current timeframe. I 
think that is a good idea. It is a harmonization step. They 
would require that FCMs that are undercapitalized provide 
immediate notice to the SROs and to the CFTC. That is a good 
idea. There are a number of things in there that are a good 
proposal. There are others that--residual interest isn't the 
only interest that we had trouble with, and I recited in my 
testimony some of those concerns that we have, none of them as 
grave as with respect to residual interest, so there are a 
number of things in here that we fully support, and I hope the 
rule proposal goes forward, and I certainly hope they make the 
changes that they need to make.
    Mr. Anderson. NGFA has been a big proponent of customer 
protections. You know, again, these two points, we have debated 
them here. But in general, a lot of the transparency that they 
are trying to bring through the new rule is positive. So we are 
certainly supportive, again, of most of what is proposed.
    Mr. Austin Scott of Georgia. I guess the loss of faith in 
the markets is just as detrimental as the increased costs that 
may drive people out. Either one of them can drive people out 
of the markets. I hope we are able to get a commonsense, good 
resolution that increases that transparency and does not 
increase the cost astronomically.
    Mr. Chairman, with that said, I will yield the remainder of 
my time out of respect for other Members.
    The Chairman. Thank you, Austin.
    Randy Neugebauer, 5 minutes.
    Mr. Neugebauer. Thank you, Mr. Chairman.
    Mr. Duffy, I enjoyed your editorial in The Wall Street 
Journal.
    Mr. Duffy. Thank you, sir.
    Mr. Neugebauer. You know, one of the things that I am 
hearing is that, does anybody support the enhanced settlement 
rule?
    Mr. Anderson. Could you repeat that?
    Mr. Roth. Congressman, I am sorry, does anybody support the 
residual interest rule, is that the question?
    Mr. Neugebauer. Right. Yes, I am sorry. Yes.
    Mr. Duffy. No.
    Mr. Neugebauer. One of the things that I wanted to bring 
out, Mr. Duffy, in your day-to-day operations at the exchange, 
I mean, you all are monitoring market movements and where there 
is potential risk. I mean, it is not like you wait until 2 or 3 
days later and say, what happened? Some of those things are 
happening in a real-time environment, are they not?
    Mr. Duffy. Congressman, they might have been happening in a 
real-time environment, they have been happening for a long time 
in a real-time environment. So we do what is considered twice 
daily mark to market. We can do pays and collects on an hourly 
basis if need be under what market conditions dictate. We spend 
a tremendous amount of money to make sure to police our markets 
not just from abuses in them, but from a risk management 
standpoint, and that is critically important to the health of 
the marketplace. So, yes, sir, we do that.
    Mr. Neugebauer. And, Mr. Johnson, I mean, you have 
customers out there, some large and some small, and with 
various positions out there. You are monitoring the 
marketplace, as you said, all of your people are basically risk 
managers because you are helping your clients manage their 
risk. But you are also managing your risk in the sense that 
making sure that you will be able to meet the exchange 
requirements. Is that a fair statement?
    Mr. Johnson. Yes, that is correct. I mean, the bottom line 
is if one of our customers is unable to meet their requirements 
and goes debit, it is our money that is on the line first. From 
that standpoint certainly we are constantly monitoring what our 
customers are doing, how their positions are being affected by 
market moves at any given time. I mean for us, as I said, our 
whole firm is essentially a risk management department, and we 
are doing that all the time.
    Mr. Neugebauer. Mr. Roth, you mentioned that the response 
from the CFTC is that their hands are tied and that they feel 
like there is a legal obligation for them to implement this 
rule. We are headed for a reauthorization period here. What 
legislative fix would you suggest that we look at if it appears 
that the Commission is going to go ahead and implement this 
rule?
    Mr. Roth. I think if the Commission, in fact, went forward, 
Mr. Anderson pointed out that there is--the qualifying language 
to the requirement that no one customer's funds be used to 
margin another customer's positions, the Provided, however, 
language that follows that, in our view, currently provides the 
Commission the flexibility that it needs. But if the Commission 
determines otherwise and goes forward with this rule, God 
forbid, then that is an area where Congress might be able to 
insert language into the Commodity Exchange Act to make clearer 
that the Commission's rule is invalid and not necessary.
    Mr. Neugebauer. Mr. Duffy?
    Mr. Duffy. If I could just add to that, what would be 
acceptable is, at least from CME's standpoint and the Futures 
Industry Association, is adopt the rule that they have put 
forward, which is to do trade day plus 1 at 6 p.m. And as I 
said earlier, we feel very confident in surveying a lot of our 
FCMs that the moneys can be collected 80 to 90 percent by 6 
p.m. trade day plus 1.
    Mr. Neugebauer. Anybody else want to comment?
    Mr. Chairman, with that I will yield back.
    The Chairman. Thank you.
    Mrs. Hartzler, 5 minutes.
    Mrs. Hartzler. Thank you, Mr. Chairman.
    Dr. Culp, I was very interested in your testimony about the 
insurance study. And you said, given the projection that a 
government-mandated creation of a Futures Investor and Customer 
Protection Corporation would not have $1 billion in assets to 
protect futures customers until around 2041. Would that imply 
that a taxpayer-funded line of credit at the Treasury 
Department would be necessary for it to be viable in the 
foreseeable future?
    Dr. Culp. That is a good question. But part of the answer 
to the question revolves around where the target funding level 
comes from. I mean, the target funding level of $2.5 billion is 
basically what SIPC's target funding level is. The $1 billion, 
I made mention of that in my written testimony because it is a 
nice round number.
    The real question is how much do you actually need to cover 
big potential losses. And with a mandated universal scheme, 
given what the potential risks are, I find it extremely 
unlikely that there would be adequate funding without a 
government backstop to cover a truly catastrophic loss 
scenario.
    Part of the problem is it covers everyone. It is mandated 
by the government and it is universal, so that includes small 
customers and really large customers. Even though there is a 
contemplated policy limit, there is a lot of risk out there. 
And the advantage of the voluntary solutions is it enables the 
people who most value insurance to try to get the insurance 
that is tailored to their needs as opposed to, again, forcing 
the square peg into the round hole of one size fits all for the 
whole industry.
    Mrs. Hartzler. Now, you have used the word scheme twice, so 
we know where you are coming from there.
    Dr. Culp. Sorry.
    Mrs. Hartzler. No need to apologize. You are the expert. 
And I just, from a gut level, feel like we would be 
establishing another Federal Flood Insurance Program, or FDIC, 
or some new government-backed insurance program where the 
taxpayer ultimately could be responsible for loss there. I 
appreciate your input on that. I will look forward to hearing 
what the insurance companies come back with as far as quotes 
for other options there.
    But I want to move on. Mr. Anderson, first of all, I think 
I might have some of your facilities in my district in 
Missouri. Do you have any retail outlets in my district?
    Mr. Anderson. No, our retail outlets are all in northwest 
Ohio, Toledo area.
    Mrs. Hartzler. Oh, well, that is all right. I wanted to ask 
you a question, though. Your testimony highlights the points 
that had the CFTC's proposed rule been in place when MF Global 
failed, possibly twice as much customer money, the hard-earned 
money of many farmers and ranchers would have been lost. So how 
must the CFTC change its proposed rule in order to avoid such a 
stark possibility from happening in the future? I believe Mr. 
Duffy said something about criminal penalties earlier. I don't 
know if both of you want to respond, but if you want to start, 
Mr. Anderson, and then Mr. Duffy.
    Mr. Anderson. Sure. You know, frankly, we have supported 
going back to the consistent interpretation that has been 
there, which would allow a lot of the futures industry to 
continue operating as it has. That is our opinion. And FIA also 
had a proposal a little bit different than that, but either of 
those will keep--the goal is really to keep the FCM from asking 
for money upfront----
    Mrs. Hartzler. Yes.
    Mr. Anderson.--to cover that move that may or may not come. 
If we can go back to the consistent interpretation that we have 
always had, that would suffice.
    Mrs. Hartzler. Okay. Mr. Duffy, do you want to add 
anything, go back to the----
    Mr. Duffy. Actually, I was only emphasizing the point that 
Mr. Roth made, he said it earlier about the civil and criminal 
penalties.
    Mrs. Hartzler. Okay.
    Mr. Roth. I am sorry, did you need to hear more than that?
    Mrs. Hartzler. Sure.
    Mr. Roth. Just the point, the question is whether we should 
increase the civil penalty sanctions that the CFTC can impose, 
and my only point was that civil sanctions are very important, 
but in my experience the most effective deterrent to wrongful 
conduct by far is not civil penalties, but criminal penalties. 
And so ultimately you have to enforce the rules that are on the 
books and get criminal prosecutions when people steal money.
    Mrs. Hartzler. Okay. Yes, do you want to add something?
    Mr. Koutoulas. Just to add to Mr. Roth, the rule is already 
on the books that any willful violation of the Commodity 
Exchange Act is a felony and bears up to 10 years in prison. 
The CFTC has already brought a civil enforcement act against 
the CEO of MF Global. We think that the Department of Justice 
should go ahead and bring criminal prosecutions along the same 
vein. And we also think that the Department of Justice needs to 
investigate the misrepresentations made by MF Global senior 
management before this Committee and other Committees when 
testifying about their conduct in the days leading up to the 
bankruptcy.
    Mrs. Hartzler. All right. Thank you very much.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentlewoman.
    Mr. LaMalfa, 5 minutes.
    Mr. LaMalfa. Thank you, Mr. Chairman.
    For Mr. Johnson here, earlier you testified how your family 
has been around 30 years in the business, and you work 
primarily with the smaller firms, the smaller growers. And you 
already went through some difficulty obviously back in 2007 
because you were caught up in that, you had to close one of 
your offices. What was the impact on the number of personnel 
because of that, or in general since then, with the changes in 
rulemaking, et cetera?
    Mr. Johnson. Well, in that case we closed one of our three 
offices, which had about 25 percent of our staff, total staff, 
and that was as a result of--we have talked a lot about the two 
main FCM failures here, the PFG and MF Global, and that was 
another FCM failure which didn't result in any customers losing 
money but a number of other FCMs who had money invested there 
did lose money, and we were one of those.
    Mr. LaMalfa. Okay. If CFTC rules are adopted as proposed 
for your operation, how much would you have to alter or are you 
one of the ones that in 10 minutes is in big trouble?
    Mr. Johnson. Well, that is a possibility. For us, because 
we are a very small FCM, we clear a lot of our business at, for 
instance, the CME through another FCM. So it will depend a 
little bit on how they treat it. If they force us to double or 
triple our margins, we will initially have to do that to our 
customers, and then it becomes an issue. I don't think that we 
would be gone in 5 or 10 minutes. In our case it would be a 
question of how many of our customers are going to leave us 
because of that.
    Mr. LaMalfa. Will they have a better place to go under 
those conditions then, it would be more attractive to go to a 
larger?
    Mr. Johnson. It may be if they can find a larger FCM that 
is even willing to clear them.
    Mr. LaMalfa. Yes.
    Mr. Johnson. In a lot of cases with many of our smaller 
customers, the larger FCMs aren't even interested in doing 
business with those people. So a lot of them may just decide to 
leave the futures markets altogether----
    Mr. LaMalfa. Completely.
    Mr. Johnson.--which is a problem for them and for the 
industry as a whole.
    Mr. LaMalfa. Certainly. Certainly.
    Mr. Duffy, we are hearing about a proposal from the White 
House to impose a transaction tax on the operations of CFTC. 
Now, we have seen similarly that the SEC's budget over a decade 
has practically doubled. What do you see if this tax is imposed 
and there is a larger budget for CFTC, what do you see 
happening in the future there with that additional requirement 
for a budget for CFTC and what they are going to be doing with 
it as far as enforcement?
    Mr. Duffy. I think that the user fee question and the CFTC 
budget question and the SEC has doubled their budget, 
obviously, Professor Culp mentioned the difference between 
capital formation and risk management. Capital formation you 
can go ahead and charge a per share stock, per transaction fee 
to fund the SEC because most people will hold on to a share of 
stock much longer than they will a derivative product, and you 
have many more participants in the marketplace to make it up, 
so it is much easier.
    In our world there is not nearly as many of the liquidity 
providers that are in the marketplace, and right now our 
highest liquidity providers that are standing there all day 
long creating tight bid offers, in order to get the $300 
million that the CFTC has proposed, there would have to be a 
4.5 charge to our largest liquidity providers to raise that 
$300 million annually. That is a 70 percent increase in their 
cost of doing business to provide liquidity.
    If, in fact, you charge any business a 70 percent increase 
in cost to do business, they are going to do one of two things. 
They are going to figure out how to lay off that risk to 
somebody else or that cost to somebody else, and the only way 
market makers could do that is to widen their bid offer as I 
talked earlier. So if, in fact, we were to impose a transaction 
tax or a user fee on the participants of liquidity providers, 
the bid offer spread would widen, so the producers of products 
of grains and livestock and products like that, those costs 
would either be out of the market and have to be assumed 
themselves, passed on to the consumer.
    And there is one thing that is really important here, 
Congressman. The United States Treasury has an auction every 
