This article originally appeared in the April 22, 2013 edition of Crain’s Chicago. To view the original, click here.
By Lynne Marek
When people ask Michael Mason, a trader in the lumber pit of the Chicago Mercantile Exchange, why he’s wearing a flimsy temporary trading badge, he says it’s a reminder that MF Global Inc. still owes him money.
He once used MF Global to help execute his trades—with a badge that displayed that relationship—until the futures broker failed almost overnight, swallowing $1.6 billion in customer money that was supposed to be in protected accounts. “They stole it,” says Mr. Mason, who’s out $10,000. “It shouldn’t have happened.”
And then it happened again. The collapse of MF Global in 2011 was followed the next year by the equally surprising demise of Peregrine Financial Group Inc., whose 13,000 customers lost approximately $215 million. While futures market regulators repeatedly had disciplined both companies—New York-based MF Global had more violations than any other in the previous five years—they not only failed to prevent the biggest scandals in decades, but critics say the system hasn’t evolved adequately to confront changes in the market.
Crain’s reviewed five years of enforcement action by the two day-to-day regulators of the futures markets—CME Group Inc., which owns and operates exchanges including the CME, and the National Futures Association—the first comprehensive media report on the data. Among the findings:
• Actions against firms like MF Global and Cedar Falls, Iowa-based Peregrine, the entities that deal with customer money, accounted for only a small percentage of regulatory cases.
• The overall caseload has plummeted even as trading volume is growing.
• Especially at CME, regulators prefer to fine violators and allow them to continue to operate, rarely turning to harsher punishments even for repeat offenders.
In addition, while both organizations are overseen by the federal Commodity Futures Trading Commission, they often act like private clubs, meting out discipline with little transparency. CME even refuses to disclose the names of many companies responsible for a significant percentage of its trading.
For an industry like the futures industry that has always been known as safe and sound as far as segregated (customer) funds go, maybe we have taken that too much for granted,” says outgoing CFTC Commissioner Jill Sommers, who used to work as a lobbyist for CME. “Maybe it took those situations to show the rules are antiquated, how technology has to be integrated into policing the industry and how we can do these things more effectively and efficiently.”
CME and NFA say they have been vigilant in their oversight, kept pace with the industry’s electronic evolution and responded to the broker crises.
“Nothing is more important than the confidence customers have in our marketplace and the protection of our customers, and I think that’s underscored by the action and the leadership action that we’ve undertaken over the years to historically build up comprehensive surveillance and monitoring programs,” CME Chief Operating Officer Bryan Durkin says. The for-profit company operates the world’s largest futures exchange, audits large futures commission merchants, or FCMs, such as MF Global, and polices its own trading floors.
Chicago-based NFA, an industry-funded nonprofit that registers participants in the U.S. futures markets, has oversight over smaller brokers like Peregrine and a variety of other industry players. NFA President Daniel Roth says the scandals have driven his organization to rethink its enforcement procedures. “It’s an ongoing process, but, yes, I think we’ve made huge changes as a result of Peregrine and MF Global,” he says.
CME and NFA were well- acquainted with MF Global and Peregrine by the time the two firms collapsed. Crain’s review found that MF Global chalked up 20 offenses in the five years before it liquidated—more than any other firm or person in the CME database. And disciplinary actions over that span weren’t aberrations: MF Global was fined $10 million by the CFTC in 2009 for supervisory oversights between 2003 and 2008.
Peregrine was dinged six times by NFA and CFTC between 1996 and its demise. That included an unusually large $700,000 fine NFA assessed Peregrine in February 2012 for working with brokers who put their desire to maximize trading commissions over customer interests.
The enforcement data show that actions against futures commission merchants like MF Global and Peregrine, which are responsible for customer funds, generally accounted for about 15 percent or less of cases annually, though that percentage rose in the wake of the two failures, jumping to 30 percent at CME last year. At the same time, seven of CME’s nine biggest repeat offenders were approved to act as FCMs (although some of them play multiple roles on the exchanges).
