There’s Still Work to Be Done to Rebuild Trust in the Futures Market

The CFTC’s recently proposed rules for the protection of segregated customer funds in derivatives accounts would have made it less likely that the MF Global collapse would have proceeded undetected. But the fact that none of the senior officers of MF Global has been prosecuted is still of concern.

By Neal L. Wolkoff

We recently marked the first anniversary of the sudden failure of MF Global, which was led by former New Jersey senator and governor Jon Corzine. Just months thereafter, Peregrine Financial Group, a non-clearing FCM, failed when its CEO admitted to a long-running scheme to steal customer funds to benefit his lifestyle. Both failures highlighted frailties in the futures industry system for protecting customer funds, as they represented the first clear-cut violation of the CFTC’s segregation rules.

The Financial Times put it most harshly, but probably best summed up the headline fears of futures customers resulting from these two failures: “The twin collapses exposed as fallacy the belief that customer funds are safe with registered brokers.”

To its credit, with exchange and industry input, the National Futures Association, an industry-wide self-regulatory organization of a kind with FINRA, proposed or adopted a variety of operational changes to help improve the safety of customer funds. Writing in Futures Magazine, Terry Duffy, the Chairman of the CME Group, nicely summarized these various steps in an article that he authored, “A Year after MF Global Failure, Customers Safer than before Collapse.”

The Commodity Futures Trading Commission (CFTC) has now published its own recommendations to rebuild client confidence in the system of segregation. The CFTC has proposed various rules in an uncommonly large federal register release of more than 400 pages to add further safeguards to better protect the security of customer funds. The Commission’s staff has composed a handy question and answer piece to summarize the main points.

The Commission’s proposals will undoubtedly raise concerns about increasing the costs for FCMs, and perhaps driving some of them out of the business entirely, thus reducing choice and competition. On the other side of that fear is a trend of falling volume of business that is hard to attribute solely to economic conditions. If volume continues to drop because of customer concerns that the safety of their money is under-regulated, that too will cause some FCMs to leave the business.

[Related: “<http://tabbforum.com/opinions/evolving-futures-markets-could-squeeze-out-traditional-players>Evolving Futures Markets Could Squeeze Out Traditional Players”]

According to a prediction by TABB Group: “The total available revenue of FCMs for listed futures will be US$4 billion in 2013, a decrease of over 40% in the past five years.”

Attributing this long-term dramatic fall in trading levels to economic conditions is a tricky job, and probably not supported by the trend in the normal driver for futures volume -- volatility. While absolute interest rates have been low, they have continued to be volatile, as have equities, foreign exchange, energy and metals.[1] Volatility should be buffering a large-scale reduction in the use of listed risk management markets. At least some part of the sharp declines in volume must be attributed to the loss of customer confidence in the integrity of the business, given that volatility is still robust.

The CFTC, NFA and futures exchanges have done a fine job in adding a number of sensible new regulations over the custody of customer funds. The newly proposed regulations, had they been in place, would have made it considerably less likely that MF Global’s situation would have proceeded undetected. There would have been additional capital in the secured account, and the trick of adding secured balances to the segregation report to overstate the amount of funds on deposit would have been outlawed. Executives would have been called upon to report their instructions to make certain transfers, and may have been more careful under the circumstances. Additional welcome reforms include measures that set minimum standards for an FCM’s risk management program, along with much improved transparency of funds information to customers.

Unfortunately, the failure of MF Global in particular -- because it was so much larger than Peregrine, and with much greater prominence in the industry -- has left a great deal of suspicion among market users about whether rules will be followed.

MF Global was a fast-moving crisis, and the officers of the company (who specifically authorized transfers of what were not in fact “excess” segregated funds) have relied on their history of recordkeeping failures, lackluster technology, and procedures that seemed to be invented on the fly with few if any controls in order to avoid or escape liability. Jon Corzine, the chief executive officer, has proclaimed his own complete lack of culpability.

As reported in The New York Times’ Dealbook:

“Mr. Corzine, in his testimony, offered little insight into the missing money. He said he had learned about the shortfall on Oct. 30, the day before MF Global filed for bankruptcy. He also said there “were an extraordinary number of transactions during MF Global’s last few days,” calling it a “chaotic” period that was “extremely difficult” to “reconstruct.”

“As the chief executive officer of MF Global, I ultimately had overall responsibility for the firm,” he said in testimony. “I did not, however, generally involve myself in the mechanics of the clearing and settlement of trades, or in the movement of cash and collateral. Nor was I an expert on the complicated rules and regulations governing the various different operating businesses that comprised MF Global. I had little expertise or experience in those operational aspects of the business.”