week, and at that auction every week, as you know, the yields 
have not been very great, but they are aggressively in there 
bidding for them. The reason people can aggressively bid for 
the United States auction every week is because there is a 
liquid futures market to lay that risk off. If that spread 
widens in the futures market because the cost of business goes 
up by 70 percent, the amount that will cost to taxpayers in 
facilitating that debt will go up by billions and billions of 
dollars because those spreads will widen. That will force the 
yield to go up on the Treasury debt.
    So this is one of the most penny-wise, dollar-foolish 
things I have ever seen in my entire life. We have seen user 
fees, just as an example being in India, just this past summer, 
absolutely destroyed their market by 25 percent. Sweden 20 
years ago imposed a transaction fee; they no longer are a 
financial services center whatsoever. In Europe there was a 
Tobin tax proposed, as we all know. That Tobin tax has not been 
implemented and been watered down to basically nothing 
throughout the rest of Europe and will not even apply to 
derivatives.
    So there are big issues associated with these markets, how 
fragile liquidity can be and what the cost of liquidity can be.
    Mr. LaMalfa. I appreciate that answer. My time is up, but 
thank you.
    Mr. Duffy. Thank you, sir.
    The Chairman. All right. Mrs. Roby for 5 minutes.
    Mrs. Roby. Thank you, Mr. Chairman.
    Thank you all for being here today.
    We have touched on this, Mr. Johnson, but I really want to 
drill down and if you could elaborate. If the industry 
consolidates as a result of the proposed rule, let's talk about 
the little guys, what the impact is going to be on small 
farmers and agricultural firms that make up most of your 
customers, if you would.
    Mr. Johnson. Well, as I stated earlier, most of our 
customers are small farmers, maybe some larger farmers or small 
agricultural firms. The issue with a consolidation of the FCM 
industry is that for the most part the larger FCMs, especially 
the bank-owned FCMs, are not interested in doing business with 
really small customers. From their standpoint, doing the risk 
management on a small customer is really about the same amount 
of work as it is on a large customer in terms of time and staff 
and things like that, and yet the benefits that they get from 
those larger customers are a lot greater.
    You know, from our standpoint, we have been doing business 
with our customers for years. I mean, we will celebrate our 
30th year next year. Many of our customers have been with us 
for a long time, a large portion of that time. Our order desk 
staff averages between 15 and 20 years of experience in the 
industry. So we know our customers, we are able to do the risk 
management on those customers in an efficient way.
    If a firm like us were to no longer be able to do business 
because a number of our customers left us for some reason, I 
believe that a lot of them would have a very difficult time 
finding another place to do business or, if they did, the 
business would be a lot more expensive for them. They would 
either be required to put up a lot more margin or pay a lot 
higher commissions to other firms to cover their costs in terms 
of doing the risk management and things like that.
    But the real issue is that the small FCMs, the midsize FCMs 
like us are the ones that do the farmer business, and those are 
the ones that are most at risk.
    Mrs. Roby. Sure, thank you very much.
    And, Mr. Anderson, can you elaborate as well what the 
consequences for your business and your customers if the CFTC's 
proposed rule on the customer protections is finalized with no 
changes?
    Mr. Anderson. Sure. The double margining--we think that is 
a reasonable conclusion, it is going to drive up our cost of 
doing business. When we buy grain from the farmer, we sell 
futures on the Chicago Board of Trade or CME Group, and now it 
is going to cost us twice as much to do that. We typically pass 
on some sort of fee to the farmer, so it is either going to 
come to them on the front end or, we are a low-margin business, 
so we will look to make a little more margin to offset some of 
those fees. And I don't think that is unique among the elevator 
industry. I think that people will look to recoup that cost one 
way or another.
    Mrs. Roby. Thank you again for all being here today.
    Mr. Chairman, I yield back.
    The Chairman. I thank the gentlelady.
    Mr. Davis for 5 minutes.
    Mr. Davis. Thank you, Mr. Chairman.
    And thank you to all the witnesses. Raise your hand if you 
are from Illinois. Let the record show. Thank you, Mr. Enyart. 
Let the record show that four witnesses raised their hand being 
from the great State of Illinois. I just wanted to gloat to my 
fellow colleagues how important the State of Illinois is to 
this issue.
    The Chairman. Gloating was noted and offensive.
    Mr. Davis. Thank you. Duly noted, sir. Offending the 
Chairman is probably not a good way to start the hearing today, 
is it?
    But a lot of questions have been asked. And, Mr. Duffy, to 
start with, I enjoyed your expanding on the White House's 
proposal for the transaction tax. Are there any other issues 
you would like to address on that particular question that you 
may not have had time for?
    Mr. Duffy. Other than--this is one of those fees--I was 
asked this in the United States Senate a couple months ago--if 
the industry is not going to pay for it, who should pay for it? 
And it is a very difficult scenario to say.
    This is one of those situations where we are talking that 
the CFTC is looking for funding because they have to have 
oversight of $641 trillion over-the-counter business. I like to 
remind Congress that the $640 trillion over-the-counter 
business has less than 2,000 transactions a day. We don't 
measure risk in notional value; we measure it in the amount of 
transaction and participants in the marketplace. We do 15 to 20 
million transactions in the futures markets today; we trade 
over a quadrillion dollars of risk on an annual basis. I mean, 
that is 17 zeros, Congressman, so that is a lot of risk. And we 
have been doing that flawlessly for many, many years. So I 
don't think we can measure the amount of funds associated with 
an agency on the notional value of the contracts.
    Second, I think that any time we look to impose user fees, 
the detriment that that could do, like I said earlier, I mean, 
if you want to charge an industry $300 million, unfortunately 
you are going to charge the taxpayers several billion dollars 
of the offsetting cost that people will pass on to the users, 
not just in the Treasury debt facilitation, but in the price of 
wheat, corn, barley, livestock, and everything else because it 
will have to go up if there is no risk management or the cost 
of risk management goes up. So this is essential for the food 
supply of the United States of America.
    Mr. Davis. I agree, and thank you very much.
    One other question. I mean, obviously MF Global has been an 
issue that has been discussed already in most of the testimony 
and in some of the questions. What is CME's role in 
facilitating the processes that are being put in place to avoid 
another MF Global situation?
    Mr. Duffy. Mr. Roth and I both have outlined several things 
in our testimony, both orally and written, and I think that 
these are new things that have not had a chance to be fully 
either implemented but let's see the full value of them, and 
that is what is important here. We have put many new 
protections in, and Dan said it right, the look-through into 
the customers' balances is something that we didn't have 
before, which if we had had the electronic look-through before, 
PFG wouldn't have happened or would have been discovered much 
earlier.
    First of all, with all due respect, Congressman, you can 
put a cop on every corner and somebody is going to still try to 
commit a crime. There was falsified records associated with MF 
Global. I don't want to debate all the facts, we have done that 
many times in this Committee and others. The good news is that 
there are many new protections for the clients today, and if we 
can have the deterrent that Mr. Roth referenced where we have 
criminal penalties associated with some teeth in it, that would 
be the most important thing.
    Mr. Davis. Thank you.
    And last, obviously we have heard through your testimony, 
Dr. Culp and others, that if customers are unwilling to 
purchase private insurance, that a government-mandated program 
funded by market participants might be a viable option.
    Mr. Duffy, I have seen your testimony, you disagree with 
this, and can you expand on that, too?
    Mr. Duffy. Yes, I am not big on government-mandated 
programs. I don't think they are good. I like the private 
sector answers better. If people want to have an opt-in 
insurance policy that they want to pay for, I have said it 
before in public testimony, that should be their right to do 
so.
    I will tell you, Congressman, we have a $100 million fund 
set aside for farmers and ranchers for this type of activity, 
so if there is any type of fraud or things of that nature, we 
will pay bona fide hedgers, which we have done in PFG's case, 
where we didn't even have the obligation to do it because we 
weren't even a DSRO for PFG, but we paid them out on that 
particular program.
    That $100 million, think about that, that is not a lot in a 
business that has got multibillions under management. We have 
$105 billion of margin on account. That $100 million was 
uninsurable from a practical standpoint. So I can't imagine how 
we could ever get a scheme together--I don't want to use the 
word scheme again--but a scheme together to put together enough 
money to oversee the system. And the last thing that I or 
anybody at CME Group would support would be to have a 
government backstop.
    Mr. Davis. Thank you. My time has expired.
    The Chairman. The gentleman's time has expired.
    Mr. Enyart, any questions?
    Mr. Enyart. I will waive my time to Mr. Scott. I have no 
questions.
    The Chairman. The gentleman yields to Mr. Scott for 5 
minutes.
    Mr. David Scott of Georgia. All right. Thank you.
    Let me go back. I want to make sure we get everybody on the 
record on this. Does everybody agree? I think, Mr. Duffy, you 
concur that we should have criminal charges being brought, you 
spoke to that. Is that correct?
    Mr. Duffy. Yes, sir.
    Mr. David Scott of Georgia. All right.
    And, Mr. Roth, you gave an eloquent answer.
    What is interesting is, Mr. Chairman, you put such a nice 
diverse panel here, it would be good to see if we could get 
everybody on board on that, so I put that question to everybody 
pretty quickly. To really protect the customers and to punish 
these violators and manipulators, do you all agree or disagree 
with Mr. Roth and Mr. Duffy that we should bring criminal 
charges and that that would help this if we could put some of 
these folks in prison, and that would cut it down? Is everybody 
on board with that or is somebody different?
    Mr. Anderson. NGFA, we haven't recommended any specific 
penalties, but we certainly believe there needs to be 
appropriate teeth in the law. We just haven't quite advocated 
exactly what we mean by that yet.
    Mr. David Scott of Georgia. So you do not agree that we 
should bring criminal charges?
    Mr. Anderson. Today we would not have enough information to 
say yes or no to that.
    Mr. David Scott of Georgia. All right. Mister--I do not 
want to murder your name. What is it?
    The Chairman. Koutoulas.
    Mr. David Scott of Georgia. Koutoulas.
    Mr. Koutoulas. Koutoulas. Perfect.
    Mr. David Scott of Georgia. Thank you, I am sorry.
    Mr. Koutoulas. Not at all. Thank you.
    We believe that the current law is there to bring criminal 
charges for MF Global, we believe there is a mountain of 
evidence to support that, as Mr. Duffy alluded to, and we think 
the bringing of criminal charges would do a lot to restore 
confidence in the futures markets.
    Mr. David Scott of Georgia. Very good.
    And Mr. Johnson?
    Mr. Johnson. Well, I certainly believe that any time that 
somebody commits fraud or steals money from their customers 
they deserve to be criminally charged.
    Mr. David Scott of Georgia. Thank you. Thank you very much 
on that.
    Now, Mr. Anderson, let me ask you, in your testimony you 
call for a pilot program of a customer option for a fully 
segregated account structure to be set up, but by the industry 
itself and not through legislation, correct? But the point is, 
if Congress fails to make changes to the Bankruptcy Code 
clarifying that customer funds in segregated accounts are 
always first in line for disbursement, then does a fully 
segregated account structure really provide much additional 
protection?
    Mr. Anderson. That is a very good question, and it is going 
to come down, like you said, to the Bankruptcy Code and where 
those assets lie.
    The reason for a pilot program is maybe to see a little bit 
of how that would work as well with those funds being 
completely fully segregated away from the FCM, how does that 
work, how do the mechanics work, what are the costs associated 
with it. I think some time needs to be spent on the law as 
well.
    Mr. David Scott of Georgia. Okay.
    Dr. Culp, in your testimony, you mentioned that over the 
long history of the futures industry few customer funds have 
been lost either from the failure of futures commission 
merchants or losses arising from the result of fellow-customer 
risk exposures. That is until recent events with MF Global and 
Peregrine Financial Group.
    On the securities side, the Securities Investors Protection 
Corporation has initiated at least 325 proceedings under the 
Securities Investment Protection Act to recover cash or 
securities for customers, and approximately $120 billion have 
been distributed back to customers over SIPC's 42 year history, 
$1.1 billion of that from the SIPC Fund. And as you have 
researched the possibility of some kind of futures insurance 
fund like SIPC Fund, have you found any explanation for why 
over time we have seen far more instances of customer losses on 
the securities side than we have seen on the futures side?
    Dr. Culp. I can say that wasn't a question that we 
specifically addressed in the study, but from my familiarity 
with the markets it goes a little bit to an earlier comment, 
the fundamental difference between securities and futures and 
the constituents of those markets. Many of the investors in 
securities markets are investors, they are buy-and-hold stock 
purchasers, and a lot of the claims that the SIPC has 
encountered over time have been related to the fact that there 
are different risk managements and controls in place in 
securities than there are in futures. For example, the at least 
twice daily margining that Mr. Duffy mentioned, that is not 
