“If this can happen to a highly regulated company like [MF Global], who can we trust in the future? Now speculators have three concerns: 1. The market, 2. Our own poor judgement and 3. To hope the clearing [firm] will not steal the accounts.” Futures reader

It’s time to wipe that smug smile off our face, the “our” meaning the futures industry. The bankruptcy of MF Global revealed a breakdown of an industry that has thrived knowing that customer margin was “safe” because of segregated fund protections. The sacrosanct institution of protecting margin at the exchange clearinghouse level while enforcing a strict segregation at the clearing firm has been tested throughout the years: Refco, Stotler, Lehman, et al. Sometimes it wasn’t as it should be: Volume Investors, Sentinel. But typically the funds were moved over with accounts and positions so clients would not have to worry about where their money was in addition to market risk.

Having covered many of these firm failures — my first was in the 1980s when Volume Investors went down in flames because of the overtrading of three of its customers — I’ve learned moving funds is never flawless, but typically gets done quickly. Some events have had major snags, like the Baring default when overseas exchanges froze all Baring margin accounts. And of course Volume Investors was a disaster, largely because commodity options were so new and basically no margin was required on far out-of-the money positions. Although other clearinghouse members were fine, customers who had margin money at Volume had their funds frozen. The reality is that an exchange clearinghouse is obligated to its members, not to the customers of the clearing firm.

Enter MF Global, which adds some new wrinkles (see Trendlines overview, and “Top 50 Brokers: This one is on us” by Managing Editor Dan Collins):

1. Securities Investor Protection Corp. (SIPC) immediately took control of the bankruptcy after a request by the CFTC and Securities and Exchange Commission. Although SIPC took over the Lehman failure, Lehman’s futures commission merchant (FCM) and broker/dealer were able to send funds/accounts to Barclays before going into bankruptcy and before SIPC took control. MF Global didn’t have that luxury. Why?
2. Missing segregated funds at MF Global complicated the moving of seg funds. Required margin held by the exchange was fine, but roughly $633 million in excess margin held by the firm somehow disappeared between the time the CME Group — MF’s designated self-regulatory organization (DSRO) — audited MF Global the week of Oct. 24, and the following Monday, Oct. 31, when the firm declared bankruptcy. The funds — still publicly missing as I write this, 14 days after the firm went down — have been blamed on sloppy bookkeeping by MF Global. Of course it could be something more sinister, but if sloppy bookkeeping is a possibility, wasn’t this ever seen during audits? And does it really take more than a week to find $633 million, especially when the CME just had done an audit? And what about the outside auditor? Further, on July 31, 2011, the CFTC FCM Financial Data report showed MF Global already undercapitalized, so why wasn’t an auditor or regulator camping out at the firm?

Perhaps most blame should go to the trustee, who didn’t seem to understand the rules of the game. But the CFTC deserves as much blame, abdicating its responsibility when a huge majority of the MF Global accounts were futures based. Then of course blame the DSRO, which apparently dropped the ball on monitoring MF Global when things heated up.

So trading just got riskier, and the futures industry has been humbled. But worse, its bedrock — segregated funds — is now under fire while thousands of MF Global customers get burned.

The three practitioners on the panel did their best to dispel some of the myths surrounding high frequency trading helped by moderator John Lothian and had a sympathetic audience of members of the Chicago trading community but for those who view this practice as potentially disruptive, I am not sure they gained any believers.

Lothian presented a list of quotes — some fairly ridiculous — from media coverage of the space along with the correlated “myth.” Lothian did touch on the point that what these traders are doing is similar to what trades have always done — trade faster than the other guy, anticipate congestion levels and perhaps where stops may be lurking in the market and take advantage of it. Basically, finding an edge and exploiting it.

But when pressed, they had difficulty stating exactly what they do. In fact one of the panelists described HFT as trading done at high frequencies.

It is true that there are many different strategies than come under the broad umbrella of HFT. Don Wilson, Chief Executive Officer, DRW Trading Group volunteered that simple intercommodity spreads are a common HFT strategy. In the options world some strategies attempt to take advantage of maker taker pricing convention but the panel indicated that is a small percentage of professional traders. And there is nothing wrong with that. If you create rules with different price levels, traders will try and use it to get an edge. Perhaps that is the best definition of what they do, ‘attempt to get an edge.’

Richard Gorelick, Chief Executive Officer, RGM Advisors said that nearly all the numerous studies of HFT invariably show that HFT either has no impact on market volatility or that it acts to dull volatility. This makes sense as active short-term trading eats up volume and makes it easier for others to execute size without having a huge impact on the market. Hundreds of traders scalping in a market allows larger players to get off their size without it having a huge impact on the market. That is a good thing.

Wilson, said, they aren’t competing with institutional and retail traders; they are competing with other low latency traders. “It is not a new thing, it is a new way of doing an old thing,” he said.