In fact, Corzine has squarely laid blame on the company’s Assistant Treasurer, a non-officer of the company, who has invoked her constitutional right not to testify. (“I had explicit statements that we were using proper funds, both orally and in writing, to the best of my knowledge,” Corzine: told a subcommittee. “The woman that I spoke to was a Ms. Edith O’Brien.”)

Taking nothing away from the benefits that will accrue from adopting the CFTC’s proposed regulations, it is still of concern that none of the senior officers of MF Global has been prosecuted. A system that treats the invasion of customer funds as an egregious offense of the fiduciary duty that corporate officers of FCMs owe to their customers is likely to have the respect and confidence of clients. A system that lets these same officers wriggle out of criminal prosecution will undermine the effectiveness of prescriptive regulations. For those who remain suspicious, the failure to prosecute leaves open the possibility that egregiously sloppy recordkeeping and controls will, in a future fast-moving event, serve as a defense to an “unintentional” violation of rules that result in a large-scale failure of segregation.

The failures of MF Global and Peregrine Financial Services also highlight a separate frailty within the system of safeguards: Customer funds that are not used to margin a position are controlled by the FCM and, notwithstanding a number of important safeguards, are not as secure as funds held in custody by a clearinghouse to margin positions. An insurance fund is a needed step to provide assurance that balances that are not covered by the clearinghouse’s custody would still be protected. A joint program between the securities and derivatives industry, as is the case in Canada, would keep costs down to a much lower level than would be the case with a derivatives program alone. The specifics of such a program are explored in “Expanding the role of SIPC,”

and require both cooperation and leadership of financial regulators in order to secure this important investor benefit.

The CFTC’s rule proposals address an extensive list of possible shortcomings in addition to those directly related to the custody of funds, including accountant qualifications and better training of FCM personnel. As a package, it is well thought through and does not try to redo the brokerage and clearing systems from the ground up. Prosecution decisions, at least criminal actions, are outside the purview of the Commission, and an insurance fund is a more complex endeavor that cannot be implemented solely with new regulations. On the basis of the problems the CFTC had before it -- and its powers to address them -- the proposed rulemaking is a solid piece of work. One hopes that the areas outside of its jurisdiction will also be treated with assertive, sound actions by the officials holding the power in their hands to act.

---

[1] Sources:

CBOE Volatility Indexes (VIX Calculations)

http://www.cboe.com/micro/volatility/introduction.aspx

Estimated Historical One Year/Ten Year Basis Point Swap Rate Volatility, 2007 - 2012 

http://www.cboe.com/micro/srvx/default.aspx

The CBOE Crude Oil ETF Volatility Index ("Oil VIX") http://www.cboe.com/micro/oilvix/introduction.aspx

The CBOE Gold ETF Volatility Index ("Gold VIX", T GVZ)ticker - http://www.cboe.com/micro/gvz/introduction.aspx

The CBOE EuroCurrency Volatility Index ("Euro VIX", Ticker - EVZ) http://www.cboe.com/micro/evz/introduction.aspx

The CBOE S&P 500 3-Month Volatility Index (VXV)

http://www.cboe.com/micro/vxv/

CME v. CFTC – A Regulator’s Conundrum

The Commodity Futures Trading Commission faces a conundrum that impedes its ability to create an efficient and cost effective solution to establish a comprehensive data-set of interest rate swaps.   The lawsuit that CME has recently brought against the CFTC highlights the issues facing a regulator to implement an often poorly drafted statute.  It also highlights the disruption to the existing futures industry as it seeks to enter and compete in the swap market.  Before describing the Catch 22, a review of the issues in CME v. CFTC is useful.

The Commission has determined that CME, as a registered Derivatives Clearing Organization, or “DCO,” is obligated to report all swap data, including proprietary customer information, to a third party Swap Data Repository, or “SDR,” most likely the DTCC.   Of all the parties to compel the CME to report to, DTCC is among the most sensitive competitive possibilities as DTCC currently competes directly with the CME on interest rate futures clearing.

The CFTC is preparing to oversee a newly regulated world of swap transactions for which it has little technical infrastructure already established.  In theory, having all swap data aggregated through a single SDR could alleviate the cost, development effort, and “time to market” for the Commission to employ a system to aggregate data across many SDRs and DCOs in order to view the positions and exposures of swap entities in a single location and format. 

