The good news is that the trustee located and began to bring in $1.3 billion in customer segregated funds. This may have prompted CME Group to increase the guarantee it made to the trustee to $550 million from $250 million. This is not an allocation but a “good faith” attempt by CME Group to expedite allocation of customer funds by the trustee. This followed the shocking news that nearly three weeks after the bankruptcy filing the trustee stated that the shortfall in customer funds could be twice as much as previously believed. 

Adding to the growing confusion was the trustee’s insistence that the additional $1.3 billion in customers segregated funds did not change their opinion that the shortfall was larger, $1.2. billion or more, than what had been reported basically from when it was first discovered. 

The trustee did not explain how this could be even though a trustee spokesman acknowledged that the total of customer funds secured — funds that have been allocated back to customers and funds being held to eventually be allocated in an expedited claims process — was now north of $5 billion. CME Group disputed that the shortfall was much larger.

The apparent anomaly is in what MF Global should have had segregated at the time of the bankruptcy. CME Group estimates this number to be just short of $5.5 billion, the trustee does not acknowledge what this number should be, though they acknowledge that they have secured more than $5 billion so the only conflict appears to be what that number should be.

We do know that many customers going into the bankruptcy were pulling funds away from MF Global and that MF Global had, in the weeks prior to the bankruptcy, altered its approach to moving customer funds. We have heard from several sources that the broker stopped executing wire transfers and instead began cutting checks to move customer funds. Some of those checks bounced. If the difference in what should have already been moved out and what actually had been moved out is the cause for this discrepancy, the process could become even sloppier.

We do not understand how there can be confusion over this point at this stage of the game. We have heard plenty of anecdotal first person evidence that the trustee does not have a good grasp on futures operations and has not shown the appropriate sense of urgency in getting customer property back to them.

At the heart of this anomaly seems to be confusion over what customer segregated funds are or are supposed to be vs. typical claims in a bankruptcy. This may be because this is not the trustee’s area of expertise, which has been our first question in the whole process.

By some strange anomaly in the law regarding dually registered entities, a securities regulator was put in charge of what is predominantly a futures commission merchant liquidation. This made little sense and the entity we would expect to make this clear to the judge appointing a trustee, the Commodity Futures Trading Commission (CFTC), has been much less active than one would expect in this situation.

 The futures industry has grown exponentially in recent years not only because of its value in managing risk, but  in its structure that promises that customer funds are secure, even in case where a clearing broker fails. That principle is at stake. Great damage has already been done. In our December issue, that went to press just a week after the bankruptcy, we noted that a rather large story — the failure of MF Global, the eight largest bankruptcy ever — had become a sidebar in a larger story of why the customer protections we assumed would work in such cases, was not working. 

We already are seeing regulatory fixes, such as securities style insurance programs, being recommended for the futures industry. This seems extremely odd seeing that we still don’t know what happened in this case. The one focus should have been getting account holders their money back.

They are still waiting.

Worse yet, we keep on hearing frustrating tales about poor communication whether it be from the Commodity Futures Trading Commission (CFTC), CME Group or the Securities Investor Protection Corporation (SIPC) trustee from MFGI customers who for years were told by the leaders of the industry that what has been happening could not happen. Namely that their segregated funds where safe and would not be put in jeopardy even — or especially — in case of an FCM collapsing.

While there has been progress of late there still has not been a viable explanation why it has been so difficult to get customers their money back. We understand there is a shortfall in customer segregated funds and we understand an investigation takes time but there has been no logical explanation from the trustee why they can’t pinpoint the size of the shortfall or why what customer money is accounted for hasn’t been returned to them already.

And perhaps most disturbing is that what progress has been accomplished so far has been attributable to a grassroots movement of a handful of angry customers and ad hoc organizations formed on the fly as opposed to the so called leaders of the futures industry who have appeared to be asleep at the wheel and willing to let futures customers twist in the wind.

CME Group blamed MF Global shortly after the bankruptcy claiming that on the week they were in trouble (later determined to be Wednesday Oct. 26) they completed an audit that showed MF Global was in compliance with its segregation requirements. They then learned on Oct. 31 that MF Global had a shortfall in customer segregated funds (and by the way put out a pretty specific estimate of the shortfall of $633,027,696). According to numerous back office sources an FCM is required to report its customer segregated funds to its designated self regulatory organization (DSRO), in this case CME Group, on a daily basis. At the point their audit was completed, it was common knowledge that MF was in much distress so we find it difficult to understand how CME was not more on top of it. As former CME regulator Peter Moy wrote on a comment board, “in previous situations like MF Global, the Audit Department would be present at the firm everyday to insure that all segregated customer funds were properly accounted for. The excuse that they transferred the funds after the audit is lame.”