They also argued that low latency and speed are not enough to guarantee profits. The strategies must be sound.

While it is understandable a group of high frequency traders get together to commiserate their fate of being misunderstood and unfairly maligned — hearing some of the more illogical charges, I sympathize — it does not educate those that would scapegoat them.

They have a perception problem and while many of us who see what they are doing as simply replicating what traders have always done just in the new trading environment, those that don’t understand include some regulators who can affect their business. And make no mistake, all those criticizing HFTs are not confused trading neophytes, there are some pretty knowledgeable people who believe they have an unfair advantage and are harming the markets.

It all goes back to a question I asked: You described some of the misperceptions but not precisely what you do. What do you do?

They need to do a better job of answering that question if they don’t want the regulatory hammer to come down on them. And the exchanges need to do a better job in explaining how collocation works and any other means to connect to an exchange match engine that can be viewed with skepticism. Who has access to it, how different market players access it, what is the cost. There is a pretty consistent opinion in many quarters that exchanges are giving these folks an advantage because they account for so much volume at the expense of other market participants.

If this is not true, then they need to do a better job of explaining why.

The story went on to say, “ Wall Street firms pushed up estimates for Standard & Poor’s 500 Index earnings for a 10th straight quarter, forecasting a 17% gain in 2011… That’s 9.9 times more than economists say gross domestic product will grow.”

Those economists are party poopers. 

My initial reaction was “duh.”

In finding analysts to provide an opinion on a market, we always have a hard time when looking at equities because we face this perma-bull outlook. When talking to futures brokers about say soybeans, some may be bearish and some may be bullish but when talking equities, it is hard to find a bear. If you watch certain business shows on cable you surely have seen some folks who have not given a sell recommendation this century, which included two huge bear markets, if not outright crashes.

It is awfully hard to find a broker to come up with a bearish outlook. This has been proven painfully obvious with scandals over the last decade showing e-mails from analysts at investment banks talking about how cruddy some stock was that they just had given a buy recommendation to. With the potential for greater restrictions on short selling, I don’t see this changing.

What was odd is the story tried to analyze this discrepancy as if there was some great mystery. “The split underscores the skittishness among investors, whose confidence has been shaken by Europe’s debt crisis and the slowing global economy.”

No. The split underscores the conflict of interest of brokers who want commissions. Every sell-off is a great buying opportunity. Sometimes they are sometimes they aren’t but when you hear that repeated after every move over many years you have to question the motivation of the analysts continually singing the same tune.

 I have to admit I found that amusing. You see, I had just posted a chart on our web site indicating how some significant technical support areas had been breached on the Dow Jones Industrial Average. I had been having a conversation with one of our contributors about this and he had indicated earlier in the week that the market could be facing a turning point.

Jeff Greenblatt (aka Fibonacciman) had noted on Monday, “Last week, it appeared we could be setting up for an inversion of the 610 trading day cycle to the March 2009 Haines Bottom. That window kicks in at the end of this week….  I remarked to my client base that we started getting that ‘end of world’ feel to things. It seemed like we were having a smaller version of 2008 all over again. … there has always been and now can’t be ruled out a chance we could have a market top as a result of all this on day 610.”

Actually it looks like the market topped on July 21 when it failed to take out a top from two weeks earlier and began its current slide. A slide that pushed the indexes up against significant trendlines that were subsequently breached. The point being there was some significant technical validation in yesterday’s move.

However what amused me harkens back to Geithner’s nomination. Jeff is an ardent technician who has pointed out in articles in Futures and at numerous conferences, that most important market reversals can be predicted through the study of technicals, more specifically market cycles.

He has pointed out that often we look to the newswires for reasons but even when the reason seems legitimate, like the Lehman Bros. bankruptcy, TARP vote, Japanese tsunami etc. there is a corresponding technical cyclical reason for a major price reversal.

Sometimes the news event seems paramount and at other times it seems a stretch as when in November of 2008 the pundits attributed a market bottom and subsequent rally to President Elect Obama naming Timothy Geithner Treasury Secretary. Really; that is what turned around the market?

At the time, Greenblatt had detected a significant technical top in the U.S. dollar, which he attributed to setting a floor in equities. The dollar and equities have been negatively correlated (look at yesterday’s action) especially in the last decade.

The Geithner story from 2008 illustrated just how silly the business media can be in trying to tie a market move to a particular item in the news. Now yesterday’s story was partly tongue in cheek but I guess it is only fair to blame yesterday’s carnage on the chance Tim Geithner will be staying at Treasury.

The scary thing is just how easily some of us can accept such dubious cause/affect assumptions. I am sure over the weekend you will hear blame being tossed around for what happened in the markets. It was the Tea Party? It was the President. It was the failure to extract deeper budget cuts. It was the cuts.