The enforcement data also point to a system that largely has been focused on the trading pits and hasn’t changed dramatically as most trading has moved online.
The pits have been shrinking over the past decade, leaving just about 10 percent of overall trading in “open outcry” today. Over the same period, U.S. volume has increased 150 percent, despite a recession-related stall in 2009 and an 11 percent drop in contracts traded last year post-MF Global.
CME says low interest rates and low volatility have dampened trading, but others point to doubts about the system.
“The black eye that MF Global gave the futures industry, combined with the lack of response from the federal government, has left the market with a lack of confidence,” says Jeff Carter, a former CME board member based in Chi-cago who doesn’t trade anymore. “It will take a long time to bring confidence back to public markets.”
Another example is Rohit Patel, an independent electronic trader based in Dallas who initially lost $100,000 in the MF Global collapse and says he’s doing only about a fifth as much trading as in the past. Although he recouped most of that money, he says the slow return of his capital and the forced liquidation of positions he held in several accounts at MF Global multiplied his real losses to as much as $2 million.
“I am still trading futures, but I’ve cut back a lot,” Mr. Patel says. “I just don’t have as much faith in the system or the regulators.”
As floor trading declined, CME’s caseload contracted by more than half to 162 in 2012 from 455 in 2008, with many of the recordkeeping and procedural violations that were commonplace on the trading floor rare in the electronic realm. There was no obvious corresponding rise in electronic trading violations.
Several people who serve on CME disciplinary committees say that’s because recordkeeping mistakes, or even fraud, are less likely to occur in an automated system. But others question whether CME and other regulators have tools sophisticated enough to police the high-speed electronic traders, most of which are so-called prop shops, using their own capital rather than trading on behalf of customers.
Eric Wolff, a former head of market regulation at CME who serves on NFA’s business conduct committee, says that part of the problem is an unequal distribution of brainpower.
“I suspect that there are forms of violations—although clearly less frequent—that are occurring that are more difficult to detect because of the relative anonymity of electronic trading, that only really powerful analytic software is ever going to find. It’s not so much about resources—it’s about where the rocket scientists are. The rocket scientists are developing trading algorithms for prop trading shops,” says Mr. Wolff, who also is an industry consultant. “They’re not developing surveillance software for regulators.”
CME says the percentage of electronic violation cases has increased and last year led to two-thirds of all its enforcement actions. But it would not provide specific numbers and says it came to that conclusion by excluding pit-based recordkeeping cases.
CFTC Commissioner Bart Chilton says there’s evidence electronic traders routinely execute “wash trades,” an illegal move to buy and sell a contract with the intent of boosting trading volume and manipulating the price.
“I think we all are behind the curve in doing the types of surveillance, monitoring and enforcement that we need to do in the fast-paced ‘cheetah’ trading world,” Mr. Chilton says. “It’s almost impossible to keep up with them—you certainly can’t do it in real time. I’m convinced that on a regular basis, we miss a lot of things that have the potential to be unlawful.”
A recent study of NFA’s response to Peregrine found that front-line regulators were often green and easily intimidated. At CME, they’re more reluctant to acknowledge structural weaknesses.
“We have worked very hard over the last couple of decades, I would say, in trying to stay ahead of the curve in the context of developing very sophisticated surveillance technology, and we did so with the mindset of having technology that evolves with the market,” Mr. Durkin says.
In the handful of recent CME cases against high-speed trading firms whose systems ran amok, CME slapped them with some of its biggest fines, underscoring their threat to the market.
“The risks have changed,” says Neal Wolkoff, who formerly led CME rival ELX Futures L.P., a smaller, New York-based exchange. “Rather than serious risk to individual customers, it’s rather much more to the market as a whole.”
Chicago-based Infinium Capital Management LLC paid $850,000 in 2011 to settle charges that on different occasions in 2009 and 2010 its systems went haywire, in one case spitting out thousands of errant orders. Infinium sought and received price adjustments on the orders.
