MF Global collapse prompts regulatory rethink in Washington

By Ian Fraser

Published: QFINANCE

Date: February 8th, 2012

A commissioner at a leading US financial regulator has launched a stinging attack on his own organization, accusing it of having its priorities all wrong.

Scott O’Malia accused the Washington-based Commodities Futures Trading Commission, an agency of the US Federal government, of becoming so bogged down in the complexities of drafting new rules for the swaps market in a follow-through from the 2010 Dodd-Frank Act, that it is neglecting its role of overseeing the futures markets. He earlier said that the CFTC’s version of the Volcker Rule, which bans proprietary trading at banks and limits their ownership of private equity and hedge funds, is “unworkable.”

In a speech at New York Law School on January 31, O’Malia, one of two Republicans on the CFTC’s five-member panel, said:

The Commission continues its all-consuming fixation on swaps regulation. Since the Dodd-Frank Act became law, the Commission has acted like a little child, abandoning the old toy and “swapping” them out for the new. It has concentrated on swaps rule-making, while averting its gaze from the futures markets.

O’Malia implied that the CFTC had failed to avert the collapse of global derivatives broker MF Global, which filed for chapter 11 bankruptcy on October 31 last year, because the regulator had become so distracted by the Byzantine complexities of applying Dodd-Frank. The MF Global collapse sparked after investors became concerned about MF Global’s $6.3bn bet on European sovereign debt, caused investors to lose some $1.2 billion in segregated accounts, of which about half has reportedly since been found by administrators KPMG.

Dodd-Frank, the financial reform act passed by US congress in July 2010, handed the CFTC and SEC responsibility for re-regulating the swaps market. The US’s experiment with an unregulated OTC derivatives market, which commenced in 1999, ended disastrously in 2008 with the collapse of the investment bank Lehman Brothers and the onset of the global financial crisis.

In his speech O’Malia argued that the CFTC’s obsession with rule-making has done little to enhance customer protection in the derivatives markets, adding that the CFTC has singularly failed to get to the bottom of the reasons for MF Global’s collapse. He said: “Futures customers – including farmers, ranchers, and manufacturers – have been suspended in excruciating limbo… This situation is intolerable and unacceptable.”

Ann Barnhardt, (admittedly a somewhat whacky) broker is so outraged by the circumstances surrounding MF Global’s collapse that she claims to have lost all confidence in financial markets and shut down her brokerage, returning funds to customers. In a powerful and much commented-upon blog post (“Nutshelling the MF Global collapse”), dated October 31, Barnhardt wrote:

“The regulatory bodies are run by evil, evil people at the top who are complicit in these goings-on. There is NO POSSIBLE WAY that MF Global could have passed any honest audit with the amount of exposure it was carrying in the European bond market. By the way, MF Global’s audit would have fallen under the jurisdiction and oversight of the Chicago Mercantile Exchange itself AND the Commodity Futures Trading Commission on the Federal level. It is just impossible that the CME and the CFTC didn’t know MF’s position and risk exposure all along.”

O’Malia used less intemperate in his language. He said:

“I’m puzzled by the Commission’s attempts to regain public confidence through new regulation. I am particularly puzzled because the Commission’s most recent rulemakings don’t even address MF Global … Now is the time to articulate a thoughtful, coherent approach to strengthening our segregation structure. We owe futures customers at least that much.”

O’Malia told the New York lawyers that he advocates a system of random spot-checks to ensure compliance with rules governing the segregation of customer funds and restore market confidence. He also said he wants the CFTC to promote revisions to the US bankruptcy code that would ensure customers are prioritised in the event of the failure of an intermediary such as MF Global, which was run by former Goldman Sachs CEO and former governor of New Jersey Jon Corzine.

As chairman of the commission’s recently reinstated Technology Advisory Committee O’Malia added that he wants to harness the expertise of those on the C-TAC, in order to establish technological ‘best practices’ for oversight and surveillance considering such issues as algorithmic and high-frequency trading, data collection standards, and technological surveillance and compliance.

He stressed that MF Global had not failed because of lack of regulation, but because it broke the rules and the commission had been insufficiently vigilant. He does not believe that regulation and oversight can substitute market discipline.

On February 1 it emerged that CFTC Chairman Gary Gensler, another alumnus of Goldman Sachs, had ordered an extensive review of how futures brokerages are regulated. According to a Reuters report, Gensler wants a shake up because of the crescendo of questions about whether the CFTC or exchange-operator CME Group, whose self-regulatory arm acted as MF Global’s front-line regulator, were asleep at the wheel ahead of MF Global’s collapse.

Maybe this review will conclude that outsourcing the minutiae of regulation to private-sector bodies such as CME Group, and having a disjointed approach to regulation that leads to massive “underlap”*, is a recipe for disaster.

*The opposite of overlap, this occurs when multiple regulators oversee the same firm, and important aspects of regulation fall between two stools and get ignored. It was one reasons for the failure of the tripartite system introduced by chancellor Gordon Brown in the UK in 1997.

This article was first published in QFINANCE on February 8th, 2012

Further reading on swaps and futures regulation:

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