Perhaps it was technical.

Perhaps some analysts and pundits breathed a big sigh of relief when equities rebounded after a huger sell-off on Wednesday to close higher. No relief was in sight today as the Dow dropped more than 500 points and the S&P 500 dropped 55 pushing both indexes into the red for 2011. 

We see two possible explanations: fundamental and technical. First perhaps investors and the rest of the world where a bit shaken that a significant portion of our elected leaders would take us to the brink of default to prove a point. Basically that they would not be the first to blink.

 How much confidence can you have in an economy with such recklessness in high places going on? We pointed out last week that the debt ceiling debate was having real consequences. People and markets were working in a chance of a default — albeit a slight one — into their risk models. Margins rose and haircuts on Treasuries were increased. That meant funds had to be diverted from other things to cover that small downgrade in collateral.

That being said, the markets did seem a little toppy and last week’s sell-off pushed the indexes to some significant support levels that were taken out. So while you listen to blame get tossed around the next couple of days remember this move may be mostly technical.

More on this shortly.

In the last 10 years, however, things have changed as futures’ volume exploded, exchanges became public companies and big players in mergers and acquisitions, and assets allocated to futures based investment strategies have grown by a factor of 7X.

 Futures had moved into mainstream or so we thought. Yesterday the Wall Street Journal had a story about the CME Group revamping its Chinese renminbi futures contract. Below the main headline was a subhead that could have been 39 years old. It stated: “Exchange Group Plans Futures on Chinese Yuan, Denominated in Dollars; Moving Beyond the Pork Belly Pit.”

Moving beyond the pork belly pit? They moved beyond the pork belly pit before I started in the industry more than 20 years ago.

It was 1972 When the Chicago Mercantile Exchange launched currency futures through the International Monetary Market. In following decades the CME and Chicago Board of Trade launched interest rate futures, stock index futures, electronic trading and merged.

I understand that there is a certain romance with the pork belly contract and have even noted in print how the CME, now CME Group, is synonymous with it even though it has been decades since it has been a significant part of its business. But this is 2011. It was the 1980s when financial futures greatly surpassed agriculture futures in volume for Chicago’s futures markets. By that time bellies were more lightly traded than the other livestock contracts at CME, let alone their financial contracts.

We even wrote an obit on it when CME decided to move pork bellies exclusively online when they moved CME Group products to the CBOT trading floor. There was no room for the aforementioned belly contract.

And it is not jus the headline writer. The story includes the following: “…as it tries to keep pace with rapidly consolidating rivals, moving beyond the pits trading pork bellies, wheat and corn.”  The vast majority of futures volume in all its products have traded electronically for several years now.

Pork belly futures are still listed according to the CME Group Web site but there has been virutally no volume in 2011. Saying CME Group is moving beyond the pork belly pit is akin to saying Ford is moving beyond the Edsel or perhaps Model T.

When Derivatives giant Deutsche Borse announced its proposed acquisition (yes acquisition) of NYSE Euronext earlier this year, it was floated that CME Group would step in to acquire the NYSE, not the other way around. While that has not happened, it gives you an idea  of the size and scope of its business.

 Yet despite all this we still see talk of pork bellies and floor traders.

Earlier this week the answer from the Obama Administration appears to be “yes” as they decided to open up the Strategic Petroleum Reserve (SPR) along with the International Energy Agency (IEA)to make-up for lost Libyan production. The decision to release 30 million barrels of oil from the U.S. SPR over the next 30 days seems to be a stretch of the emergency role of the SPR and could be an omen of a slippery slope towards more government intervention.

As we noted in a subsequent post on the UNCTAD report, which recommended that central banks take affirmative action to roll back the effect of what it called the “financialization of commodity prices,” part of the reason for higher commodity prices is the use of agricultural commodities in creating biofuels. In the United States the ethanol industry is being subsidized by government so government action is, in part, causing some of the price dislocation the UN is  recommending be solved by more government action.

While the thrust of the UNCTAD report is that it believes speculation in these markets is to some degree the cause of higher prices — a view we do not necessarily subscribe to — it does acknowledge that more traditional fundamentals are playing a role. We continue to ask why all the prescriptions to address the so called problem focuses on the one side of the equation where there is no consensus rather than the side where there is a consensus.

As far as the Administration’s move, it is probably borne more of political considerations than an overall philosophy on markets, but we have seen that bad policy often pushes more bad policy. It is easier for politicians to create policy to address problems caused by other bad policy than simply reverse the original bad policy. This is a slippery slope towards more intervention in markets.

On the other hand, there is a civil war going on in Libya that has affected supply. Though there have been other supply disruptions that did not push us to tap the SPR.

The recent credit crisis proves that regulation is necessary, but the goal of regulation and government policy should be to allow markets to do what they do best. It should not be used to create an outcome, however beneficial that may appear to be at the time. The list of negative unintended consequences for this type of intervention are too numerous to mention.

