Tuesday, November 20, 2012

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.

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

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