something that we do in securities markets. We do that in 
futures markets. And there is a litany of other risk 
managements and controls.
    But it is easy to think securities and futures are more 
similar than they are. They are actually very, very different 
in a lot of ways. And although, like I said, I didn't research 
this for this study, I am pretty convinced that is the answer.
    Mr. David Scott of Georgia. Thank you, sir.
    I yield back.
    The Chairman. Thank you, Mr. Scott.
    First off, I ask unanimous consent to enter into the record 
the written statement from the Managed Funds Association. 
Without objection, so ordered.
    [The information referred to is located on p. 61.]
    The Chairman. Dr. Culp, one of the criticisms of the 
insurance product was that you have a disproportionate burden 
of the funding of this thing versus the risks being protected 
based on a 0.5 percent fee on gross transactions for everybody. 
Did you look at other funding models that would be more in line 
with risks covered being paid for by that risk? In other words, 
is there any possible way of scaling the fee structure back to 
cover just the $250,000 that is the gross of the account, other 
funding models?
    Dr. Culp. Just to clarify, you mean in a universal mandated 
scheme?
    The Chairman. Yes, universal mandated scheme.
    Dr. Culp. No. You know, we thought about it. The problem is 
there are a lot of different possibilities. So for the mandated 
universal coverage scheme we focused on the proposal that is 
out there. Part of the problem with the scenario-based approach 
that we used is you can come up with an almost endless number 
of potential scenarios, so we tried to focus on the ones that 
were most likely to be proposed.
    The Chairman. So, in other words, the $2.5 billion in 
reserves that you think are needed to cover the scheme in 50 
years, whatever, covers just the $250,000 per account risks?
    Dr. Culp. Yes, sir.
    The Chairman. So you pull the folks whose assets are beyond 
$250,000 and not charge those a fee. The fee would be such that 
it just makes no rational sense at all to get to the $2.5 
billion, if you billed your fee just to the activities within 
the $250,000 accounts and less?
    Dr. Culp. Then it would be even harder to get to that 
target number, substantially so.
    The Chairman. Okay.
    Mr. Roth, I have two questions regarding your initial 
confirmation of account balances prior to the failure of PFG 
Best. One, there was some evidence that the owner there had 
been falsifying the bank statements provided to you on a daily 
basis. Could you reverse that now and falsify the confirmation? 
In other words, you are comparing the balances confirmed by the 
FCM as to segregated accounts with what the bank says is there.
    Mr. Roth. Correct.
    The Chairman. And so could this fellow have falsified the 
records that you are comparing to, to cook the books, just the 
reverse of what PFG did?
    Mr. Roth. Yes, Congressman, I am never going to suggest 
that there is a silver bullet which prevents----
    The Chairman. No, no, I am not suggesting that. I am just 
saying, but at least the second question is, after the PFG 
issue your organization went through an extensive review of 
your own process and own audits.
    Mr. Roth. Right.
    The Chairman. Can you walk us through that?
    Mr. Roth. Yes. We actually retained a group, the Berkeley 
Research Group, and the principals of the Berkeley Research 
Group are the same individuals that performed a study for the 
SEC on the Madoff study. And we asked them to come and review 
the entire history of NFA's dealings with Peregrine in 
particular, and to review all the examinations that we had 
done. And in the course of their study they reviewed three 
million pages of documents going over our entire history, and 
they made a number of really helpful suggestions. They 
basically found that the exams that we had performed were 
professionally and competently done but that we need to do 
better, and we are incorporating all of those suggestions.
    And the core suggestion really is to just always inculcate 
an attitude of professional skepticism in your staff. We have 
had all of our staff now, anyone who has been at NFA in the 
Compliance Department for more than a year will have to go 
through a certified fraud examiner training process to try to, 
again, develop and nurture that sort of attitude of 
professional skepticism of always trying to view every 
possibility of uncovering fraud.
    The Chairman. All right. And the idea that if I am the FCM 
and I am stealing out of my segregated account, and I send the 
NFA a falsified document, but, I am tracking what is actually 
there. I have been stealing from customers.
    Mr. Roth. Right.
    The Chairman. I send you the document that says, here is 
what I think is in the account. You get from the bank a 
confirmation that that is where I have stolen. But how do you 
catch me stealing from the account?
    Mr. Roth. Well, if you are claiming to have $200 million in 
the bank and the bank says that you have $5 million----
    The Chairman. I have that part. If I say I have $200 
million, and the bank says I have $200 million, but I really 
should have had $400 million.
    Mr. Roth. Yes. So that is when you are undercounting your 
assets and underreporting your assets, and what we do to try to 
address that issue is in the examination process we do 
confirmations with customers. So on a select basis.
    The Chairman. Okay.
    Mr. Roth. But you test certain customers and say the firm 
is reporting that you have X. Do you in fact have X? That can't 
be done on a daily basis, but it is part of the examination 
process.
    The Chairman. Right. I got you. I appreciate that.
    One question that we haven't really touched much on is the 
CFTC's attitude toward cost-benefit analysis on proposed 
rulemaking. David and I and, quite frankly, the Committee is 
working toward strengthening those cost-benefit analysis 
procedures at the CFTC. Can any of you or all of you comment on 
your experience with--not that we are going to retread or redo 
Dodd-Frank, but I have plenty of anecdotes where the CFTC said, 
here is what we think it will cost the industry or the 
participants to comply with this rule, and it has turned out to 
be a multiple of that number in most instances. Can you talk to 
us about what your attitude is about the cost-benefit analysis 
attitude at the CFTC and how they are mechanically going about 
it one more time?
    Mr. Roth. This may not be particularly helpful, but----
    The Chairman. Well, then, don't say it. Just kidding.
    Mr. Roth. The rulemaking process within NFA is that we 
develop rules and you are always trying to develop rules that 
are cost-effective, and we just get input directly from the 
industry. And as part of our rulemaking process when we have to 
deal with our advisory committees and our board of directors 
and we have to go to the industry professionals and say this is 
the public policy we are trying to achieve, this is how we are 
proposing to do it, they would give us real good and real 
direct input about what the costs are. So in NFA we get that 
input directly from the industry as part of the rulemaking 
process, and it is very, very helpful.
    The Chairman. But in terms of what the CFTC has done 
through the Dodd-Frank implementation and their ability to use 
cost-benefit as a part of their decision-making process as to 
what rules to put in place or what rules not to put in place, 
i.e., the residual interest information this morning, did the 
CFTC look at the concerns that you talked about as a part of 
their deliberations to get to their rule that they think is 
appropriate?
    Mr. Roth. I don't know what their internal deliberations 
were, but I can certainly tell you that they didn't have any 
contact with NFA where they asked us for our input on that 
topic.
    The Chairman. Mr. Duffy?
    Mr. Duffy. There has been a tremendous amount of comment 
letters filed on this particular issue, and obviously the 
Congressional testimony, so the final rule is yet to be voted 
on. So hopefully the cost-benefit analysis that you are 
referencing, they are taking all the comment letters along with 
this Congressional hearing and taking that into account, which 
will come up with a decision that is yet to be made. So 
hopefully, we are getting a little ahead of ourselves yet, and 
to Chairman Lucas' point earlier, we may not have a lot of 
faith, but at the same time we do need to let the process go 
through.
    The Chairman. All right.
    Other Members on the Committee have questions? Yes, David.
    Mr. David Scott of Georgia. Let me follow up a little bit 
on our bill, H.R. 1003, cost-benefit analysis, which is very 
important. The President in his Executive Order has ordered all 
those agencies to do cost-benefit analysis for rulemaking. The 
CFTC, being the primary regulator, or making joint rulemaking 
with the SEC, for example, they have assessment and cost-
benefit analysis before each. However, again, I just make this 
comment, that the CFTC doesn't have enough staff right now to 
do what it is that they are doing.
    And so I just urge each of you, and each of you have your 
own constituencies, that we have to increase the funding of the 
CFTC. If we don't, it is going to hurt all of us. No matter, we 
could pass all these bills and all these regulations that put 
it on it, and it needs to be. But this needs to happen, but we 
need to give the CFTC the tools with which to work right now. 
Right now they are bleeding people.
    So I just make an appeal to you in the industry to join 
with many of us here in these real tight budgetary times. Right 
now the government is shut down. Right now we are running the 
government by crisis. I mean, I don't know how long this is 
going to go on.
    But this is a primary example of what I am talking about 
that brings about the uncertainty, unassuredness that we have. 
And I always am taking the opportunity to push and hope people 
will hear, not like John the Baptist in the wilderness, but I 
guarantee you, I am asking for you all to join with me in that 
and say, look, doggone it, let's give the CFTC the money they 
need, not pour this load on them, so they can do the job that 
we absolutely need.
    And finally, the other reason we need this is to be able to 
put the CFTC in a stronger defense position for any lawsuits or 
legal activity, for if they had the cost-benefit analysis 
requirement to back themselves up, they would be more in a 
better position to sustain these outward charges and lawsuits.
    Yes, Mr. Duffy?
    Mr. Duffy. Mr. Scott, so I don't leave any misimpressions, 
I have been on the record and the CME has been on the record 
for many years that we do believe that the CFTC needs to be 
adequately funded. So we wholeheartedly support what you are 
saying.
    We have one of the more dynamic businesses in the United 
States. If you look at the growth rate of the listed 
derivatives, regulated derivatives business in the United 
States over the last 40 years, it has been just exploding, and 
it has benefited farmers, ranchers, bankers, all the different 
people--mortgage people--that use the marketplace. These are 
all benefits to the United States of America.
    So we agree with you wholeheartedly that it needs to be 
fully funded and it is absolutely essential to do so. So we 
echo your comments. And I hope we didn't leave the impression 
that we don't think it should be funded to a proper level.
    Mr. David Scott of Georgia. Thank you very much.
    Anybody else? Yes, Mister----
    Mr. Koutoulas. Ranking Member Scott, we agree also 
wholeheartedly that the CFTC needs adequate funding, especially 
when you contemplate the implementation of Dodd-Frank and 
essentially that the industry is building a new regulatory 
regime for cleared swaps essentially from scratch.
    I will give, I guess, an anecdote as to the attitude inside 
CFTC when it comes to managing funds, that we met with just 
about every Commissioner to discuss the conversion of MF 
Global's holding company to a Chapter 7. And we continuously 
got the response, why would you do that? Just let the trustee 
handle it. And, I mean, they just didn't seem to grasp how 
expensive relying on the three different trustees that were 
there in MF Global was. And after testifying last February at 
the roundtable on customer protections regarding residual 
interest, staff really did not seem to grasp just how expensive 
that proposal would be for the industry and how damaging it 
would be to the gentlemen on my left and right.
    I think a little bit of attitude adjustment is required, 
but more funding would go a very long way to helping them 
fulfill their mission.
    Mr. David Scott of Georgia. Thank you very much.
    Thank you, Mr. Chairman.
    The Chairman. I thank our witnesses.
    And, David, do you have any kind of closing remarks, 
anymore John the Baptist references or anything?
    Mr. David Scott of Georgia. This has been a very effective 
hearing and very enjoyable. I have learned a lot from it, and 
you did a good job in getting a great diversified group from 
different areas, although most of them are from Illinois.
    The Chairman. Well, I also want to thank all the witnesses, 
including the ones from Illinois. We will do a little better 
job of looking for Texas witnesses next time perhaps.
    But on a serious note, I appreciate each of you coming in. 
I know there was some uncertainty this week about whether or 
not we would have this hearing. There may be those out there 
that criticize Dave and I for going ahead and having this 
hearing in the face of the shutdown.
    It is our constitutional responsibility to reauthorize the 
CFTC. It is better off if we reauthorize it than if we don't, 
and this hearing is integral to that. We would not be able to 
get your comments and the written record established had we not 
had the hearing today, if we moved forward with the 
reauthorization at the pace that we are going to try to move 
forward with, so David and I made a decision to go ahead and 
hold the hearing. And I appreciate the witnesses taking their 
time to come share that with us this morning and look forward 
to folding your comments into our markup and the rules and the 
bill that we will do in terms of the reauthorization.
    So with those comments, I again thank the witnesses for 
being here. And under the rules of the Committee, the record of 
today's hearing will remain open for 10 calendar days to 
receive additional material and supplementary written responses 
from the witnesses to any question posed by a Member.
    This hearing of the Subcommittee on General Farm 
Commodities and Risk Management is adjourned. Thank you.
    [Whereupon, at 10:48 a.m., the Subcommittee was adjourned.]
    [Material submitted for inclusion in the record follows:]
 Submitted Letter by Hon. Frank D. Lucas, a Representative in Congress 
                             from Oklahoma
September 25, 2013