And while my first reaction to the announcement was positive based on self interest — I am driving to the east coast this week — this doesn’t seem the type of emergency envisioned for the SPR.

It was a considerable victory for the upstart exchange because it would make it easier for end users to transfer their open interest to its clearinghouse from the CME Group clearinghouse or vice versa. 

But as we noted at the time it takes two to tango and the rule would not hold much weight unless the CFTC forced CME Group to accept EFF trades. Given a chance to say whether he would compel the CME early in the controversy, CFTC Chairman Gary Gensler told Futures that he would let the issue work through the appropriate channels. That he did.

What ensued was an almost comical back and forth between CME Group lawyers and the CFTC with an increasingly frustrated ELX asking the Commission to take more affirmative action. CME Group claimed that EFFs were illegal wash and or fictitious trades. The CFTC staff concluded that they were not and CME came back with yes they are.

At one point we figured that that we could simply add “CFTC says no they aren’t” and “CME Group says yes they are” to previous stories and be done with it.

Not to make light of the controversy because there were real issues on both sides. Exchange for Risk (EFR) transactions usually involve two related but materially different products such as cash and futures Treasuries where there is a risk involved. It is hard to dispute that the sole purpose of EFFs was to transfer open interest.  At the end of the day CME didn’t want that to happen,  ELX did and the CFTC, while perhaps thinking it may be a good thing, decided to stop short of forcing it.

The Commission did, however, hedge its bet by stating, “It is possible that in the future, under a different set of circumstances, the Commission could conclude that an exchange’s prohibition of EFFs does not comport with Core Principal 18.”

It also reiterated its disagreement with CME Group on its position that EFF trades violated the Commodity Exchange Act and said the exchange could not characterize them that way.

While this particular battle is over, I have a feeling we probably have not heard the end of EFF trades.

We found this disturbing and pointed out how the report acknowledged some of the fundamental factors behind the recent surge in commodity prices but then ignored them in seeking solutions.

The report talks about the surge in demand in emerging and emerged economies. The report also talks about how the use of food based commodities in biofuels has affected price and how government mandates that subsidize that use, have affected price. Oddly the UNCTAD report recommends more government mandates for a problem partially caused by government mandates.

The report also acknowledges the role of a weakening dollar on commodity prices and the fact that commodities have always been seen as a hedge against inflation.

But while acknowledging these real fundamental factors the report suggests that they alone do not explain the price surge and look to the financialization of commodities and the increasing number and impact of speculators. It seems odd to decouple the two because it is these fundamental factors that the speculators are reacting to.

The report’s analysis reminds me of the old philosophical riddle, “If a tree falls in a forest and no one is around to hear it, does it make a sound?”

However we must change the riddle a bit.

If nobody used commodity markets to hedge against inflation and the depreciation of the dollar, would commodities still go up in the face of rising inflation and a falling dollar?

If you follow the UN and the rest of the blame speculators crowd’s logic, the answer is no. They acknowledge that growth in Asian economies is leading to greater demand for meat and the grain to feed cattle and that commodities react inversely to a falling dollar and are used as a hedge against inflation but argue that those obvious fundamentals do not explain in full the rise in commodity prices. For that they blame excessive speculation or the financialization of commodities. However, it is exactly those fundamentals speculators are following. It is why they are speculating that prices will rise.

My favorite line from the executive summary of the report is: “The analysis clearly shows that information flows play a vital role in commodity price developments. The market distortions described above are closely related to the fact that market participants make decisions under conditions of substantial uncertainty (emphasis mine).”

They just described trading.

Futures markets provide certainty for hedgers in that they can lock in the price of a commodity, the future price of which is uncertain. A speculator speculates on the uncertain price of a commodity. Without “substantial uncertainty” there would be no need for these markets. Markets by their nature are substantially uncertain.

Be weary of anyone or any institution that believes they can change that fundamental truth.

The preliminary report showed the Barclay CTA Index down 1.79% and the Barclay BTOP 50 Index down 2.49%.

While many folks like to talk about bubbles and speculators, the culprit for the poor performance appears to be the large reversal in commodities that started at the beginning of May in response to an upward correction in the U.S. dollar.

Another interesting element in the report is that year-to-date the Barclay CTA Index is up 0.53% while the Barclay BTOP 50 Index—which includes managers with the most assets under management — was down 2.34%. This indicates a difficult trading environment for managers with a greater allocation to the most liquid sectors: financial and energies. Our slide show illustrates the key reversals in commodity markets as well as the choppy market conditions in some of the larger sectors.

While each market has its own fundamentals, it is hard to ignore the impact of the dollar, which has recently reversed again and is approaching its May 4 low. CTAs wouldn’t mind if the dollar decided on a direction.