What I do not own, I cannot spend. Maybe one of the most fundamental principles of life and basic budgeting. Even a 5-year-old knows that if you cannot afford it, you cannot have it. But what about money that is not mine and I still manage? Is it a grey area?
Tuesday saw the CFTC trying to make rules against financial institutions from using their client’s money to pay off the obligations of the company itself. Things do get murky when one thinks whether the money spent is going to help the clients in some manner. Still, it should be a choice that clients make and they should be consulted or permission should be asked before their money is used. To the lay man it might seem a little odd considering that the money that was supposed to be used for the client is being used by the institution with their discretion. But if we analyse any run of the mill bank, it works the same way. Depositors put their money into the bank and then it is loaned out to borrowers.
For a financial institution, it is more important to keep this money cycle going where the finances from one client can be loaned out to a borrower. Consider a simple day where Mr. X opens up an account at PF Group. (PF is just being used as an example. Not because it actually went down. Similarity to any actual organisation is purely ironic). Now Mr. Y calls up the same company and asks to buy some shares for him and, as he is low on cash, he would like to leverage the position. This way his returns are magnified when he puts down little money up front. The company gets to earn brokerage and interest on the trade and Mr. X gets part of the profit in interest returns for money that would have earned nothing in other circumstances. This situation becomes even better in futures market where trade takes place at the end of the month so the borrower has more time to either cover his losses or make money on the trade. In regular market, money changes hands after two days.
This might seem to be a catch 22 situation. Should an institution should try to sell off its clients and stays afloat in order to keep running or to risk going down itself for the betterment of the whole investment community? The simple answer will always be to show the true picture to the clients and tell the position as it stands. Markets go up and markets go down. That’s a given. Clients expect to lose money now and again and this is part of the equation which they do understand. But what they don’t expect is to be lied to and shown a rosy picture while their money is actually disappearing and losing. And then suddenly when their 401k or their life savings are gone, that’s when people like Russell Wasendrof Sr. come forward and apologise for their company going bust. The stance of the CFTC also supports this. They want to assure investors not that they will always make money; but that they will know where their money is and how safe it is.
The chief of CFTC has already accepted the fact that regulatory system had failed which caused investors to lose money in the futures market on the back of a failure of MF Holdings and PF Group in the last month. Both of them led to billions of client’s money being lost and more importantly investors confidence suffering. The loss of money has been so dire that Wasendorf cannot even afford a lawyer now and is at the mercy of the state providing him one. Gensler, chief of CFTC, accepted that there were loopholes that were being used by financial institutions to game the system and leave it unregulated. He has said that regulators took their eyes of the ball and, just like police cannot stop every robbery, regulators cannot detect every financial fraud. Yes sir, it is difficult to regulate but when a burglar is caught, he gets five to ten years for robbing a few thousand dollars. Mr. Wasendorf would probably get the same or lower sentence in a minimum security prison for stealing billions and destroying the trust of the clients in the process.
Now, in order to protect the investors, rules are being proposed which include giving the regulators direct access to the broker’s bank and custodial account. This will deter the broker from doing anything which raises red flags. New laws are needed and they need to be implemented as quickly as possible. Old rules are archaic and obsolete and so new rules have to be put in place which counter the situation in a better manner. Old rules did less to police the system or appease the investors. What ended up happening was that Peregrine Financial Group had to keep a finger on the pulse of the markets. And a hand in their client’s pockets…