“The problem with the automation is that it’s like the ‘I Love Lucy’ episode where something goes wrong on the conveyor belt in the factory. It’s not just one mistake,” says Dale Rosenthal, an assistant professor of finance at the University of Illinois at Chicago and a former derivatives trader at Long-Term Capital Management L.P. “That said, it’s very easy to reform that sort of thing because you have clear evidence.”
But CME didn’t always spot the snafus itself. Rather, like Infinium, the firms reported problems, sometimes in hopes of revising bad trades. (Adjusting or canceling trades is frowned upon as a form of revisionist history, changing the way the market responded at a particular point in time.)
Unlike CME, NFA’s caseload has fluctuated over the past five years. The 2009 number was up more than 50 percent over 2008, mainly because the organization was granted more enforcement authority over foreign exchange firms. The association had been campaigning for years to have more authority in that area and ardently pursued targets once it received the go-ahead, Mr. Roth says. Even so, the total caseload fell 23 percent from that peak in 2011 and 2012.
Any fluctuations in caseload during the most recent five years are less important than a roughly 20 percent increase in actions by the association compared with 2002-07, he says. “Our risk-profiling system prior to that wasn’t as sophisticated as it is now,” Mr. Roth says.
The manner in which the Peregrine fraud was discovered highlights how NFA’s enforcement tools had fallen behind the times. The criminal activity was spotted within 24 hours after the association deployed an electronic bank statement confirmation service, called Confirmation.com. The service has been in use at the top 10 U.S. banks since 2010 and at some other regulators even longer, says Brian Fox, founder and chief marketing officer of the service.
Once wrongdoing is alleged, the most serious cases go to the CFTC for civil court proceedings or to the Justice Department for criminal prosecution. That was the case with Peregrine CEO Russell Wasendorf (at right), 65, who is serving a 50-year sentence at a federal penitentiary in Terre Haute, Ind. Neither MF Global nor any of its executives have been charged with wrongdoing, although the firm remains under investigation by both the CFTC and the Justice Department.
The CFTC says its annual caseload has nearly doubled, to 153 cases in 2012 from 85 in 2008. (Those figures include some cases outside the futures markets, such as Ponzi schemes.) “We have ramped up a lot,” says CFTC spokesman Steven Adamske, noting the agency’s enforcement staff has risen to 700 employees from 400 in the mid-2000s. Still, CFTC Chairman Gary Gensler said in congressional testimony in February that the agency was being forced to shelve some enforcement cases for lack of resources.
The feds have worried openly that CME has been slow to recognize the new order. In a 2010 review of enforcement procedures at the company’s Chicago Board of Trade and Chicago Mercantile Exchange and again in a 2011 review of CME’s Nymex, the agency expressed concern that CME’s compliance staff was being overtaken by rising trading volume and the increased number of products.
CME says it has increased its compliance budget to $40 million annually and has a total enforcement staff of about 200, with plans to add 11 positions this year.
Once CME regulators determine that punishment is warranted, they rely almost exclusively on fines to penalize rule-breakers. In each of the five years examined, more than 90 percent of the punishments assessed by CME were fines. Twelve cases resulted in fines of more than $200,000, including five against FCMs and two related to automated trading systems that went haywire. CME declines to say how much it collected in fines over the five-year period.
NFA also turned frequently to fines but was more likely than CME to bar wrongdoers permanently. NFA tended to deal more harshly with firms than individuals. A firmwide problem is a “serious rule violation,” but sometimes an individual just ends up at a “bad firm,” NFA’s Mr. Roth says.
NFA says it collected $7.1 million of the $7.4 million in fines it levied over the five-year period. If fines aren’t paid, members are barred.
SHORT ON INFORMATION
But the system is far from transparent, a major obstacle in assessing the regulators’ performance. For instance, it’s difficult to find out basic facts such as how many electronic trading firms are active on the futures exchanges.
