This morning, CFTC Commissioner Bart Chilton was on CNBC and spoke about the MF Global disaster. The one point I want to concentrate on is segregated funds. Corzine and MF Global committed fraud, and had a severe breach of ethics when they used customer funds to plug holes in their business. No other firms had ever done this, and it shocked the street when they did.
When someone is determined to commit fraud for whatever reason, no law, rule, regulation or penalty will stop them. In Corzine’s case he had enough hubris and money that he figured he could commit the fraud, get out of the situation and no one would be wiser. The bonds he bought blew up in his face. At that point, the trade became about ego not running a company and so he added up the costs/benefits of continuing the fraud and figured with his money and connections he wouldn’t get in too much trouble even if found out.
Now, the question becomes what to do about it. As my friend Jack B predicted, the predictable government reaction would be to ban it. Ban firms from investing segregated customer funds in low risk assets. We wouldn’t be in this situation if MF Global had invested in US Treasury bills, long taught in finance courses worldwide as an almost risk free asset. In virtually all finance equations, the risk free rate is implied to be the rate of some US Treasury.
When one looks at the market, or economic, impact of MF Global’s breach of ethics, what do we see? Who was hurt by the fraud the most? It wasn’t the banks($GS, $INTL, $MS, $C, $BAC). It was an exchange like $CME. The banks that got whacked were sold for reasons other than MF Global defrauding customers.
Exchanges have more of an economic interest in preventing this sort of fraud than the CFTC. They get punished financially. A bad or misguided regulation punishes everyone, and creates a different set of economic incentives. In this case, it’s truly one bad apple spoiling the apple cart.
What if we tackled the problem differently? Maybe instead of a ban, the CFTC ought to require more transparency by the firms and have them tell their customers what they are investing seg funds in. Customers would have more information and could choose firms accordingly. Or, the CFTC could say, “only invest in US Treasuries”. That still gives customers comfort, and if the US Treasury market blows up like the European one, we have much bigger problems.
A ban will create economic disincentives to become a clearing firm. It will further limit competition in a space that has seen rapid consolidation already. A ban will reward big firms that draw income from elsewhere, and hurt little guys. However, that being said, I understand the sentiment for an outright ban. It’s just not good economics.
If we look at market fallout, a different solution might happen. Since exchanges bore the brunt of decline, they have a huge economic interest to keep their customers in line. More stringent audit procedures and better tracking of funds surely will come. However, what about something really radical like disintermediation? This means that instead of being a client of a firm, you simply become a client of the exchange. If the exchanges are going to be on the hook, why should their clearing members collect all of the “consumer surplus” from commissions on trading. Why shouldn’t that go to the exchange?
Obviously, exchanges benefit from having a system of distribution. However, as we go forward, that system of distribution fights the transparency an exchange brings at every twist and turn. Goldman Sachs is no friend of any exchanges. They want to keep all their trading in house, and detest the transparency that open markets bring. It hurts their profit margin and ability to schnooker their customers.
But, an outright ban on investing customer seg funds is the wrong approach, and short sighted by the CFTC. However, when has anyone accused a federal regulator of being ahead of the curve and smart?