October 29, 2012 8:12 pm

Futures: Prominent failures leave self-oversight in spotlight

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After an annus horribilis, the futures industry is trying to make scandal a thing of the past.

On October 31 2011, broker MF Global failed and left a $1.6bn hole in customer accounts. Then in July a smaller broker, Peregrine Financial Group, went bust after its founder acknowledged a massive fraud. Clients of both are still fighting to get their money back.

The twin collapses exposed as fallacy the belief that customer funds are safe with registered brokers. These deposits, known as margin, are a critical part of the structure of futures tied to markets from corn to stock indices, ensuring traders make good on losses.

The damage to futures markets is easy to see. Global trading volumes declined in the first half of the year, according to the US Futures Industry Association. As of August 31, customer deposits entrusted with brokers were down 13 per cent from a year earlier. Lawsuits are flying.

Now regulators, industry groups and traders are jockeying over how to repair the damage without making markets too costly or onerous to trade.

“We understand it is going to take time to regain public trust and we’re committed to doing whatever it takes to restore confidence in the safeguards for customer funds,” Walt Lukken, FIA chief executive, told lawmakers in August.

At MF Global, funds were diverted from customer accounts as the company scrambled to keep itself afloat during a “run on the bank”, its bankruptcy trustee has said.

At Peregrine Financial, founder and chief executive Russell Wasendorf Sr has pleaded guilty to stealing more than $100m from customers. Authorities say he sustained the fraud by mailing forged bank statements to auditors at the National Futures Association (NFA), a regulator funded by the industry.

Unlike Peregrine, no one has been charged with a crime at MF Global. But in some ways the apparent lack of criminal intent makes the case more unsettling for the industry.

“Peregrine is a real outlier,” says Philip McBride Johnson, a former chairman of the Commodity Futures Trading Commission (CFTC) and veteran derivatives lawyer. “I can see customers being more concerned about MF Global. If it was nothing more than a crisis in the back office, that could happen anywhere, even among people who are perfectly nice.”

Regulators have pushed through reforms already, but other changes face an uncertain future. After the MF Global collapse the CFTC placed new limits on where brokers may invest excess customer funds.

From November, information about where futures brokers have invested customer funds and other financial details will be posted online. Another rule addresses so-called “excess” funds that brokers routinely add to margin deposits as a cushion to cover a default by a customer. The so-called Corzine rule, named after former MF Global chief executive Jon Corzine, requires top executives to sign off on big withdrawals from excess funds.

The Peregrine case was embarrassing for regulators because Mr Wasendorf, a high-profile figure in the futures world, said he had duped them for 20 years.

“As the [Peregrine] case highlighted, there were a lot of red flags that should have been spotted and weren’t,” says Lauren Nelson of Attain Capital, an introducing broker that had assets frozen in the Peregrine bankruptcy.

Mr Wasendorf’s scheme unravelled after the NFA switched to electronic rather than paper verification of customer accounts. One pending rule would let regulators view customer accounts online without notifying brokers or their banks, a system meant to prevent another Peregrine-style fraud.

One change that has not been proposed is the end of the industry’s model of self-oversight. The CFTC delegates front-line broker regulation to the NFA and CME Group, the exchange operator that was responsible for auditing MF Global.

In October the CFTC proposed raising standards for the way self-regulators examine brokers and that it be alerted sooner when a broker becomes distressed. But the government agency lacks the budget to audit brokers itself.

The industry wants to maintain self-regulation. Terry Duffy, CME executive chairman, said in written testimony in August: “We have very compelling incentives to ensure that our regulatory programmes operate effectively. We have established a robust set of safeguards designed to ensure these functions operate free from conflicts of interest or inappropriate influence.”

Another idea that has not come to pass is the creation of an insurance fund to cover losses suffered if a broker collapses, as exists in US securities markets. NFA says it is committed to study the idea.

Bart Chilton, a CFTC commissioner, said in a speech in August that a fund protecting customer claims of up to $250,000 would “help remedy the present crisis of confidence in the futures markets in the wake of the fall of Peregrine Financial Group and MF Global”. But industry executives say the securities insurance fund is an imperfect comparison.

Unlike stock markets, futures are dominated by large institutional traders whose positions often far exceed $250,000.

A year after MF Global, the futures market’s future is still murky.

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