Matt Simon, a senior analyst at Tabb Group, a financial markets research firm based in New York, estimates that high-speed traders are responsible for about half of futures trading volume. But he’s not sure because CME stopped sharing that information with him two years ago. Understanding where an order begins and ends is an important part of market transparency, Mr. Simon says.
CME won’t disclose the names of its high-speed market-making firms. “We consider that information to be proprietary customer information,” Mr. Durkin says.
Mr. Chilton of the CFTC says CME won’t disclose that information to him, either. He has urged requiring registration by the high-speed trading firms, but some commissioners oppose a mandate on firms that only trade for their own accounts and don’t use customer money.
CME also doesn’t disclose the names of people who sit on its disciplinary committees, though NFA does.
“We don’t want parties who may be appearing before a disciplinary panel to be in a possible position to influence those sitting on the panel,” Mr. Durkin says. If a case is moving forward to a hearing, then panelist names are disclosed to the parties, he adds—but not to the public.
And, as with any self-regulated organization, there are questions about conflicts of interest. CME, which is owned by shareholders, and NFA, which is funded and led by its 35,000 industry members, are focused keenly on expanding the futures market. Neither organization discloses publicly that a firm or individual has been charged with wrongdoing until a case has been resolved, sometimes years later.
Despite the recent scandals, CME has shown a reluctance to change even when questioned by its government overseer. Earlier this year, for example, the CFTC held a public meeting to discuss a proposal to review how CME and NFA examine firms like MF Global and Peregrine.
“Why do we need to have this done?” asked Ann Bagan, the head of CME’s clearinghouse audit department, posing what she said was a “fundamental question” for the gathering, given existing CFTC avenues for oversight.
CFTC Director Gary Barnett, who heads the agency’s division overseeing the swaps market, responded: “So, you’re OK with the status quo?”
After losing money with MF Global, managers Phil Farrell, left, and Howard Laube, at Elburn Cooperative Co.’s Maple Park facility, have taken precautions with their funds. Photo: Kendall Karmanian
Managers at Elburn Cooperative Co., a farmer-owned grain elevator operation that handles 30 million bushels of grain annually, say they have no choice but to keep hedging risk through the futures market despite losing money with MF Global. But they doubt the system can prevent another debacle, so they spread their funds among three FCMs and don’t leave excess cash in their accounts.
“Do we feel like enough changes have been made so that things like this won’t happen again? No, we don’t,” says Phil Farrell, an assistant manager at the Sycamore-based co-op. The response from CME’s leadership was particularly troubling, he says. “It really rubbed people the wrong way when they told people they didn’t do anything wrong.”
AN AUDITING ISSUE
Both CME and NFA have treated the MF Global and Peregrine scandals largely as an auditing problem. NFA commissioned a report by an outside consultant, who recommended that the organization revamp auditor training and hiring practices, update auditing procedures and better incorporate information from its own disciplinary reviews.
CME stepped up its reporting requirements for futures commission merchants, which are now “subject to more transparency and more accountability as it pertains to the maintenance and reporting of segregated assets,” Mr. Durkin says. Those include daily reports on the balances of customer funds, CEO sign-off on the transfer of more than 25 percent of total customer funds and more frequent spot-checks by CME staff.
Will that be enough?
John Roe doesn’t think so. He’s a former MF Global commodity trading customer who helped create the Chicago-based Commodity Customer Coalition to demand the return of customers’ money lost in the firm’s collapse. He’s also a newly elected NFA board member and wants the group to ban Jon Corzine (at right), former chairman and CEO of MF Global, from the futures industry.
“This is a kind of bureaucratic malaise,” he says. “If we’re not going to hold the big guys to the standards everybody else has to play along with, you’ve got to throw your hands up and walk away from the whole system. I want to make sure the system works.”
But, at least so far, the response from market regulators is to tweak the system rather than overhaul it.