Section 20a(c)(4)(a) of the Commodity Exchange Act (Act) , 7 USC § 24a (c)(4)(a) - Swap Data Repositories - explicitly allows the Commission the power to require SDRs to send swap data, including proprietary data, to a central SDR: 

“A swap data repository shall—

(4) (A) provide direct electronic access to the Commission (or any designee of the Commission, including another registered entity);”

In governing the data requirements of SDRs, Section 20a of the Act broadly empowers the Commission to establish data standards for SDRs’ public price and transaction dissemination as well as for collection and retrieval of proprietary data.

CME is contesting the Commission’s authority to require it as a DCO to follow the Commission’s directives.  The suit makes two main claims:  (1) the Commission’s regulation requiring CME to report non-public swap data to an SDR violates the Commodity Exchange Act by requiring a DCO to perform actions that are outside the statute’s allowable area of regulatory authority;  and (2) the Commission failed to perform a sufficient cost-benefit analysis even if the regulation is otherwise permissible. 

The CME’s Complaint highlights the various and clear distinctions in the CEA governing the duties of a DCO with respect to sharing transaction data for cleared swaps with SDRs. Specifically,  the CME draws a bright line between providing price and basic reporting information to an SDR for contemporaneous public reporting (a market data function) versus providing detailed information of proprietary client information, such as name, counterparty, clearing firm, account designation, etc.  As paragraph 70 of the Complaint states,

“CEA Section 5b(k) unambiguously requires DCOs to make nonpublic regulatory reporting of cleared swap data available to the CFTC.  Section 5b(k) does not mention SDRs.”

As the CME points out in its Complaint, it has outstanding with the Commission an application to be designated as an SDR.  However, the Commission has not approved the CME’s application, and has so far indicated that without changes to the CME’s proposed operating rules as an SDR it is not inclined to give its approval.

It appears that the Commission’s most straightforward solution to the claims leveled in the lawsuit would be to grant the CME its application to be an SDR, and then use the powers given to the Commission under Section 20a a(c)(4)(a) of the Act to require the CME as an SDR, and not as a DCO, to report swap data to a designee.  In the case of interest rate swaps presumably that designee would be the DTCC.  Of course, even if CME were designated as an SDR it might still litigate to avoid sharing proprietary information with a competitor.  

However, litigating as an SDR, and not as a DCO, would appear to considerably weaken the CME’s arguments.  First, Dodd Frank grants the Commission clear statutory authority to require “SDR to SDR” reporting, but does not grant the CFTC specific authority to require “DCO to SDR” reporting of proprietary swap data.   The CME’s “cost-benefit” argument would also be weaker.  Unlike the recent federal court ruling against the Commission (ISDA v. CFTC) on position limits - where the court found an unambiguous requirement in Dodd Frank to justify the imposition of position limit regulations on hard data - in this instance, Dodd Frank does not appear to make a similar fact-finding condition a prerequisite of regulation.  In addition, the Commission presumably could make a clear showing of the heavy impact on its own costs, as well as causing delay to implement a core statutory purpose of Dodd Frank, should it not designate interest rate swap reporting to a central depository.

The CME’s lawsuit describes a standoff between it and the CFTC over the issue of the Commission’s view of the competitive requirements of Dodd Frank as they pertain to the CME’s application for designation.  According to the CME’s Complaint:

“57. The FAQ also makes clear that a DCO cannot require, through agreement or otherwise, market participants to select the DCO’s SDR or an affiliated SDR: “Market participants may choose to use a. . . DCO’s SDR for reporting swap transactions, but a.. . DCO as part of its offering of trading or clearing services cannot require that market participants use its affiliated or ‘captive’ SDR for reporting.”

58. CFTC staff has taken the position that CME must amend its SDR application to show compliance with the FAQ before staff will recommend approving the application.

This piece is not intending to pass judgment on the merits of the Commission’s position with respect to the CME’s application to be an SDR.    However, while Dodd Frank requires the Commission to take steps to not promote anticompetitive conduct, the statute also circumscribes the authority of the Commission to  compel sharing of proprietary swap data other than between registered SDRs. 

The Commission’s Catch 22, it appears, is to approve the CME’s SDR application, notwithstanding its competitiveness issues (which of course might prompt other lawsuits from other parties), or to limit its ability to create an efficient, cost-effective mechanism to centralize interest rate swap data – which is critical to the success of its Dodd Frank mandate to understand, monitor and regulate swap exposure. 

