Changes to GIB and Branch Office Supervision?

The financial services industry has been enduring a period of intense consolidation for more than a decade. Perhaps the sector most impacted by this trend has been the commodity interest marketspace. While trading volumes in cleared commodity futures and options, forex, swaps, and other derivatives have generally increased, the number of independent registered brokerage and trading firms handling such transactions has declined.

Until the late 1990s and early 2000s a large percentage of commodity industry registrants were small businesses that controlled their own trading operations. Many individuals worked as floor brokers, traders, or clerks sending orders to exchange member clearing FCMs on behalf of their customers. During this period those working on trading floors were largely regulated by the exchanges they traded through. This paradigm remained until high speed internet and electronic trading became ubiquitous; eliminating the need for open outcry trading floors. As technology radically transformed the commodity trading landscape, floor brokers and traders were forced to look for new opportunities. A common choice amongst this group was to establish a direct relationships with the exchange member FCMs they had originally brokered business with. For many this meant registering as a Guaranteed Introducing Broker (GIB) or becoming a direct branch office location.

The self-regulatory model

The Commodity Futures Trading Commission (CFTC) has federal authority in the United States to regulate commodity interest transactions. While this is true, a high percentage of daily industry compliance and oversight matters have been handed off to what are known as self-regulatory organizations (SROs). Traditionally, commodity industry SROs have been limited to the various commodity exchanges and National Futures Association (NFA). Industry participants are required to register themselves with the CFTC and then become members of at least one SRO based upon the type of activity they conduct. After joining an SRO these participants are then subject to the specific compliance rules of the SRO as well as the various regulations set forth by the CFTC.

The aforementioned regulatory structure by and large has been successful for the commodity industry. It has allowed SROs to develop appropriate rules to govern the unique activities of their members. This has resulted in a compliance framework that is not “one size fits all” which is a good thing. On the other hand as the industry has shifted away from centralized trading floors certain elements of this regulatory model have not kept up with these changes. One of these areas is the approach taken by SROs with respect to how they monitor the supervision of GIBs and branch offices.

Branch office, GIB, and FCM relationships

A Guaranteed Introducing Broker is a commodities brokerage firm that has entered into a mutually beneficial arrangement with a Futures Commission Merchant (FCM). This arrangement dictates that in exchange for the GIB exclusively conducting all of its trading business through the FCM, that FCM will in return provide to the GIB certain “guaranteed” services. Typically these services include, at a minimum, regulatory and financial support which ultimately limits a GIB’s direct engagement with their respective SRO. Regulatory support often means that an FCM’s internal compliance department will directly develop GIB compliance programs, monitor GIB marketing efforts, and review nearly all GIB trading and operational activities. This relational structure enables SROs to police the compliance of GIBs nearly the same as they would an FCM branch office location.

Current SRO Approach

Under current SRO rules GIBs are primarily regulated by their Guarantor FCMs. That is, SROs tend to evaluate compliance at the FCM level as opposed to reviewing GIB activities on a case-by-case basis. This effectively shifts liability for GIB shortcomings onto the respective Guarantor FCM; again the same scenario as with branch office locations. Such an approach by SROs in turn creates the potential for certain conflicts of interest to develop in regard to both GIB and branch office oversight. This is particularly true for firm’s that utilize internal staff to conduct branch office or GIB reviews annually.

The unintended consequences for firms using internal audit staff to conduct outside reviews can be severe. As an example internal audit staff runs more of a risk of treating outside locations as extensions of the core company, much the same way SROs view these locations. Such a perspective, after years of review work by the same staff members, at the same office locations, can begin to produce examinations that do not adequately scrutinize GIB or branch behavior. If and when this occurs there is little to no incentive to self-report compliance short comings to management or to the firm’s respective SRO. Not only would reporting such findings expose problems at the GIB or branch location a reviewer has become friendly with, but it also threatens existing firm regulatory programs, and in turn the internal reviewer’s job. This, if it happens, only further opens FCMs to potential regulatory fines and headline grabbing disciplinary actions.

