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.

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[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.