Will the CME amend its SDR application to satisfy the Commission’s concerns while its lawsuit is pending and likely to be successful?  Will the CFTC justify approving an SDR application that it believes is problematic in order to quickly get the technology solution to implement a rational method of interest rate swap data collection? 

As I said: a conundrum.

Expanding the Role of SIPC to Provide Futures Account Insurance

Following the collapses at MF Global and Peregrine Financial Group the futures industry has been considering various steps to reclaim investor confidence in the safety of funds deposited with registered futures commission merchants.  Regulators have adopted various proposals to improve audit standards by requiring electronic record submissions, and self-reporting by FCMs of transfers of segregated funds that exceed prescribed thresholds.

Still waiting on the sidelines is the discussion around an insurance fund for futures accounts held at FCMs.  The futures industry, for all its value to the financial markets, is quite small compared to the securities markets.  An insurance fund solely dedicated to protecting futures accounts raises concerns over the prospect that significant fees will need to be added to futures trades, and that liquidity will be curtailed as a result.  These fears are entirely reasonable.  The markets have become accustomed to low transaction costs, and enjoy a level of efficiency that we do not want to lose.

MF Global and Peregrine Financial were relatively small actors in the scheme of things.  However, in combination, they represent the fear of clients of federally registered FCMs that they do not have an effective mechanism to evaluate the financial health or financial honesty of the firms with which they do business.  Certainly, investors do not have a better process to evaluate these firms than the federal regulators and the SROs.  The financial crisis of 2008 highlighted the fragility of even the largest firms (and by deduction their affiliated FCMs).  Whom can you trust?

In the 1960s, the securities industry had to deal with similar concerns about the safety of customer accounts held by federally registered broker-dealers.  In the late 1960s, the increase in volume in securities transaction began to overwhelm the system.  The NYSE was forced to close early on Wednesday afternoons to help deal with the logjam caused by a spike in volume up to 12 million shares per day.  The amount of errors, or fails, became so substantial as a result of a fourfold increase in volume from the start of the decade that many firms were left with large errors. In a self-correcting process, volumes began to decline as investor confidence eroded in the ability of the industry to perform as needed.

In 1969, share prices started to fall and volumes fell along with them.  The plunge in volume reduced commission income, and along with the liabilities incurred because of the fails resulting from operational difficulties in clearance and settlement, approximately 160 NYSE member firms declared bankruptcy, closed, or merged with other firms in an effort to survive.

The SEC and Congress acted aggressively to restore investor confidence in the securities industry.  It took tangible steps to improve the record keeping mess, raise broker-dealer capital requirements, and the transparency of financial well-being of each broker-dealer.

It was in this environment that Congress passed the Securities Investor Protection Act of 1970, or SIPA, which created the Securities Investor Protection Corporation, commonly known as SIPC.  The prospect of investors wondering about the safety of their accounts after numerous broker-dealer failures was not tolerable, and Congress along with the SEC acted decisively.  There were other significant actions taken at the same time to consolidate clearing and simplify processing, but the introduction of an insurance plan that was modeled on the FDIC to insure bank accounts was a big piece of the solution.

Whether Congress and the regulatory agencies are up to decisive and aggressive action to address the current problem of customer trust in the futures industry is an open question.  Certainly, our national finances do not permit many new government initiatives.  However, in the case of SIPC account insurance, the burden is on the industry to finance the insurance fund through small transaction assessments, and is not a government funded initiative.  The introduction of something similar for the futures industry suggests that a government created safety net for financial accounts need not be an add-on to the current deficit.

Nonetheless, introducing a fee large enough to create a meaningful fund for the futures industry risks affecting the liquidity of the markets.  Additionally, for Congress to pass an entire new piece of legislation is a daunting and unlikely prospect. However, amending SIPA to combine insurance funds across both the securities and futures industries is an attractive concept to resolve our current crisis of confidence among futures customers.  Significant hurdles must be overcome. Two of the biggest are the willingness of one industry to subsidize a benefit for the other; and where jurisdiction lies post-SIPA amendment over the futures industry. But, in looking at the separation of jurisdiction and regulation of the markets, we might find a better way of managing oversight of futures and securities, and placing both industries on level ground of customer trust.

Canada has a regulatory system for financial markets that is separated among provincial regulators, while the insurance coverage for securities accounts and futures accounts is still a national program – the Canadian Investor Protection Fund.  Getting Congress to act across Committee jurisdictions, and regulators to act across regulatory fiefdoms are complex and difficult tasks. The SEC and CFTC would need to jointly lead on this issue, and coordinate between themselves and across Congressional oversight committees to show that client concerns over funds deposited in securities or futures accounts are affected by a lack of trust in either area.

