November 16, 2011
Last Thursday, the Commodity Futures Trading Commission (the “Commission”) confirmed that our Division of Enforcement is investigating MF Global, Inc. (“MF Global”) for possible violations of the Commodity Exchange Act (“CEA”) and/or Commission regulations. I fully support the Commission’s efforts to conduct a thorough investigation to determine what happened with the customer funds, how we can return all customer funds as soon as possible, and punish any wrongdoing.
Segregation of customer funds is fundamental to our markets. The CEA expressly prohibits intermediaries like MF Global from (i) commingling customer and proprietary funds (i.e., house funds) and (ii) using customer funds to support proprietary transactions. It appears that MF Global failed this fundamental responsibility.
While it’s tempting to compare the MF Global proceedings to the Lehman Brothers Inc. (“LBI”) bankruptcy, it is important to keep in mind that MF Global is unique because customer funds are missing from the segregated account. In the LBI bankruptcy, there was no shortfall in the segregated account, which meant that selling the segregated account, with its customer positions and funds, to Barclays was a straightforward process. In contrast, since the Securities Investor Protection Corporation (“SIPC”) placed MF Global into insolvency on October 31st, MF Global customers with positions have received an inadequate percentage of their total funds. Customers that thought it prudent to liquidate their positions prior to the insolvency (the “Cash-Only Customers”) have received none of the funds used to secure their trading at all. The inability of MF Global customers as a whole to access their funds has affected trading in futures markets, and has shaken public confidence in our customer protection regime.
I understand that the SIPC trustee may be seeking to transfer a percentage of the funds belonging to Cash-Only Customers. I also understand that the SIPC trustee may be developing an expedited claims process for all customers. I fully support both the transfer and the expedited claims process. My only concern is that neither happened quickly enough. The livelihood of market participants has been dangling by a thread for over two weeks. The Commission should work with the SIPC trustee to ensure that the transfer to Cash-Only Customers occurs as soon as possible. Additionally, the Commission should work with the SIPC trustee to ensure that the expedited claims process disperses the maximum amount that can be equitably distributed, given our current knowledge of the size of the shortfall.
To renew public confidence in segregation and to assure the public that MF Global is an isolated incident, the Commission should immediately take action.
The Commission should ensure that all intermediaries are in compliance with segregation requirements. I support the Commission’s plan to immediately spearhead the review of certain intermediaries, while ordering designated self-regulatory organizations (“DSROs”) to review others. All intermediaries should actively facilitate such a review by engaging a third party (such as an independent accountant) to verify their segregation balances (including investment valuations, if necessary and possible). All intermediaries should also promptly report this information to the Commission and the DSROs. Once the reviews are completed and confirmed, intermediaries should provide daily – instead of monthly – reports of segregation balances to their DSROs. To enhance deterrence and customer protection, the Commission should, with DSRO assistance, institute a system of random spot checks of such daily reports. If any intermediary fails either the third-party verification or the spot check, then the Commission and the DSRO together should institute appropriate procedures and sanctions, including identifying the reason for such failure, setting forth remedial measures, and instituting further oversight.
The Commission should also take longer-term actions to increase public confidence. Without disclosure to its customers, MF Global dramatically changed the risk profile of its proprietary operations and its incentives relating to customer intermediation. That is unacceptable. The Commission should adopt improved transparency measures to give customers more comprehensive information on the risk profiles of the intermediaries with which they entrust their hard-earned money. Customers must have the ability to understand (i) the proprietary trading business of each intermediary (including size and scope), (ii) the current risk practices, controls, and procedures of such intermediary (for both proprietary trading and customer intermediation), and (iii) the methods by which each intermediary ensures compliance with segregation requirements. Customers have every right to know these facts and to be promptly notified of any changes.
The Commission must use MF Global as its own teachable moment and reconsider its final and proposed rulemakings under the Dodd-Frank Act.
First and foremost, we must reconsider the proposal that would limit investments of segregated customer funds. Somewhat prematurely, this proposal is being hailed as the solution to the MF Global problem. At this time, we have not identified the cause of the segregation shortfall, and any action that we take obviously cannot be the solution until we have greater clarification on what caused the problem. In general, however, the Commission should focus on ensuring that intermediaries are maintaining segregation, properly diversifying their customer cash investments, accurately and transparently valuing such investments, and applying appropriate haircuts.
Another proposal that the Commission should re-examine is the segregation of swaps customer funds. That proposal purports to offer greater protection to swaps customers, by permitting such customers to move their positions and collateral notwithstanding a shortfall. In order for the proposal to actually deliver such protection, the proposal relies on the Commission actively intervening in insolvency proceedings to facilitate transfer of customer positions and collateral in the face of a shortfall, even if such action brings the Commission into conflict with the trustee. The Commission has not actively intervened in such a manner in MF Global, and so it is questionable whether the Commission would so intervene in the future.
Finally, MF Global was a clearing member at multiple clearing organizations and one of the main proponents of lower capital requirements for swaps clearing. In light of MF Global’s demise, the Commission should revisit the open access discussion, to ensure that clearing organizations are able to diversify their membership without introducing risk. Specifically, the Commission needs to give greater guidance on the minimum membership standards that a clearing organization can legitimately set ex ante, without incurring questions from the Commission ex post.
MF Global has highlighted areas that the Commission should reexamine, including (i) the manner in which it ensures that intermediaries are complying with segregation requirements and (ii) its role in protecting customer positions and funds in the days leading up to and following the insolvency of an intermediary. The Commission must also improve its coordination with domestic regulators, including the Securities and Exchange Commission (“SEC”). Self-regulatory organizations under the Commission and the SEC should coordinate as well, especially regarding the exchange of information. Finally, the Commission must continue to work with international regulators to achieve a measure of harmonization, as the insolvency of MF Global affected markets and customers in Australia, Canada, Germany, Singapore, and the United Kingdom, among other countries.
Many have said that the failure of MF Global was not systemic and that we are lucky. I don’t view it in the same light. I am certain that the thousands of individuals who have lost money or can’t get access to their rightful property don’t share that sentiment either.
The Commission is working to implement the Dodd-Frank Act, which will drive markets into intermediation and clearing. However, we must be mindful that while clearing has numerous benefits, it does not eliminate counterparty risk. We cannot permit ourselves to be distracted by politically expedient -- but ultimately ineffective – regulations in the name of safety until we complete our investigation. We owe customers in our markets that much.
Last Updated: November 16, 2011