  Hon. Gary Gensler, Chairman;
  Hon. Bart Chilton, Commissioner;
  Hon. Scott O'Malia, Commissioner;
  Hon. Mark Wetjen, Commissioner;
  U.S. Commodity Futures Trading Commission,
  Washington, D.C.

    Dear Chairman Gensler and Commissioners Chilton, O'Malia and 
Wetjen:

    We write regarding concerns that have been brought to our attention 
with the Commodity Futures Trading Commission's (CFTC) November 14, 
2012, proposed rule to improve protections for futures customers. While 
we support your efforts to protect customers in the futures markets and 
believe the Commission's proposal contains needed reforms, we have also 
heard from a wide variety of farmers, ranchers and small-to-medium 
sized futures commission merchants (FCMs) who argue that parts of the 
rule could dramatically change their business models and prohibitively 
increase costs.
    We certainly recognize that the failures of MF Global and Peregrine 
Financial Group inflicted terrible losses on futures customers, many of 
whom were farmers and ranchers merely seeking to hedge their commercial 
risks. We are pleased that the CFTC, self-regulatory organizations, 
industry trade groups, FCMs, and market participants have worked 
together in the interim to strengthen customer protections.
    However, as you work to finalize the rule on customer protections, 
we ask that you weigh the benefits of these regulations against both 
the costs to America's farmers and ranchers and the potential impact on 
consolidation in the FCM industry. In making this determination, 
carefully consider the consequences of changing the manner or frequency 
in which ``residual interest''--the capital an FCM must hold to cover 
customer positions--is calculated. The goal of increasing futures 
customer protections should be to strengthen the markets without 
harming the ability of American farmers, ranchers, and end-users to 
hedge their legitimate business risks.
    Our Committees place a high priority on the concerns of the 
agricultural marketplace. We urge you to take these views into account 
as you review and vote on a final rule.
            Sincerely,
            
            




Hon. Frank D. Lucas,                 Hon. Debbie Stabenow,
Chairman,                            Chairwoman,
House Committee on Agriculture;      Senate Committee on Agriculture,
                                      Nutrition, and Forestry.


