Futures Industry Releases Futures Insurance Study
Commentary by Bob Zwirb
CME Group, Futures Industry Association ("FIA"), and The Institute for Financial Markets, and National Futures Association ("NFA") announced the release of a study on the economic feasibility of adopting an insurance regime for the U.S. futures industry. The study was conducted by Compass Lexecon, a consulting firm, by examining four models for providing customer asset protection insurance ("CAPI") for losses arising from the failures of futures commission merchants ("FCMs"). The study involved developing quantitative estimates for the potential costs of two models in particular, based on customer data provided by six FCMs ranging in size from large to small as well as risk exposure data provided by CME and NFA. The four CAPI models were as followed:
- CAPI provided to individual futures customers by primary insurance carriers;
- CAPI provided to customers of individual FCMs that purchase insurance on behalf of all of their customers;
- CAPI provided to customers of FCMs opting to participate in a captive insurance company backed partially by reinsurance; and
- CAPI provided to all customers of all FCMs under a government mandate.
The study found that the first two scenarios were too cost-intensive, so the analysis was then targeted to the last two models. The study found that for private, voluntary CAPI, there is an interest and willingness on the part of reinsurers to offer CAPI to U.S. futures customers through an FCM Captive that would absorb the first loss layer. As for the government-mandated CAPI, it was concluded that a Futures Investor and Customer Protection Corporation ("FICPC") fund would be significantly underfunded to meet its target funding level. In order to be adequately funded, a "significant taxpayer-backed government backstop would be necessary" to supplement the envisioned paid-in capital of the FICPC.
See: Customer Asset Protection Insurance for U.S. Futures Market Customers; Joint Press Release.
Commentary
The fact that this study was sponsored by NFA and the Institute for Financial Markets, two entities with no axes to grind on the question, gives the study a good deal of credibility. Moreover, it is a serious study performed by one of the most talented economic consulting firms in the nation, one that was started by a group from the University of Chicago. Further, the study was directed by Christopher Culp, one of the nation's leading economic experts on financial derivatives. Indeed, it represents the type of rigorous economic analysis that the CFTC should be engaging in with respect to these kind of issues and with respect to each of its Dodd-Frank rules. That said, it points out the heavy costs – both quantitative and qualitative – that likely would arise if the industry were to follow that of the securities and banking industry and impose, or be required to impose, insurance to reimburse futures and swaps customers for losses resulting from FCM insolvencies: costs that ultimately would be borne by customers, as is the case with any insurance scheme.
In the futures industry, there has never been an insolvency insurance scheme analogous to that provided by the Securities Investor Protection Corporation, although certain of the CFTC Commissioners have advocated for one. Maybe, just maybe, there is a good reason for not having such insurance, such that reformers at the CFTC or Congress should think twice before they mandate insurance for this sector of the financial market.
What is good about this report is that it goes beyond quantitative estimates of what an insurance scheme would cost to include a discussion of important qualitative issues, most notably, that of "moral hazard" and how it affects the incentives of customers shopping around for appropriate financial intermediaries, something that financial regulators too often don't think about, or think too little about, when adopting measures to enhance customer protection, e.g., the LSOC segregation model recently adopted by the CFTC in the wake of the MF Global and Peregrine failures. On that score, this report makes two important points that those involved in this issue should take into account, one of which involves the appropriateness of such a scheme in a market dominated by institutional investors:
"Insurance providers cannot accurately observe the actions of insureds without incurring significant costs. As such, insurance can give rise to 'moral hazard' – i.e., insurance purchasers engage in less effective risk management and mitigation because they know they are insured."
"If the limit [of insurance coverage] is set too high, it could give rise to moral hazard amongst customers in selecting their FCMs. But if the limit is set too low, then large customers likely will consider CAPI to be of little or no real value."