Ironically, yesterday I wrote a piece on how the regulators around the world are not doing their jobs. Everyone wants to blame the banks. But we should be looking really hard at the regulators. Especially since it looks like they are tipping off the big banks as to policy action and helping them lie.
Late yesterday, a futures firm named PFG Best had “accounting irregularities”. They are now defunct. Unfortunately for a lot of customers, they had moved their accounts from MF Global to PFG. How sad is that?
It is very clear that the CFTC is not doing it’s job. Obama appointee, Chairman Gary Gensler is more concerned with trying to establish new regulatory powers and expand the reach of the CFTC than he is policing and running a clean marketplace. It’s up to the CFTC to make sure customers don’t get screwed.
In addition, MF lingers on. 28% of customer money hasn’t been returned. No one has received immunity, and no one has been charged with fraud, or had RICO statutes thrown at them. The MF case is political in an election year. The CFTC looks like a political machine hack organization rather than a regulatory commission charged with overseeing a volatile marketplace.
However, PFG is slightly different than MF Global. MF was a full line clearing firm. That means they not only had to pass muster with the CFTC, NFA, FIA but also with the exchanges. PFG wasn’t. They were a non-clearing member of exchanges. That means that all the trading done via PFG went through another clearing member who provided the capital and infrastructure to interface with the exchange. In PFG’s case it was Jefferies ($JEF). Non-clearing members are a 106.J member in CME Rulebook parlance. All firms are eligible for this category, including FCMs, hedge funds, commodity pools and other collective investment vehicles. They may have seats assigned to them, or they may lease seats, or some of the owners of the firm may own seats at the exchange-but they aren’t subject to all the regulatory requirements as a full line clearing firm.
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A non-member clearing firm doesn’t have a guaranty fund deposit, capital requirements/parent guarantees, financial reporting requirements, exchange audits, or in some cases NFA fees. That means if you clear through one of these firms, you better trust your operator.
The reason for this category is that CME wants to make it as painless and easy to do business with them as possible. In many cases, non-member firms provide valuable services to customers that otherwise would have a more difficult time accessing the market. So having this category has been beneficial not only to CME ($CME, $ICE), but to the entire marketplace as well.
But, now we see the risk in having this category. Since it’s a bit looser on the regulatory and capital front, there is risk. Especially in times like these when you have to question everyone’s capital allocations.
According to published reports, PFG was understating the amount of capital it had for months. Not by a little, but by a longshot. We will have to see how the situation unfolds, but it will have severe consequences for the industry. Exchanges will be forced to rethink how they interact with member firms.
Here is what I think will happen:
1. Traders are going to keep the minimum capital in their accounts. Only enough to hold a position, not one penny of excess. This increases the cost of trading since they will have to wire money back and forth all the time. It also makes it tougher on back offices for clearing members since they will have to work harder to process the transactions. In addition, clearing members rely on earning interest on the float. There won’t be as much interest when there isn’t cash lying around.
2. Futures brokers will have a hard time selling customers on trading futures. If I am a retail customer interested in trading, why would I put my money at risk in futures when I can do everything in the ETF market. $GLD vs $GC_F, $SPY vs $ES_F, $ZC_F vs $CORN. There are other considerations as to why you would want to trade futures, but with the unnecessary risk of worrying about if your money is safe, pay more all in to trade the ETF.
3. This will make the CFTC and other regulatory organizations go after futures exchanges and the entire industry even harder. Because of the way Dodd-Frank was written, they have the full force of the Federal government behind them.
4. Exchanges are going to have to rethink clearing. They will have to find a way to create more demand for clearing-and increase the amount of oversight on clearing firms. This will increase costs for trading. Independent traders will be hurt by this more than big hedge funds.
5. There will have to be some sort of insurance fund established for futures accounts. Bad eggs have ruined the system. We need to insure against that happening again. That increases costs for everyone.
Increased costs, more regulation mean lower volume. Lower volume means less efficient and transparent markets. Less efficient markets in the futures industry mean that it is harder and more expensive to transfer risk. That means higher prices for consumers.
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