Customer protection: segregated funds, risk disclosure

When you open a futures account, your money goes to a futures commission merchant (FCM). Two sets of rules protect you before you ever place a trade: segregation, which controls where your money sits, and risk disclosure, which makes sure you were told the risks in writing first.

Segregation: your money is not the firm’s money

The Commodity Exchange Act (Section 4d(a)(2), 7 U.S.C. 6d) says an FCM must treat customer money as belonging to the customer. It must be separately accounted for and not commingled with the FCM’s own funds.

CFTC Regulation 1.20 turns that into practical rules:

• The FCM must separately account for customer funds and segregate them as belonging to its customers.
• The segregated accounts must hold enough, in total, to cover what the FCM owes all of its futures customers.
• The accounts must carry a name that clearly identifies them as futures customer funds held in segregation.
• The money may be deposited with a bank or trust company, a derivatives clearing organization (a clearinghouse), or another FCM.
• The FCM may not mix customer funds with its own money or its proprietary accounts, and may not use them to secure or guarantee its own obligations.

Pooled with other customers, but never used for them

Segregation does not mean every customer has a private bank account. The statute allows customer funds to be commingled with each other “for convenience” in the same account at a bank or clearinghouse.

The line that cannot be crossed is in Regulation 1.22: an FCM may not use one customer’s funds to purchase, margin, or settle the trades of, or extend credit to, anyone other than that customer.

A worked example

Made-up numbers, for illustration only:

Both deposits sit in one segregated account labeled as customer funds, so the account started at $15,000.

• B’s loss uses up B’s $5,000. B now has a deficit of $2,000.
• The FCM may not use any of A’s $10,000 to cover B. That would be using one customer’s money for another (1.22).
• The segregated account must still hold enough to cover everything owed to customers, so A’s $10,000 has to be there in full (1.20).
• Regulation 1.23 lets the FCM add its own money to the segregated account to keep it from becoming undersegregated, and if the FCM finds the account short, it must immediately deposit enough to bring it back into compliance (1.23(a)(2)). That added money is the FCM’s “residual interest” in the account, not customer money.

What segregation does not do

Segregation is protection, not insurance. The CFTC risk disclosure statement in Regulation 1.55(b) tells every customer plainly that funds deposited with an FCM are:

• not protected by insurance if the FCM goes bankrupt or the money is misappropriated,
• not protected by the Securities Investor Protection Corporation (SIPC), and
• generally not guaranteed or insured by a clearinghouse.

The risk disclosure statement

Regulation 1.55(a) says an FCM (or, for an introduced account, the introducing broker) may not open a futures account for a customer unless it first gives the customer the written risk disclosure statement and receives an acknowledgment signed and dated by the customer saying they received and understood it. The wording of the statement is written into the regulation itself, in 1.55(b).

It opens by saying the risk of loss in futures can be substantial, so you should consider whether trading is suitable for you in light of your circumstances and financial resources. Among the points it covers:

• You may lose all the funds you deposit, and losses can go beyond that amount.
• Funds are not insured and not SIPC protected (see above).
• FCMs commingle customers’ funds in one or more accounts, and you may be exposed to losses incurred by other customers if the FCM does not have enough capital to cover them.
• In some market conditions, such as a limit move, it may be difficult or impossible to exit a position.
• A spread position may not be less risky than an outright long or short.
• Leverage can work against you as well as for you.

Two related rules:

• Institutional customers: under 1.55(f), an FCM may open an account for an “institutional customer” (as defined in Regulation 1.3) without giving the statement or getting the acknowledgment.
• Firm-specific disclosure: under 1.55(i), before it enters into a customer account agreement or first accepts funds from a customer, an FCM must also disclose information about itself (its business, operations, risk profile, and affiliates) that would be material to a customer deciding to trust it with funds, updated at least annually.

Knowing the customer (NFA Rule 2-30)

NFA Compliance Rule 2-30 applies to individual customers and other customers who are not eligible contract participants. At or before the time the customer first opens the account, the firm must use due diligence to obtain the customer’s true name, address and principal occupation; estimated annual income and net worth; approximate age or date of birth; and previous investment and futures trading experience. If the customer declines to give the information, the firm records that they declined. The firm must also provide the required risk disclosures, including the 1.55 statement when Regulation 1.55 requires it.

Key ideas

• Segregation: customer money belongs to the customer, is separately accounted for, sits in clearly labeled accounts, and never mixes with the FCM’s own money.
• Customers’ funds may be pooled together, but one customer’s money can never margin or settle another customer’s trades.
• An FCM may add its own money to the segregated account to keep it fully funded (residual interest), and must deposit more at once if it finds the account short.
• Futures deposits are not insured and not SIPC protected.
• The 1.55 risk disclosure statement must be given, and a signed, dated acknowledgment received, before the account opens. Institutional customers are exempt.
• Rule 2-30 requires the firm to collect basic financial and experience information from individual customers.