                                      
                                      




Hon. Collin C. Peterson,             Hon. Thad Cochran,
Ranking Minority Member,             Ranking Minority Member,
House Committee on Agriculture;      Senate Committee on Agriculture,
                                      Nutrition, and Forestry.


                                 ______
                                 
 Submitted Statements by Hon. K. Michael Conaway, a Representative in 
                          Congress from Texas
                       managed funds association
    Managed Funds Association (``MFA'') is pleased to provide this 
statement in connection with the House Agriculture Subcommittee on 
General Farm Commodities and Risk Management's hearing held on October 
2, 2013 on ``The Future of the CFTC: Perspectives on Customer 
Protections''. MFA represents the majority of the world's largest hedge 
funds and is the primary advocate for sound business practices and 
industry growth for professionals in hedge funds, funds of funds and 
managed futures funds, as well as industry service providers. MFA's 
members manage a substantial portion of the approximately $2.375 
trillion invested in absolute return strategies around the world. Our 
members serve pensions, university endowments, and other institutions.
    MFA's members are among the most sophisticated institutional 
investors and play an important role in our financial system. They are 
commodity pool operators (``CPOs'') and commodity trading advisors 
(``CTAs''), which are customers of futures commission merchants 
(``FCMs''). Our members are active participants in the commodity and 
securities markets, including over-the-counter (``OTC'') derivatives 
markets. They provide liquidity and price discovery to capital markets, 
capital to companies seeking to grow or improve their businesses, and 
important investment options to investors seeking to increase portfolio 
returns with less risk, such as pension funds trying to meet their 
future obligations to plan beneficiaries. MFA members engage in a 
variety of investment strategies across many different asset classes. 
The growth and diversification of investment funds have strengthened 
U.S. capital markets and provided investors with the means to diversify 
their investments, thereby reducing overall portfolio investment risk. 
As investors, MFA members help dampen market volatility by providing 
liquidity and pricing efficiency across many markets. Each of these 
functions is critical to the orderly operation of our capital markets 
and our financial system as a whole.
    MFA appreciates the Subcommittee's thoughtful review of and focus 
on customer protection issues. We supported financial reform and 
policymakers' goals to improve the functioning of the markets and to 
protect customers by endorsing central clearing of derivatives, 
increasing transparency and implementing other measures intended to 
mitigate systemic risk. We also appreciate that Congress remains 
vigilant about and has held hearings related to the MF Global, Inc. 
(``MF Global'') and Peregrine Financial Group, Inc. (``Peregrine'') 
insolvencies. Our members have investors in their funds; and are 
customers themselves, and therefore, we remain deeply troubled by the 
MF Global and Peregrine events and the consequences of their 
insolvencies.
    Accordingly, we support thoughtful legislative and regulatory 
changes to strengthen protections of customers. We believe some 
additional refinements to the Commodity Exchange Act (``CEA'') and the 
regulations of the Commodity Futures Trading Commission (``CFTC'') 
would further fulfill the Subcommittee's objective to enhance 
protections for customers.
    In these respects, we believe Congress should: (1) encourage the 
CFTC to finalize its proposed rules on enhancing customer protections 
with certain modifications intended to bolster the rules' efficacy; (2) 
amend the Bankruptcy Code to help shield the collateral of cleared 
swaps customers from another MF Global or Peregrine-like failure; (3) 
encourage the CFTC to repeal the prohibition on futures customers' use 
of third-party custodial accounts as a mechanism to protect their 
collateral; and (4) amend the CEA by adopting stronger protections for 
confidential information.
    MFA appreciates the Subcommittee's consideration of this written 
statement. As customers and active participants in the derivatives 
markets, we are committed to working with the Congress, the CFTC and 
other interested parties in addressing customer protection issues.
CFTC Rules on Enhancing Customer Protections
    MFA strongly supports the CFTC's issuance of proposed rules on 
enhancing customer protections (the ``Proposed Rules''),\1\ and the 
CFTC's efforts to ensure adequate protection of customers and their 
funds by augmenting the requirements imposed on FCMs and enhancing the 
oversight of FCMs. As customers in the derivatives markets, we applaud 
the CFTC for recognizing the potential weaknesses in the current 
customer protection regime and proposing thoughtful measures to 
increase the protection and confidence of customers. We ask the 
Subcommittee to support the CFTC in finalizing the Proposed Rules with 
certain modifications that we, as customers, believe would assist 
Congress and the CFTC in furthering its customer protection goals.
---------------------------------------------------------------------------
    \1\ 77 Fed. Reg. 67866 (November 14, 2012).
---------------------------------------------------------------------------
Residual Interest Requirement
    MFA agrees with the CFTC that the timely collection of margin is a 
critical component of an FCM's risk management program, and that it is 
important to require FCMs to bold sufficient funds to protect against 
insufficient margin in customer accounts. However, from a practical 
perspective, we are concerned about the CFTC's proposed residual 
interest requirement, which would require an FCM to maintain its own 
funds ``at all times'' in an amount sufficient to exceed the sum of all 
of its futures customers' margin deficits.
    MFA emphasizes that it supports the retention of the residual 
interest requirement. However, as proposed, the continuous ``at all 
times'' nature of the residual interest requirement would not provide 
FCMs sufficient time to collect margin from their customers. The 
unintended result for customers is that it could significantly increase 
our operational burdens and costs because, to ensure compliance with 
the residual interest obligation, FCMs might require their customers to 
pre-fund their margin obligations or to meet intraday margin calls.
    MFA views both of these outcomes as troubling and an unacceptable 
imposition on customers. In particular, it would create margin 
inefficiencies by causing customers to reserve assets to pre-fund their 
obligations or in anticipation of intraday margin calls, and thus, 
reduce the amount of assets that customers have to use for investment 
or other purposes.
    As a compromise, to preserve the residual interest requirement 
(which we agree is important) while avoiding the negative impact and 
burdens on customers, MFA recommends that the Subcommittee encourage 
the CFTC to finalize the Proposed Rules but modify the proposed 
residual interest requirement so that it is not a continuous real-time 
obligation, but rather a ``point in time'' obligation. We believe the 
appropriate ``point in time'' is close of business Eastern Time on the 
business day after the FCM issues a customer's margin call, which is 
consistent with current margin practices and infrastructure. This 
approach would eliminate the need for customer pre-funding or intraday 
margin calls, while also ensuring that FCMs hold sufficient funds to 
protect one customer from another customer's shortfall or margin 
deficit.
Disclosure of FCM Information to Customers
    MFA strongly supports the CFTC's proposals that would require FCMs 
to provide enhanced reporting and disclosure of certain information to 
customers and the public. Increasing the transparency of customers and 
the public into the operations, accounts, policies and procedures of 
FCMs is crucial because it would place customers in a better position 
to assess an FCM's stability, and if customers identify concerns and 
deem it appropriate, to transfer their positions and funds to a 
different FCM. Customers also would be in a better position to assist 
the CFTC and designated self-regulatory organizations (``DSROs''), that 
supervise FCMs for example, by alerting the CFTC or DSRO to customer 
concerns with the FCM or the FCM's decisions. Therefore, MFA believes 
that, in the aggregate, the enhanced disclosure in the Proposed Rules 
will give customers comprehensive information about FCMs' risks, and 
allow them to make meaningful judgments regarding the appropriateness 
of using a particular FCM.
    In light of the importance of FCM disclosures to customers and the 
public, MFA believes that additional public disclosure of certain FCM 
information (i.e., in addition to what the CFTC has proposed in the 
Proposed Rules) will be beneficial to the market. In particular, as the 
CFTC is finalizing the Proposed Rules, we ask the Subcommittee to 
encourage the CFTC to mandate that FCMs make publicly available each 
month their computations for, and compliance with rules related to, 
segregated customer collateral as well as FCMs' summary balance sheets 
and income statement information for the most recent twelve months.
    MFA believes that imposing such a public disclosure obligation on a 
monthly basis is important because an FCM's financial stability may 
change significantly in a short amount of time. Therefore, we believe 
less frequent disclosure to the public is insufficient from a customer 
protection perspective.
Protection of Customer Collateral
Protection of Cleared Swaps Customer Collateral
    MFA supports efforts to strengthen the legal framework applicable 
to collateral for customers related to cleared swaps transactions with 
FCMs. As mentioned, MFA remains concerned about the MF Global and 
Peregrine Financial insolvencies. The misuse or misplacement of 
customer funds in those situations resulted in customers experiencing a 
delay, in some cases a significant delay, in the return or outright 
loss of substantial amounts of their assets. Therefore, we believe that 
Congress should amend the Bankruptcy Code to bolster the protection of 
customer collateral.
    Under current law, if an FCM becomes insolvent, all of the 
collateral of the FCM's cleared swaps customers would be aggregated and 
distributed to each customer on a pro rata basis. Therefore, even when 
a customer was not at fault, if there is an insufficient amount of 
cleared swaps customer collateral available in the FCM's customer 
account to repay all customers who posted collateral, the customer 
would lose a portion of its posted collateral. To remedy this concern, 
we urge Congress to amend Chapter 7 of the Bankruptcy Code so that, 
upon an FCM's insolvency, customer assets posted as collateral on 
cleared swaps transactions would not be subject to pro rata 
distribution. Such an amendment would ensure that cleared swaps 
customers do not share in any shortfall due to the FCM's or another 
customer's default.
    An amendment to the Bankruptcy Code also would enhance the 
effectiveness of existing and potential segregation protections for 
cleared swaps customers. For example, the CFTC has adopted the 
``legally segregated operationally commingled'' model (``LSOC'') for 
cleared swaps, which should generally reduce the likelihood of there 
being a customer asset shortfall in certain FCM default scenarios. 
However, uncertainty remains as to how LSOC will perform in an FCM 
insolvency. An amendment to the Bankruptcy Code, as discussed above, 
would alleviate this uncertainty and further assure the protection of 
non-defaulting customers in certain FCM default situations.
    In addition, market participants are continuing to consider other 
enhancements to customer protections, such as optional full physical 
segregation of customer collateral. This arrangement would allow a 
customer to put its collateral in an account with a custodian or other 
third party in the customer's name, rather than have the customer's FCM 
hold its collateral directly, and thus, protects the customer in the 
event that its FCM or another customer becomes insolvent. Without a 
Bankruptcy Code amendment, however, a cleared swaps customer's 
physically segregated collateral might be considered part of the pool 
of customer assets of the insolvent FCM, and thus, distributed on a pro 
rata basis. Therefore, MFA believes that, if Congress amended the 
Bankruptcy Code, it would significantly enhance customer protection.
Protection of Futures Customer Collateral
    In light of the MF Global and Peregrine failures, MFA feels it is 
also appropriate for the CFTC to re-examine the protections available 
to participants in the futures market, and to assess the appropriate 
balance between the costs of enhanced protections versus the costs to 
investors and the market as a whole of a segregation failure. As 
mentioned, we appreciate that the CFTC is working on proposals to 
enhance customer protections. As a further step, we think that the 
Subcommittee should encourage the CFTC to hold one or more roundtables, 
as the CFTC did when considering segregation rules for cleared swaps, 
to ensure full consideration of the lessons learned, and to assess 
whether further protections of the collateral of futures customers are 
appropriate.
    In addition, MFA believes that the Subcommittee should encourage 
the CFTC to repeal CFTC Staff Segregation Interpretation 10-1 
(``Interp. 10-1''), which prohibits futures customers from holding 
their collateral in accounts at a third-party custodian, rather than 
with their FCM counterparty. Although the CEA already requires an FCM 
to maintain all customer collateral separate from the FCM's own funds, 
it is also important that futures customers have the right to maintain 
their collateral remotely from their FCM counterparties at a third-
party custodian. Allowing futures customers to use third-party 
custodial is an important step towards safeguarding customers' assets 
because those accounts would: (1) protect one futures customer from 
another futures customer's default; (2) protect futures customers from 
FCM operational and investment risk; and (3) facilitate the prompt 
transfer of futures customers' positions and collateral upon their FCM 
counterparty's default.
    Some of our members already have third-party custodial accounts in 
place in the OTC derivatives market for collateral they have posted on 
uncleared swap positions. Moreover, when the CFTC adopted LSOC for 
cleared swaps, the CFTC clarified that the prohibition on the use of 
third-party custodial accounts contained in Interp. 10-1 does not apply 
to collateral posted by cleared swaps customers. MFA believes that 
there is no difference between cleared swaps and uncleared swaps on the 
one hand and futures on the other that supports retaining Interp. 10-1 
for futures and limiting futures customers use of third-party custodial 
accounts. Rather, it is important that all customers have equal 
protection of their collateral regardless of what products they trade.
    Therefore, MFA requests that the Subcommittee encourage the CFTC to 
repeal Interp. 10-1 for futures and allow futures customers to use 
third-party custodial accounts to ensure that the collateral that 
futures customers post is protected in a manner that is robust and 
equal to the protections available to swaps customers.
Strengthening Protections for Confidential/Proprietary Information
Reports of Commodity Pool Operators and Commodity Trading Advisors
    MFA believes that Congress should strengthen the confidentiality 
protections for proprietary data in the CFTC's possession. MFA 
consistently has supported reasonable reporting requirements to ensure 
that regulators have meaningful data upon which to make sound policy 
decisions, but it is critically important that our members know that in 
fulfilling their reporting obligations, their proprietary portfolio and 
other confidential information is appropriately safeguarded. Market 
participants--whether hedgers or investors--invest significant 
research, time and resources into developing proprietary hedging or 
investment strategies. Such trading strategies are proprietary 
information; the CEA and other statutes have recognized the legitimate 
commercial need to protect the confidentiality of such information.
    At the same time that the Dodd-Frank Wall Street Reform and 
Consumer Protection Act of 2010 (``Dodd-Frank Act'') required members 
of the Financial Stability Oversight Council (``FSOC''), including the 
CFTC, to collect sensitive and confidential data for the purpose of 
assessing financial stability, it also included important provisions 
directing FSOC members to maintain the confidentiality of such data. 
The Dodd-Frank Act specifically amended the Investment Advisers Act of 
1940 to protect the confidentiality of reports that the SEC requires 
for SEC-registered investment advisers, but no corresponding amendments 
were made to the CEA for CFTC reports. Such amendments would be 
appropriate to ensure that consistent confidentiality protections would 
extend to the reports, documents, records and sensitive and proprietary 
information of CPOs and CTAs.
    The current inconsistency between the confidentiality protections 
afforded to reports by investment advisers as opposed to reports by 
CPOs and CTAs creates two potential difficulties. First, it may expose 
data from CFTC-regulated entities to greater risk of public disclosure. 
Second, it creates a potential unlevel regulatory playing field, 
disadvantaging the CFTC in its efforts to collect, analyze, and share 
data. For example, we note that the SEC and CFTC have jointly adopted 
Form PF for certain reporting obligations. A dually registered entity 
filing Form PF with the SEC would have greater confidentiality 
protection than if the entity filed the exact same report with the 
CFTC. To afford confidential information consistent treatment for CPOs 
and CTAs as well as investment advisers, we recommend that the 
Subcommittee consider amending section 8 of the CEA by extending these 
important Dodd-Frank Act protections for sensitive or proprietary 
information to CPOs and CTAs.
Protection of the Identity of Traders and the Confidentiality of Trade 
        Data
    MFA believes that Congress should amend the CEA to strengthen the 
confidentiality requirements for registered swap data repositories 
(``SDRs'') and other regulated market utilities, such as self-
regulatory organizations, swap execution facilities (``SEFs''), 
designated contract markets (``DCMs''), and derivatives clearing 
organizations or clearinghouses (``CCPs'') (collectively, ``Regulated 
Entities'') to protect customer information--specifically, the identity 
of traders and the nature of their trading activities. In particular, 
these confidentiality protections must explicitly extend to swap 
transaction data reported to SDRs under the CFTC's data reporting 
rules. Our concern is not hypothetical; we are aware of instances where 
the confidentiality of customer trade data at SDRs was compromised. As 
a result of the failure of confidentiality protections, market 
participants may have had access to, and could have traded upon, 
confidential information of competitors and counterparties.
    The specifics giving rise to these concerns are best illustrated 
under the CFTC's final SDR rules, wherein it is clear that an SDR must 
protect the confidentiality of reported swap data and may not disclose 
it to market participants. However, the same rules provide an exception 
to this prohibited access rule, allowing a party to a particular swap 
to have access to ``data and information'' related to such swap. The 
final SDR rules do not define the broad phrase ``data and 
information''.
    For swaps that are traded anonymously on DCMs and SEFs and then 
cleared in accordance with the CFTC's straight-through processing 
requirements, the CCP or DCM/SEF reports the swap transaction data and 
information to the SDR, which includes the identity of the two original 
counterparties. If either one of those counterparties is then permitted 
to discover the identity of the other by accessing information at the 
SDR, notwithstanding the anonymous nature of the original trade, the 
confidentiality of that market participant's trading positions and/or 
investment strategies is breached. Such disclosure would harm 
competition, and would impair the smooth transition to anonymous 
trading on DCMs and SEFs.
    Another source of data disclosure risk stems from the sheer volume 
of data that the CFTC is now processing and analyzing from SDRs. While 
the CFTC's access to such data no doubt presents an opportunity for 
unprecedented regulatory insight into the derivatives markets--which we 
support--we are also mindful that it creates another source of 
disclosure risk if data confidentiality and integrity are not 
rigorously protected by the CFTC's policies, procedures and internal 
controls.
    Accordingly, MFA recommends that Congress amend the CEA to clarify 
the CFTC's and each Regulated Entity's obligations to maintain the 
confidentiality and integrity of swap trade data and the consequences 
of failures to perform this obligation. MFA further urges the 
Subcommittee to use its oversight to ensure that both the CFTC and 
Regulated Entities have appropriate safeguards to preserve the 
confidentiality of sensitive customer information and data furnished to 
regulators and Regulated Entities.
    Finally, we are alarmed at reports from this spring that academics 
have had access to confidential trading data and trading messages from 
the CFTC. According to these reports, the academic used this 
information to reverse-engineer trading strategies and published their 
findings in academic journals. We commend CFTC Chairman Gary Gensler 
for requesting that the CFTC Inspector General investigate this matter. 
We believe this disclosure is a fundamental violation of 
confidentiality and urge the Subcommittee to review the CFTC Inspector 
General's findings and the steps the CFTC agrees to take to enhance its 
policies and controls with respect to non-public information.
    MFA has prepared a White Paper outlining its concerns regarding 
protection of confidential information and submitted it to all members 
of the Financial Stability Oversight Council. We include a copy of that 
White Paper as an Appendix * to our testimony.
---------------------------------------------------------------------------
    * The document referred to is retained in Committee file. It can 
also be found at https://www.managedfunds.org/wp-content/uploads/2013/
05/MFA-Data-Confidentiality-paper-final-5-22-13.pdf.
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Conclusion
    MFA appreciates the Subcommittee's focus on, and the CFTC's efforts 
to enhance, the protection of customers. To further this effort and 
strengthen these protections, we believe that Congress should encourage 
the CFTC to finalize the Proposed Rules with certain modifications, 
amend the Bankruptcy Code to protect cleared swaps customer collateral, 
encourage the CFTC to repeal the prohibitions in Interp. 10-1 for 
futures, and provide stronger protections for customers' confidential 
information. MFA is committed to working with Members and staff of the 
Subcommittee as well as regulators to ensure that customer protections 
under our legislative and regulatory system are appropriately robust, 
extensive and effective.
    Thank you for the opportunity to provide you a written statement of 
MFA's views on customer protection issues. MFA would be happy to answer 
any questions that you may have.
                                 ______
                                 