Similar to the 1960s, the lack of confidence that clients have in the safety of their futures accounts is not tolerable.  A solution is needed, and an integrated fund for securities and futures accounts is a plausible one.

When Swaps Become Futures

October 12 marks the starting point for many of the new swaps regulations put into effect by the CFTC as part of its implementation of Dodd Frank.  For dealer banks and other large financial companies, the transition of their status from counterparties to registered swaps dealers seems to be going relatively smoothly.  As Dodd Frank was adopted as a means to regulate banks and large, systemically important financial institutions, in the financial world the rules have been long anticipated and broadly tracked.  Moreover, many of the regulations affecting the new categories of Swaps Dealer (SD) or Major Swaps Participant (MSP) are consistent with existing practices within the divisions of financial firms that already deal with the exchange and clearinghouse community.

The energy and commodities businesses, however, have little history in the operations and mechanics of the exchange and clearinghouse space.  Yes, they use the listed futures markets, but have no large trader reporting system or experience in trade reporting to clearinghouses or their related swaps data repositories.  The new SD and MSP rules also affect capital requirements and margin requirements, and create "know your customer" duties that are within the comfort zones of large financial entities, but unfamiliar practices and unwanted business intrusions in the commodity merchant space or among large commodity based companies with significant swap activity.

Starting Monday, October 15, 2012 the Intercontinental Exchange (ICE) will begin to treat all of its energy swaps contracts as futures contracts.  Ten years ago, NYMEX, now a subsidiary of the CME Group, started a service called Clearport in which energy swaps were converted to futures and cleared as futures.  CME has also has announced a plan to start later this year that will list these various swaps contracts as futures.

What is the difference between accepting swaps and converting them to futures, as Clearport has done for a decade, or listing swaps as futures in the first instance as ICE will start doing on Monday?  The answer lies in one of the traditional principles governing trading on futures exchanges (Designated Contracts Markets or DCMs).  Core Principle 9, as it is known in Section 5(d)(9) of the Commodity Exchange Act, requires each DCM to meet a standard of "open and competitive trading" of futures contracts.

In 2010 the CFTC proposed several new regulations that specifically defined the parameters of Core Principle 9 (CFTC Regulations 38.501-06).  Included among these proposals is a proposed centralized market trading requirement to establish a minimum exchange trading threshold of 85 percent for all contracts listed on a DCM. 17CFR§38.506 (see page 80588 in the linked Federal Register).  The punishment for a DCM's failure to satisfy the minimum trading threshold is eventually the loss of listing privileges for that contract on the DCM.  In other words, once a contract is removed from the DCM it is no longer a futures contract and can only be traded as a swap.

If the proposed 85% threshold were to be implemented most, if not all, of the current Clearport contracts would no longer be eligible to be designated as futures contracts.   Importantly to the energy firms dealing with the potential of facing registration as an SD or MSP, each swap contract that is executed from October 12 forward (subject to the CME's request for a short delay) would count toward triggering the registration requirements for SDs and MSPs.  Futures contracts, on the other hand, are not part of the triggering mechanism for SD and MSP designation.  On the commodities side, inasmuch as firms want to avoid designation, one means to do so is to convert swap contracts into futures contracts.

ICE announced that its swap contracts would be redesignated as futures contracts on October 15, 2012.  The CME announced that it would do the same for its Clearport contracts, albeit about 60 days behind the ICE schedule.

However, in order to be successful at this redesignation, ICE has announced a plan to place the swap contracts alongside its traditional futures contracts on its single futures matching engine.  CME will likewise add the swaps to GLOBEX as part of its plan.

The open question will be whether the CFTC will insist on a trading threshold of 85% or something similar which may defeat the plan of converting futures to swaps.  On June 12, 2012 the CFTC announced a "wait and see" period in considering a final rule under Core Principle 9.  Likely, one of the things the regulator will be waiting to see is whether the energy and commodity trading firms that wish to avoid SD and MSP designation will participate in trading some portion of the former swaps on an open and competitive platform.  Alternatively, should these firms not participate on the ICE and CME central limit order books, the CFTC may well see the transformation of swaps to futures as an improper evasion of the swap registration and trading requirements.

The ball at this point is really with the commodities industry that uses the futures and swaps markets.  The two leading commodity DCMs are providing a sound path to help meet the industry's desire to avoid new registration requirements while enhancing the public's interest in seeing derivatives regulated.  Either the major trading firms will change behavior, and execute a meaningful number of swaps on a central platform, or they risk becoming subject to SD and MSP registration.