Regulatory breakdowns

With the typical FCM, GIB, and branch office relationship structure in mind, please consider these recent regulatory actions (follow links below for more case details):

Kooima and Kaemingk Commodities Inc – CFTC 18-39 – NFA ID 182649

CFTC Orders an Iowa Introducing Broker and Its Principals to Pay $11.9 Million in Restitution to Farmers and a $1.25 Million Civil Monetary Penalty for Fraud, Unauthorized Trading, and False Statements to the CME, Among Other Violations. Kooima and Kaemingk is registered as a GIB.

Ironbeam Inc. – NFA BCC00006 – NFA ID 415708

On July 11, 2017, NFA issued a Complaint charging Ironbeam, Inc. pursuant to NFA Compliance Rule 2-23 with joint and several liability for the acts committed by guaranteed introducing broker (GIB) Fortune Trading Group, Inc. (FTG) in violation of NFA Compliance Rules 2-4, 2-2(a), 2-29(a)(1), 2-29(b)(1), and 2-29(b)(2). The Complaint also charges Ironbeam with failing to diligently supervise FTG, a GIB, in violation of NFA Compliance Rule 2-9(a).

Could these situations have been prevented had a different regulatory structure between SROs, FCMs, and GIBs been in place? Are there changes or adjustments FCMs might consider that could better identify, reduce, and perhaps even eliminate regulatory deficiencies at outside locations such as these?

Potential SRO and FCM Benefits

While there is no singular solution that can resolve complex regulatory matters such as those above, on occasion there are opportunities for industry participants to make common sense, business benefitting changes. Under the current regulatory model, when there is trouble with a GIB or branch office, the last thing an FCM needs is for its SRO to call into question the integrity of its compliance programs or staff. Similarly, FCMs need to avoid the public reputational risk and liability of regulatory actions that may be taken against them. For these reasons Turnkey Trading Partners believes FCMs (as well as registrants with branch offices) would benefit from the use of independent third party reviewers when conducting mandatory onsite annual GIB and branch office examinations.

Firms that utilize third party reviewers gain the following benefits:

Reduced Costs: lower or zero regulatory fines, legal fees, and less internal audit staff
Reduced Liability: potential conflicts of interest and nepotism are all but eliminated
Greater Transparency: third parties are not incentivized to avoid findings
Broader Knowledge: third party firms typically employ staff with broad industry knowledge
Increased SRO Confidence: independent external reviews can be viewed more favorably by SROs

Simple Solution to a Complex Problem

When centralized open outcry trading floors were prevalent the existing SRO supervisory structure for GIBs made a lot of sense. SROs and FCMs were better able to monitor the activities of their relationships when trading was centrally located through exchange floors. Today, FCMs have become the de-facto regulatory monitor for large networks of GIB and branch office locations around the globe. The use of independent third party review companies such as Turnkey Trading Partners could reduce both FCM operating costs, and regulatory fines over the long run. This approach also provides a relatively simple, cost effective way to eliminate potential or perceived conflicts of interest and nepotism. External, independent, third party reviews of both GIB and branch office locations can also improve the overall perception of supervisory programs. At the very least all firms should strongly consider the benefit of third party assistance in their quest to more quickly identify regulatory deficiencies. Doing so could be the best and most cost effective approach to eliminating potential outside office malfeasance and the liability that comes with it.

About Turnkey Trading Partners

Turnkey Trading Partners provides customized support to the brokerage and trading industry. We can assist Commodity Trading Advisors (“CTA”), Commodity Pool Operators (“CPO”), Introducing Brokers (“IB”), and Futures Commission Merchant’s (“FCM”) working within the alternative investments space. We can also assist Registered Investment Advisors (“RIAs”) and Broker Dealers (“BDs”) within the traditional equities marketplace. Our team is well versed in both operational and regulatory matters relating to commodity futures, equities, bonds, options, swaps, forex, cash and physical trading, as well as several other specialized OTC financial markets transaction types. Our central office is downtown Chicago, the alternatives trading capital of, and one of the biggest equity markets in the United States. We also have an office located in Ft. Lauderdale, Florida one of the fastest growing trading communities in the country.