                      state street global exchange
    State Street is pleased to submit this statement in connection with 
the House Agriculture Subcommittee on General Farm Commodities and Risk 
Management's hearing held on October 2, 2013 on ``The Future of the 
CFTC: Perspectives on Customer Protections.''
    As an initial comment, I commend Chairman Conaway, Ranking Member 
Scott, and the Subcommittee for the careful consideration of customer 
protection issues and how the future decisions by the Commodity Futures 
Trading Commission (``CFTC'') will impact the markets.
    State Street is one of the world's largest custodial banks and 
processors of derivatives transactions, and we support regulations 
which will benefit our customer base of large, buy-side, institutional 
investors, such as pension funds, mutual funds, and endowments. We 
support regulations designed to enhance customer protections in the 
event of a failing futures commission merchant (``FCM'').
    State Street believes a customer should have the opportunity to opt 
for greater protection of its cleared swaps and futures collateral in 
the event of an FCM bankruptcy by electing to hold collateral in a tri-
party custodial account that is exempt from pro rata distribution in 
the event of an FCM failure. This type of account fully segregates a 
customer's collateral by placing it in a specified account with a 
custodian rather than being in the FCM's customer omnibus account. This 
creates a solid protection of those funds in the event of attempted 
misuse or fraud by the clearing member such as those recently 
experienced during the failures of MF Global and PFG Best. However, 
without a change to the Bankruptcy Code, it does not protect those 
funds in the event of bankruptcy of the FCM. In order to provide the 
fullest protection offered by a tri-party custodial account, the 
Bankruptcy Code must be amended to exempt collateral held in such an 
account from the definition of ``customer funds'' and, therefore, from 
pro rata distribution in the event of the bankruptcy of an FCM.
    As an initial matter, implementation of a robust customer 
protection framework requires both regulatory and legislative action. 
On the regulatory front, tri-party accounts are permissible for cleared 
swaps under CFTC rules, permissible for uncleared swaps, and 
permissible for both futures and swaps in Europe. These accounts have 
proven effective in offering enhanced protections for customer funds 
across these markets. However, tri-party accounts are not currently 
permitted in the U.S. futures market per CFTC Amendment to Financial 
and Segregation Interpretation No. 10-1, making them an outlier from 
how the rest of the world's derivatives markets function. State Street 
strongly supports permitting the use of tri-party accounts in futures 
for the same reasons as it is permitted in uncleared and cleared swaps 
and, therefore, believes the CFTC should repeal Interpretation No. 10-
1. We have submitted a formal comment letter supporting this repeal to 
the CFTC and continue to work with the Commission as it evaluates how 
best to address the issue.
    On the legislative front, a statutory change is also required to 
offer the fullest level of protection possible for customer funds 
through tri-party accounts. The CFTC's legally segregated operationally 
commingled (``LSOC'') release noted that Bankruptcy Code Section 766(h) 
(which provides for pro rata distribution) likely would apply to swaps 
customers. If the LSOC model performs as designed, any losses created 
by a customer default will be absorbed by the derivatives clearing 
organization (``DCO'') rather than the non-defaulting customers of the 
FCM, and non-defaulting customers would be expected to receive their 
full account equity in the FCM's bankruptcy distribution. However, 
losses caused by FCM theft or market losses on investments of customer 
funds would be subject to pro rata distribution in bankruptcy and would 
thus affect all FCM customers.
    It is of utmost concern to State Street that customer funds held in 
a tri-party custody account could be subject to pro rata distribution 
without a change to the Bankruptcy Code. That means that a customer 
availing itself of the opportunity to increase protection of its 
collateral by using a tri-party account could still see its funds 
distributed in the event of an FCM bankruptcy because those funds, 
without a change to the Bankruptcy Code, are considered ``customer 
funds.'' Individuals with these accounts will not benefit from the full 
protections that tri-party arrangements could offer if the funds are 
subject to such distribution. Therefore, to ensure that the customers 
and the benefits tri-party accounts offer are protected, we believe 
that the Bankruptcy Code should be amended to exclude collateral held 
in tri-party custody accounts from the customer funds that are subject 
to pro rata distribution in the event of an FCM failure.
    Again, State Street strongly believes in the importance of 
protecting customers from another customer or an FCM default. We are 
willing to assist the Subcommittee in any way possible to ensure that 
customer funds held in tri-party custodial accounts are protected to 
the fullest. Thank you for the opportunity to provide you a written 
statement of State Street's views on customer protection issues. State 
Street would be happy to answer any questions that you may have.
                                 ______
                                 
