CFTC – MF Global's collapse didn't happen because of a lack of regulation, NFA ponders segregation rules

In an interesting speech given by Commissioner Scott D. O’Malia at the Center on Financial Services Law, of New York Law School

In an interesting speech given by Commissioner Scott D. O’Malia at the Center on Financial Services Law, of New York Law School quite a few interesting things were said and although O’Malia didn’t think the CFTC is to blame for MF Global’s collapse he did make a lot of sense in other areas. Unfortunately it seems (and O’Malia actually says that) his voice is not heard in the Commission. This probably means more suffocating regulatory rules are coming and NFA is mentioned as pondering segregation requirement for its members.

Commissioner O’Malia surprisingly candid speech was very critical of the Commission, especially for focusing on what matters less. O’Malia seems to be quite unhappy with the Commission excessive focus on swaps regulation: “Instead of taking action to comprehensively identify and address vulnerabilities in futures customer protection, 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 rulemaking, while averting its gaze from the futures markets and their developments.

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Indeed halting Political Binaries launched by NADEX and regulating forex swaps is more important to the CFTC then plugging existing holes in its oversight.

O’Malia was spot on saying that “more regulation does not mean more safety. Instead of drafting new regulations, the Commission may need to focus on identifying weaknesses in existing frameworks and on strengthening Commission oversight.“. This is very true – since 2008 regulators worldwide and in US in particular are in a regulatory frenzy. We’ve entered the era of hyper-regulation and the first to suffer are ironically the clients. More regulation only brings more costs to brokers which are then levied on customers in form of higher costs or decreased competition (retail forex market is a prime example of that).

But then this part came: “I’ll tell you what the Commission should do, but first, let me be clear about what it shouldn’t do. There is a perception that MF Global happened because of a lack of regulation. That perception is mistaken. Both our governing statute – i.e., the Commodity Exchange Act (the “CEA”) – and our regulations require an intermediary – like MF Global – to segregate futures customer funds. Indeed, certain of our segregation requirements precede the formation of the Commission.

OK, so because MF Global was an intermediary it’s not CFTC’s fault. Right. Although we can’t really blame regulators for everything that happens in the market – this particular statement is just too much. Instead of saying it’s not our fault (this has already been said before) CFTC should see how indeed it was their fault and plug that hole.

And indeed Commissioner O’Malia is saying exactly that but without taking the blame: “Because MF Global did not result from a lack of regulation, 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. In December of last year, the Commission approved a final rulemaking on the investment of futures customer funds. In that rulemaking, the Commission restricted the universe of permitted investments.13 Whereas I was in favor of these restrictions given the volatile economic environment, I’m not aware of any evidence that the MF Global shortfall was related to investments of customer funds. Additionally, earlier this year, the Commission approved a final rulemaking on the protection of cleared swaps customer contracts and collateral. In that rulemaking, the Commission enhanced protection of customer funds in the event of a double default. However, this protection only extends to cleared swaps customers. Futures customers – such as the ranchers and farmers bearing the brunt of the MF Global shortfall – do not benefit from such protection.

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The Commission needs to stop addressing potentially fundamental issues through ad hoc actions. Now is the time to articulate a thoughtful, coherent approach to strengthening our segregation structure. We owe futures customers at least that much.

I’m awed.

I recommended that the Commission institute a system of spot checks for segregation compliance. These checks should be randomized as to date and should include an assortment of large and small intermediaries. The Commission could also coordinate these spot checks with the SROs. To date, the Commission has not acted on my recommendation. I continue to believe that a system of spot checks would deter intermediaries from maintaining segregation structures or practices that could be conducive to shortfalls – just like random police patrols can deter vandalism. I also believe that instituting such a system would be one of the most effective shorter-term actions that the Commission could take to increase public confidence. I urge the Commission to reconsider the idea of spot checks, and the idea of taking appropriate enforcement action against any intermediary that fails such spot checks.

A regulator that makes sense? Apparently it’s not an extinct animal.

NFA it seems will soon introduce a new requirement to its members: “I understand that the CME and NFA, among others, have formed a special committee to discuss segregation initiatives.”

O’Malia doesn’t think that insurance scheme are what the clients need to feel more safe and he’s spot on once again: “Finally, in light of MF Global, I often hear arguments advocating for a government insurance scheme that would function like SIPC. I’m skeptical, given that customers in our markets need quick access to their funds to meet the margin calls that happen every day. Insurance, by its very nature, is slow. I’m even more skeptical, given the size and institutional nature of the futures markets and the swaps markets. Just to put some real numbers into the debate – currently, estimates of the MF Global shortfall range between $600 million to $1.2 billion. According to the SIPC website, “[f]rom the time Congress created it in 1970 through December 2010, SIPC has advanced $1.6 billion…”. Further, according to the website, SIPC only has a reserve of slightly more than $1 billion.30 Therefore, one incident like MF Global could essentially eliminate the reserve of a SIPC-like entity.

Once again, it’s seems O’Malia represents a minority in the Commission and though most of his suggestions actually make sense – they won’t be accepted and the Commission may apply many more requirements over its members which will eventually harm the clients and not improve the safety of their funds.

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