For the CFTC, if it relaxes a firm 85% or similar prescriptive exchange trading requirement in order to give the markets a chance to transition, the public will receive the truly significant benefit of fully regulated and transparent swap markets alongside futures markets.

Let us hope for a little give and take in the wait and see.

The SEC's NYSE Market Data Case: Will It Be the Framework for the Regulation of Trading Technology?

The Securities and Exchange Commission made findings and announced sanctions against the New York Stock Exchange on September 14, 2012 for violating Rule 603(a) of Regulation NMS, which requires exchanges to make market data for quotes and trades available on terms that are “fair and reasonable” and “not unreasonably discriminatory.” In essence, the Big Board - as it is allowed to do - provided trade data to individual clients in one data feed, and also provided market data to the public through a consolidated feed that aggregates market information originating on many different exchanges and market centers. Due to a technology error that was unknown to the NYSE, the private recipients were able to receive market data ahead of the general public.  The proprietary feed was simply faster in distributing the information to its limited recipients than the consolidated tape was in furnishing data to the public.

The SEC's action is a rare case for the agency to bring versus a national marketplace. That said, the action against NYSE was brought and settled against a backdrop of several unrelated, but embarrassing and highly visible technology problems that cumulatively raise questions about the integrity and fairness of the stock markets.  The "flash crash" of May 6, 2010, was a prelude to a succession of technology driven market failures. Nearly two years later, on March 23, 2012, the securities exchange BATS was attempting to go public on its own venue when its software malfunctioned, and the exchange felt it necessary to cancel its own IPO.

Nasdaq won a highly publicized beauty contest against the NYSE to secure the Facebook listing IPO.  However, when trading in FB opened on May 18, 2012 Nasdaq experienced systems issues which prevented the immediate confirmation of executions that brokers and investors require.  Nasdaq tried to fix the software problem without halting the Facebook market, but the exchange was not able to resolve the lapses in reporting trades, resulting in hundreds of millions of dollars of claimed losses by public investors and the exchange's own member firms.

Most recently, on August 1, 2012 Knight Capital, a major market maker and execution venue for many retail customer orders originating at a host of "discount" brokers, almost bankrupted itself by losing over $400 million in under an hour from a runaway trading algorithm.

There is no question that the NYSE committed an unknowing mistake without having any plan or thought to create a data stream that favored some investors over the interests of others.  In sanctioning NYSE, however, the SEC seems to be announcing that it is looking beyond the intent of the market actor, and taking a closer look at the plans, procedures and structural checks and balances that are in place to prevent an unintended technology event from happening.

With the NYSE action it is fairly plain to see an end to the agency accepting "good faith" technology errors that affect the public's perception of whether the markets are fair and properly regulated.  In its findings, the SEC establishes clear guidelines for the processes that market centers, and perhaps important market participants as well, will need to follow in order to remain in compliance with the securities laws.

The SEC sets out a three-pronged test to determine whether an exchange is in compliance with its duties under Rule 603(a) of Regulation NMS.   Beyond that specific rule, however, it seems entirely reasonable to foresee that this same three-pronged test will also be applied in other situations, and against other market participants, where malfunctioning technology could have a profound affect on market integrity:

1. First, firms need to have in place processes and procedures for the internal review of system architecture and performance through an audit function that is independent of the technologists and business development staff.  The SEC was critical that "NYSE’s compliance department played no role in the design, implementation, or operation of the systems."

2. Second, firms need to have in place written policies and procedures to periodically test systems that can have a market impact to assure they function properly.  The SEC found fault that "NYSE also did not systematically monitor its data feeds to ensure they complied with Rule 603, and had no written policies and procedures concerning the rule;" and

3. Third, firms must document system performance.  The SEC complained that "NYSE failed to retain computer files that contained information about NYSE’s transmission of market data."

As noted, the action against the NYSE does not read like a discreet and isolated set of concerns expressed by a regulator only to a single respondent.  Instead, the NYSE case creates a foundation for the SEC to heighten its inspection and enforcement attention over the implementation and management of technology risk controls by exchanges, brokers, high frequency traders and other industry registrants.

In the newly published October 2012 Chicago Fed Letter, the Federal Reserve Bank of Chicago asks the question "how to keep markets safe in a highly technological environment." In researching the answer, the Bank found a wide disparity in risk controls among many different organizations involved in the life cycle of securities trading. "Chicago Fed staff also found that out-of control algorithms were more common than anticipated prior to the study and that there were no clear patterns as to their cause."

