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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