                          Submitted Questions
Response from Hon. Terrence A. Duffy, Executive Chairman and President, 
        CME Group, Inc.
Questions Submitted By Hon. K. Michael Conaway, a Representative in 
        Congress from Texas
    Question 1. Mr. Duffy, as we all know, the failures of MF Global 
and PFGBest deeply rattled confidence in the futures markets. To the 
extent you are able, could you please update the Committee on the 
status of the return of customer funds, and please describe the CME's 
role in facilitating or expediting this process?
    Answer. MF Global: Status of return of customer funds:

    CME Group (``CME'') understands that, on November 6, 2013, the 
Bankruptcy Court granted the motion of James Giddens, Trustee for the 
liquidation of MF Global Inc. (``MFGI''), for an advance of funds from 
the general property of MFGI in order to permit 100% payment of all 
commodity customer account claims, and that a related motion is now 
pending in the District Court. Former officers of MFGI and others have 
appealed the Bankruptcy Court's decision, and the Trustee has recently 
indicated that ``the appeal of the allocation motion [is] the only 
barrier to 100 percent recovery by every single commodities and 
securities customer.''
    We further understand that in the interim, the trustee is 
continuing to make additional distributions to customers using customer 
funds as they become available to him. It is our understanding that 
most customers who traded on U.S. exchanges (4d) have received a 98% 
distribution, and most customers who traded on foreign exchanges (30.7) 
have received a 78% distribution.

    CME Group Efforts:

    Our efforts in the wake of MFGI's misconduct speak to the level of 
our commitment to ensuring our customer's confidence in our markets and 
our role in facilitating the return of customer funds:

   Guarantee for SIPC Trustee. CME Group made an unprecedented 
        guarantee of $550 million in order to accelerate the 
        distribution of funds to customers, thereby giving the trustee 
        and Bankruptcy Court comfort that interim distributions to 
        customers could be authorized without waiting for a 
        reconciliation of MFGI's customer records and claims.

   CME Trust Pledge. CME Trust pledged virtually all of its 
        capital--$50 million--to cover potential customer account 
        losses due to MFGI's misuse of customer funds.

   Customer Distributions. CME personnel invested thousands of 
        hours developing and implementing an unprecedented plan to 
        transfer MFGI customer accounts and related customer assets to 
        other commodity brokers, as well as making the interim 
        distributions of customer assets that were authorized by the 
        Bankruptcy Court and trustee in 2011. CME also was able to 
        deliver to the trustee in a usable format the significant 
        customer account reconciliation and transfer data that CME 
        accumulated as part of this process, thus helping the trustee 
        to resolve customer claim amounts on a highly expedited basis.

   2012 Agreement with MFGI Trustee. On August 12, 2012, the 
        Bankruptcy Court approved an agreement between the trustee and 
        CME Group that provided for the distribution of approximately 
        $130 million of MFGI proprietary assets, on which CME and its 
        members otherwise held superior claims, to MFGI customers. As 
        part of that agreement, CME agreed to subordinate its otherwise 
        valid claims to all claims of MFGI customers until they were 
        paid in full.

   2013 Agreements to Expedite Payments to Customers. On 
        November 6, 2013, CME Group, the Customer Class Representatives 
        in the ongoing MFGI multi-district litigation, and trustee 
        announced agreements that will further help expedite payments 
        to MFGI's former customers. Of the $29 million claim CME will 
        be allowed to assert against MFGI after all customers are paid 
        in full, which claim is based on unpaid obligations and 
        expenses incurred by CME as a result of MFGI's bankruptcy, CME 
        has agreed to deliver $14.5 million, \1/2\ of the distribution 
        that it will receive from the trustee, to the Customer 
        Representatives for distribution to MFGI's former customers. 
        The agreements are subject to court approval before they can 
        become effective.

   CME Group Family Farmer and Rancher Protection Fund. On 
        April 2, 2012, CME Group launched the CME Group Family Farmer 
        and Rancher Protection Fund to protect family farmers, family 
        ranchers and their cooperatives against losses of up to $25,000 
        per participant in the event of future shortfalls in segregated 
        funds. Farming and ranching cooperatives also will be eligible 
        for up to $100,000 per cooperative.

    PFG: Status of the Return of Customer Funds:

    As you may know, Peregrine Financial Group Inc. (``PFG'') was not a 
CME clearing member, and traded on CME Group exchanges through accounts 
maintained at a CME clearing member. The National Futures Association 
(``NFA'') was PFG's designated self-regulatory organization, or DSRO.
    According to the bankruptcy trustee's Status Report of August 8, 
2013 (published on the NFA website (www.nfa.futures.org)), in the fall 
of 2012, the trustee made an interim distribution which represented a 
return of approximately 30% to all domestic futures (4d) customers and 
40% to all foreign futures (30.7) customers. The trustee anticipates 
another interim distribution in the near future.
    In addition, even though PFG was not a CME clearing member, CME 
determined to permit family farmers and ranchers who maintained 
accounts at PFG to submit claims to the CME Group Family Farmer and 
Rancher Protection Fund. Eligible family farmers and ranchers received 
payments of up to $25,000 per loss, and more than $2 million was 
distributed by the CME Group Family Farmer and Rancher Protection Fund 
to family farmers and ranchers who had accounts at PFG.