The NYSE action signals the serious regulatory focus that the SEC will now be placing on the industry's ability to control the risk of harm when technology is introduced to the markets without independent testing, protocols to insure market safety, and the full documentation that systems meet technological best practices.  The Chicago Fed study will only serve to heighten the public and political interest, and unease, in the issue as well.  Firms need to take note and, if they have not already done so, implement a meaningful compliance plan to avoid not only the spotlight that comes with a technology driven event, but the regulatory investigation and action that promises to follow.

The LIBOR Scandal: Trying to Make Sense So Far

The reports by the U.S. Department of Justice and the U.K. Financial Services Authority make clear that the LIBOR scandal that has so far engulfed Barclays and driven its top three executives from their offices involved two separate types of events over a period lasting about five years.  The first category of violation started in 2005, and involved a game among traders to use their status as a member of the Committee who provided the LIBOR prices to the British Bankers Association to better their own interests.  These traders, so far identified as Barclays employees and former employees who moved to other banks, used their influence in the LIBOR price setting mechanism to facilitate better "marks" so that LIBOR would be established at a more favorable level to their proprietary trading positions than would otherwise have been the case.  


The second category of violation happened in conjunction with the financial meltdown.  Starting in 2007 and continuing through 2009, traders sought to disguise the elevated interest rates that counterparties were demanding in order to loan funds on a short term basis to Barclays.  If Barclays' borrowing rates were perceived as higher than Barclays' competitors,  clients of the large dealer banks might conclude that Barclays was an unsafe - or at least less safe - credit risk, and would choose a competitor with which to do business. 


The attempt at manipulation of LIBOR rates in the first category - i.e. helping the traders make money even when they were wrong about the LIBOR rate -  could have affected LIBOR rates in either direction.  Rates might have gone higher, thus increasing the costs to borrowers and consumers, or they may have been set lower than they should have, thus helping consumers and hurting the lenders whose lending costs were set on whatever the BBA determined LIBOR to be.  Interestingly, the second category of attempted manipulation of LIBOR rates only helped borrowers and consumers at the expense of lenders who would be receiving less than true value in return for their loans.  


The first category of falsified rate submissions occurred in the ordinary course of the trading day, and appeared to be perfectly acceptable to traders on the desk.  The DOJ report quotes emails between two Barclays traders where the submission of false rates was discussed and agreed to:

As another example, on February 22, 2006, at approximately 9:42 a.m., Trader-1 sent

an e-mail to another Barclays Dollar LIBOR submitter (“Submitter-2”) stating, “Hi (again)

We’re getting killed on our 3m resets, we need them to be up this week before we roll out 

of our positions. Consensus for 3m today is 4.78 - 4.7825, it would be amazing if we could go for 4.79...Really appreciate ur help mate.” (ellipses in original). Submitter-2 responded, “Happy to help.”

Barclays has agreed to a large fine, so it is not a question of whether these conversations to establish fictional LIBOR rates to help a trading position actually occurred.  The open question, and the one where other similar emails may or may not surface over the next few weeks or months, is whether traders who were not employed by Barclays also engaged in the same exchanges to help their own firms' trading strategies appear to be successful.  The settlement documents indicate that conversations happened between Barclays traders, and also between current Barclays traders and former Barclays traders.  What we don't know is if Barclays traders and unassociated traders working for other banks ever conspired, or if traders at other banks engaged in the same sort of comraderie that the Barclays traders had.  

In many respects, the public harm from groups of traders agreeing to give false submissions to affect a major interest rate index is greater than the harm caused by anxious bankers looking to protect their image among customers and the public from other firms low-balling their LIBOR submissions.  At least in the latter category, the public (borrower) was aided by lower interest rates resulting from the public image repair work taking place among the elite of interest rate traders.  In the case of traders simply seeking to help their failed trading strategies look better than they were, lenders, borrowers and their firm, which compensated these traders based on performance results, were all harmed, and for no higher purpose than greed.

