Below is an article I wrote about how the managed futures industry is likely to react after the MF Global bankruptcy. I originally began drafting the article at the end of 2011 and finished it in the first week of January 2012. As we have already seen, the industry is in fact moving towards addressing some of these issues and ultimately I believe that regulatory and other changes will increase the vitality of the managed futures industry.
The article was originally published as part of the Marcum Private Investment Forum newsletter and can be found here. Please feel free to contact us if you have any questions or comments on the article.
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MF Global Bankruptcy to Shape Managed Futures Regulation in 2012
By Bart Mallon, Esq. Partner, Cole-Frieman & Mallon LLP
It was a combination of the Lehman bankruptcy and the Madoff fraud that led an angry and embarrassed Congress to publicly castigate the SEC for not properly doing its job. What came to bear was the passage of the Dodd-Frank Act which ushered in new laws for the SEC and the CFTC to implement in short order and with limited budgets. The CFTC is in the middle of a similar event which saw the 8th largest bankruptcy in U.S. history as MF Global (MFG) declared bankruptcy on October 31, 2011. The biggest revelation, however, might have been that $1.2 billion of customer money was missing. The fact that there was the potential for a "shortfall" in a managed futures account was shocking – the industry that had prided itself so much on the sacrosanct customer account was now trying to make sense of how something like this happened.
While the various investigators, including the FBI, are trying to figure out where the money is and what transactions are valid, Congress and others are debating the future of regulation for the industry. The Commodity Futures Trading Commission (CFTC), the governmental agency which oversees the managed futures industry, is dealing with not only the MFG bankruptcy but a whole host of other issues. The MFG bankruptcy has brought to light issues with the regulation of the managed futures industry – (1) the practice of utilizing self regulatory organizations (SROs) to oversee important entities within the industry, (2) no "insurance" for margin in managed futures customer accounts and (3) lack of proper funding for the CFTC. Ultimately these issues will need to be addressed and will shape how the industry is regulated moving forward.
Self-Regulation – Is the Fox Watching the Henhouse?
Prior to MFG bankruptcy, the managed futures industry prided itself on the fact that "not a single cent" was ever lost in a customer account due to theft from a futures commission merchant (FCM). Perhaps because of this, the industry seemed unconcerned about the hodge-podge of government agency oversight combined with self-regulation over the managed futures participants. The central SRO for MFG was the CME Group, the world's largest futures exchange which includes the CME, CBOT, NYMEX and COMEX exchanges. The CME Group is a publicly traded company subject to oversight by the CFTC with respect to its own operations and is also subject to oversight of its supervision of MFG.
MFG ran most of its clearing business through the CME. This means that while the CME derived substantial revenue from MFG, it also was in charge of overseeing MFG to make sure the laws and regulations under the Commodities Exchange Act (CEA) were being followed. While it seems like this will be a conflict of interest on its face, this is how the futures industry works. The argument for having the CME Group act as the SRO to MFG is that as the central exchange, it was in the best position to regulate MFG. The futures industry is an altogether different beast from the securities industry and the CME Group, because of its understanding of the relationships between the firms, was in the best position to oversee MF Global and make sure the firm was complying with all of the requirements of the Commodities Exchange Act. The CME Group is now being investigated – what did it know about MFG's shortfall and when?
It is easy to paint MFG as simply the bad actor by hiding transactions from the CME Group.