    Question 2. Mr. Duffy, in order to provide customers with increased 
protections without possibly eliminating an entire segment of the 
marketplace that has served farmers and ranchers for decades, what 
should a revised version of the CFTC's rule look like?
    Answer. CME Group and the agricultural community opposed the 
residual interest rule proposed by the CFTC because it would have 
required futures commission merchants (``FCM'') to insure that each 
customer's account is fully collateralized ``at all times,'' which 
cannot be calculated in real time. Firms would have been required to 
double their customers' margin requirements or to contribute very large 
sums as ``residual interest'' on their behalf. The rule would have made 
business unsustainable for many firms that serve the agricultural 
community, and might have deprived them and their customers of access 
to futures markets. We and many others supported a compromise to permit 
an FCM to calculate and meet its required residual interest as of 6:00 
p.m. ET the next day.
    We are pleased that the 6:00 p.m. ET next day deadline is the 
approach adopted by the CFTC in the final rule beginning next November 
2014. But we continue to oppose the portion of the final rule that will 
eventually move this deadline to 7:30 a.m. CT the next day. This change 
will happen automatically at the end of the rule's 5 year phase-in 
unless the Commission acts by rulemaking to propose a different 
deadline. But the rule does not compel the CFTC to take any action, or 
even to consider the results of its self-mandated study on the rule's 
impact, before the 7:30 a.m. CT deadline is implemented.
    The final rule, which seems to pre-determine the outcome of the 
study, dismisses our concerns that the rule will adversely impact 
customers and fundamentally change the way in which futures markets 
operate without justification from a risk management standpoint or 
otherwise. These concerns have been echoed by others in our industry, 
participants in our agricultural markets and Members of Congress alike.
    If this rule is automatically implemented in 5 years' time without 
change, practically, the firms that serve the agricultural community 
will have no ability on that ``next day'' to receive payments from 
customers who are promptly meeting their margin calls. They will have 
no choice but to require their customers to prefund margin or 
contribute residual interest on their behalf in order to comply with 
the morning deadline. This will unnecessarily increase the costs of 
hedging especially for farmers and ranchers using our markets. We will 
have achieved no balance between the CFTC's aim to further protect 
customers and the rule's adverse impact on customers and market 
structure.
Response from Christopher L. Culp, Ph.D., Senior Advisor, Compass 
        Lexecon
Questions Submitted By Hon. K. Michael Conaway, a Representative in 
        Congress from Texas
December 3, 2013

  Hon. K. Michael Conaway,
  Chairman,
  Subcommittee on General Farm Commodities and Risk Management,
  Committee on Agriculture,
  Washington, D.C.

    Dear Chairman Conaway:

    Thank you for providing two supplemental questions for the record 
regarding my testimony at the public hearing held on October 2, 2013 
(``The Future of the CFTC: Perspectives on Customer Protections''). My 
responses to your questions are below.

    Question 1. According to your testimony, your analysis suggests it 
would take 55 years for a government mandated SIPC-like fund to reach a 
target amount of $2.5 billion, and would in fact not even reach the $1 
billion mark until 2041. What would happen to the timeframe of reaching 
these benchmarks if the FCM industry is consolidated or fewer customers 
participate in the markets to manage their risks?
    Answer. Our calculations were based on the following assumptions: 
(i) the Futures Investor and Customer Protection Corp. (``FICPC'') Fund 
would not experience any claims resulting from failures of under-
segregated FCMs over the projection period; (ii) assets in the FICPC 
Fund would be continuously reinvested at a rate of two percent per 
annum; and (iii) total annual contributions to the FICPC Fund by all 
futures commission merchants (``FCMs'') would be $25,521,389 (based on 
the actual annual gross revenues for 2012 reported by all FCMs) and 
these funds would be contributed once each year.\1\ Under these ``base 
case'' assumptions, the FICPC Fund would not exceed $1 billion until 29 
years after its inception and would not reach its target funding level 
of $2.5 billion until 55 years after its inception.\2\
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    \1\ Specifically, 0.5 percent of gross revenues from commodities 
across all FCMs reporting positive gross revenues for the year 2012 was 
$25,521,389.
    \2\ In this instance, I round the estimated 54.58 years up to 55 
years.
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    As your question suggests, assumption (iii) depends on gross 
revenues from commodities for FCMs remaining constant over the 
projection period, which might not be the case. If increases in 
transaction costs (e.g., the costs to FCMs of mandated FICPC 
contributions that are passed along to customers) precipitate a 
reduction of customers that manage their risks with futures, gross 
revenues of FCMs would almost certainly decline, which would result in 
smaller total contributions to FICPC and an even slower rate of 
accumulation of assets in the FICPC Fund.
    For example, a $1 million reduction in annual contributions to 
FICPC (i.e., a $200 million reduction in total gross revenues from 
commodities across all FCMs) would increase the time for FICPC to 
achieve its target funding threshold by approximately 1 year. In other 
words, with $24,521,389 in total funds paid in by FCMs each year (i.e., 
$1 million less than 2012 levels), the FICPC Fund would not have more 
than $1 billion in assets until 30 years after its inception (as 
compared to 29 years based on actual 2012 gross revenues) and would not 
reach its target $2.5 billion funding amount until 56 years after its 
presumed 2013 inception (as compared to 55 years in the base case).
    The larger the reduction in aggregate gross revenues from 
commodities across FCMs, the more pronounced is this effect. For 
example, if aggregate gross revenues from commodities across all FCMs 
fell by $5 million vis-a-vis 2012 levels, it would take 34 years for 
the FICPC Fund to cross the $1 billion threshold (i.e., 5 years longer 
than the base case) and 62 years to reach the $2.5 billion threshold 
(i.e., 7 years longer than the base case). And if aggregate gross 
revenues from commodities for all FCMs is $10 million lower than 2012 
levels, FICPC would not reach its target funding amount of $2.5 billion 
for 72 years.
    You also asked about the potential impact of consolidations across 
FCMs. In principle, if such consolidations do not result in a loss of 
customers, total gross revenues from commodities (and, hence, total 
FICPC contributions) would only change to the extent that different 
FCMs have different fee structures. If consolidations precipitate a 
change in gross revenues (either as a result of changes in numbers of 
customers, changes in per-customer fees, etc.), FICPC contributions 
would change accordingly. Without knowing how consolidations would 
impact gross revenues, however, it is difficult to say what the net 
impact would be.

    Question 2. Dr. Culp, can you please help the Committee better 
understand the ``first-loss layer'' component of the risk retention 
group option to protect futures customers--does that mean that the FCM 
industry would come together as a group to pay the first layer of 
losses up to a certain point if an FCM failed in the future? Would the 
amount of losses be predetermined, or depend on the size of the 
failure?
    Answer. The first-loss layer is essentially a deductible on the 
reinsurance policy that an industry FCM captive or risk retention group 
would purchase. In the proposal submitted by the Futures Industry 
Customer Asset Protection Co. (``FICAP''), the reinsurance syndicate 
would provide $250 million in total reinsurance in excess of the first 
$50 million in payments made by FCMs participating in the FICAP risk 
retention group. This amount does not depend on the size of the loss 
and is a fixed amount based on the reinsurers' assessments of the 
underlying risk exposure.
    Under this scenario, only customers of FCMs participating in FICAP 
would be eligible to receive customer asset protection insurance 
(``CAPI'') coverage. Suppose ten FCMs agreed to participate in the 
FICAP risk retention group. Under the terms of the FICAP proposal, 
customers of any one of those ten FCMs that fails while under-
segregated would have access to a maximum of $50 million per FCM 
failure up to a total maximum across all FCM failures in one policy 
year of $300 million. The first $50 million in losses arising from the 
failure of one or more of those ten FCMs would be paid by the FICAP 
risk retention group. The reinsurance would then cover all losses in 
excess of the first $50 million per policy year up to $300 million.
    For example, suppose one FCM of the ten that participate in FICAP 
fails while under-segregated, and that failure results in a total loss 
of customer assets (after recoveries by the bankruptcy trustee) of $25 
million. Customers of that failing FCM would be fully covered for the 
$25 million in losses. Those $25 million of CAPI claims would be in the 
first-loss layer. FICAP thus would have to pay that $25 million out of 
its own resources; the reinsurance would not cover any of those losses. 
By contrast, suppose two FCMs fail in a single policy year, and that 
losses at each FCM equal $50 million (after recoveries), or a total of 
$100 million in losses for FICAP participating FCMs. In that case, the 
first $50 million of claims would be paid by FICAP out of the first-
loss retention, and the next $50 million would be paid by the 
reinsurance.
    As to your question, the first $50 million in losses in the first-
loss layer would likely be financed by a combination of paid-in capital 
contributions of the FCMs participating in FICAP and loans to FICAP 
from external investors. FCMs and other futures industry market 
participants that are not participants in FICAP would not be 
responsible for covering any of the $50 million first-loss layer. Only 
those FCMs whose customers have CAPI policies written by FICAP would be 
required to provide part of the $50 million first-loss layer.
    The FICAP proposal did not indicate exactly how much of the $50 
million first-loss layer would have to be financed with capital 
contributions from the participating FCMs. The reinsurers would insist 
on some commitment of funds by participating FCMs to the first-loss 
layer in order to align the incentives of participating FCMs with the 
reinsurers and to encourage prudent risk management. Yet, the FICAP 
proposal indicated that there is interest by outside investors to loan 
the FICAP entity a portion of the $50 million. This means that small 
FCMs with relatively small capitalization levels would not need to pre-
fund the entire first-loss layer. Regardless of the proportion of the 
first-loss layer funded by FCMs participating in the captive vis-a-vis 
the proportion financed by external investors, FCMs that do not 
participate in FICAP and whose customers do not benefit from the CAPI 
coverage provided by FICAP would not be required to contribute anything 
to cover any CAPI payments or FICAP losses.

    Chairman Conaway, please do not hesitate to ask for further 
clarification if my responses above are unclear or to pose any 
additional questions. I appreciated the opportunity to testify before 
your Subcommittee and welcome the opportunity to provide any further 
information you would like to review in your analysis of these issues.
    With my best regards, I remain
            Yours sincerely,
            
            
Christopher L. Culp, Ph.D.
Response from Michael J. Anderson, Regional Sales Manager, The 
        Andersons Inc.; on behalf of National Grain and Feed 
        Association
Question Submitted By Hon. K. Michael Conaway, a Representative in 
        Congress from Texas
    Question. Among your recommendations to improve customer 
protections are that the CFTC should have the ability to appoint its 
own trustee in the event of an FCM bankruptcy. Why is this important?
    Answer. Our recommendation in no way is intended as a criticism of 
the trustee in the MF Global situation. To the contrary, we believe 
James Giddens and his staff have done excellent work recovering futures 
customer funds and distributing them back to their rightful owners. 
Rather, we believe it would be advantageous in a situation like MF 
Global where the vast majority of assets affected were those of futures 
customers to have authority to appoint a trustee familiar with the 
futures industry and issues faced by futures customers.

                                  
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