In 2007 and particularly in 2008 we see Barclays being slammed by the media, and likely by its competitors, for honestly submitting LIBOR rates reflecting the increased cost of borrowing when large banks were facing huge and opaque risks of loss.  At the time, was Barclays the weakest bank? No, since Lehman and Bear were far weaker, as was Citi, RBS and Morgan Stanley.  Goldman? Perhaps.  The question that will presumably be answered - or at least asked - is why Barclays' rate submissions were higher than the submissions by its peers?  If it was unlikely that Barclays' short term borrowing costs were higher than many of its competitor banks, why would Barclays have consistently been an outlier in LIBOR submissions to the BBA?  The logical, but of course unproven, conclusion is that some or many of the other banks were lying about their cost of short term borrowing when submitting rates to the BBA.  And it appears that like the SEC auditors who reviewed the Madoff trading records during the height of his Ponzi scheme, noone at the BBA sought to obtain the source records of the actual confirmed trades between the banks and their counterparties to confirm the accuracy of their LIBOR submissions.  

It is also clear that Barclays put up quite a fuss to its regulators about the LIBOR marks that its competitors were submitting. According to the DOJ Statement of Facts:

During approximately November 2007 through approximately October 2008, certain employees at Barclays sometimes raised concerns with individuals at the BBA, the Financial Services Authority, the Bank of England, and the Federal Reserve Bank of New York concerning the diminished liquidity available in the market and their views that the Dollar LIBOR fixes were too low and did not accurately reflect the market. In some of those 

communications, those employees advised that all of the Contributor Panel banks, including 

Barclays, were contributing rates that were too low. Those employees attempted to find a 

solution that would allow Barclays to submit honest rates without standing out from other 

members of the Contributor Panel, and they expressed the view that Barclays could achieve that goal if other banks submitted honest rates. These communications, however, were not intended and were not understood as disclosures through which Barclays self-reported misconduct to authorities.

My all-time favorite exculpatory (rear-end covering) statement - one regulator to another - is that "These communications, however, were not intended and were not understood as disclosures through which Barclays self-reported misconduct to authorities."  


However these statements were intended - as self-reporting misconduct or just reporting potential misconduct -  Barclays was taking the highly unusual step to notify the key regulators in the U.K. and the U.S. that it believed that other banks were fudging the numbers, and that Barclays in response was also fudging the numbers.  But, like the end of a scene in Waiting for Godot, the regulators did not move. 


Later, we learn that Barclays' CEO Robert Diamond has a conversation with a senior regulator at the Bank of England about the LIBOR submissions by Barclays and by its competitors.  As summarized in the FSA settlement:


However, as the substance of the telephone conversation was relayed down the chain of command at Barclays, a misunderstanding or miscommunication occurred. This meant that Barclays’ Submitters  believed mistakenly that they were operating under an instruction from the Bank of England (as conveyed by  senior management) to reduce Barclays’ LIBOR submissions.


According to a report in the Financial Times, the bank regulator in question, Paul Tucker, somewhat ambiguously - and entirely lamely - mewed to Mr. Diamond that  “it did not always need to be the case that we appeared as high as we have recently”.  


Whatever explanation may be put forth by the Bank of England, the FSA, the Federal Reserve, and the British Bankers Association, they all had knowledge that the integrity of the process by which LIBOR rates were being set was in severe doubt.  Again, why would Barclays - perhaps not the strongest bank, but certainly not the weakest; a bank that was able to survive the financial crisis without a bailout - have higher borrowing costs than Citi or Morgan Stanley or RBS?  Sometimes regulators take the view that they know how to calm or soothe the markets, and perhaps sometimes that is true.  But, in this case, they used that belief to enter into at best a willful blindness about what they were being told, and what the numbers showed.  The LIBOR rates were being fictionalized to hide the true financial condition of the banks from the public.


Of course, the fact that a regulator is being weak, silent, vacillating, and perhaps complicit, is not a justification for a leading financial institution to manipulate the LIBOR rate, even if its purpose is aligned with the regulators': to fictionalize the financial health of the banking system to avoid a public reaction to the truth.  At the end of the day, as Ken Lewis learned after the Federal Reserve twisted his arm to buy Merrill Lynch, Bank of America's obligations for full disclosure under the U.S. Securities laws did not evaporate because of pressure coming from an important regulator.  The Fed could not waive those obligations.  The country does not enter martial law during times of financial crises.  The rules are the rules, and even if the regulator wishes for the rules to all go away, only a fool believes that will happen when the dust settles.  What role Barclays' compliance officials played in helping the bank slide down this hellhole seems clear from the reports: as self-regulators, they attended meetings, took notes and did not utter a peep.  


The other shoe is about to fall, or not, but the Bank of England and the other financial regulators will not be the ones facing civil penalties and possible jail time.  That will be left to the regulated firms and their employees who thought they had the best interests of the financial world at heart because the regulators did not tell them what to do or not do.