The CFTC has been MIA for most of this as Chairman Gary Gensler recused himself due to his relationship with former MF Global Chairman and CEO Jon Corzine from their days at Goldman Sachs. The SIPC liquidation trustee has come under a lot of criticism but most of it has to do with his lack of knowledge of the industry, which is why many in the industry were perplexed the CFTC and CME Group didn’t fight for more control of the process. One former MFGI customer who still has nearly $185,000 frozen wondered whether the trustee assumed customers with positions got 60% of their money back instead of just 60% of the margin held at CME Clearing.

It is an important question because the trustee pledged last week—after much external pressure from groups like the Commodity Customers Coalition (CCC)—to have an interim distribution to “cash only” customers. The Intercontinental Exchange (ICE) sent a letter to the trustee pointing out that customers who exited their positions before the bankruptcy did not receive any allocation as the trustee just completed a transfer of positions and a portion of the margin used to hold those positions. While the cash only transfer addresses certain customers, many other had only minimal positions and still have 80%, 90% or 95% of their accounts frozen. Today the trustee noted that there will be another interim distribution that would attempt to get all customers 60% of their assets returned.

Former MF Introducing broker Sean McGillivray just wrote, “The impact on investors have been well documented. Inconsistent and unequal treatment of differing accounts by regulators as well as the exchanges has eroded confidence in the system. It has also forced unnecessary client liquidation losses. Our firm now holds unsecured debits on the books at our new FCM, because of the CME’s (half hearted and really half thought out) transfer plan.” McGillivray went on, “The majority of our client accounts remain frozen with little hope of a speedy resolution. The industry must step up to restore confidence. The CME is one of the few entities capable of guaranteeing any shortfall, effectively allowing for the immediate release of client funds.” 

This is one of many notes we have received detailing the frustration with a broken process and a disconnect between customers and businesses under stress  and those responsible for resolving a problem that was not supposed to happen and has not been well managed.

So lets recap. Tomorrow will be three weeks since MFGI went under. The trustee completed it initial transfer that returned positions and $1.5 billion in customer margin money last week to 14,500 accounts. It has pledged a second distribution of 60%, about $520 million, of the capital in cash only accounts. The second distribution is said to have begun but is not complete. When that is complete it would mean that just over $2 billion of $5.4 billion would have been returned to customers in just under a month. That is a little more than 35% of customer money that was never supposed to be at risk, even in a bankruptcy.

That is not a give job. Not by the trustee and not by the folks who should be looking out for their customers or the folks who are charged with keeping an orderly marketplace.

Throughout the process the language of the trustee appears to confuse the distinction between customer segregated money and general claims in a bankruptcy. Nothing has angered former MFGI customers more than the term “claims process.” They reply that they have segregated accounts. It is their money that by law is kept apart from the funds of the broker. They don’t want to make a claim, they want their money back. And they should have gotten it back by now, or at least what is left of it and they should be first in line for anything that is left.

It was no secret that the two Republican members of the commission, Jill Sommers and Scott O’Malia, would oppose the position limit rule and Commissioner Dunn was highly skeptical of its efficacy. Speaking to me at the Futures Industry Association Expo last week, Dunn acknowledged that lack of position limits where not impactful on the financial crisis and the agency needed to concentrate its efforts on things that would make the industry safer.

In several stories he has called positions limits a sideshow and his comment from a previous hearing — “With such a lack of concrete economic evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst, a placebo for one that does,”  — has gone viral.  

Dunn addressed Gensler directly asking him to give assurances that the agency would examine the impact of the rules after it became effective. You almost expected Dunn to ask Gensler to put his hand on a bible before responding to direct questions on the purpose of the rule and the role of the Commission. It made you wonder why he didn’t just vote against it. Perhaps approving a rule was the easiest way to move forward.

Dunn also expressed publicly and privately his frustration that they are still waiting on further definitions of swaps, which must be set before the rule becomes active.

What was clear from Tuesday’s meeting is that there was a myriad of compromises on the initial proposal to get the measure passed. What wasn’t so clear was why it was necessary. Those who believe speculation caused the run-up in energy prices in 2007 will not be satisfied nor will those opposed who will bear the cost of compliance, which is expected to run over $100 million.

The chairman and each of the commissioners separately made the point that the Commission was not a price setting agency. In fact, that was one of the questions Dunn asked directly to Gensler and he waited for the chairman to affirm that the agency was not in the business of setting price. The problem is that those advocates who most passionately have been pushing for positions limits believe that that is the role of the Commission or at least believe that if limits were in place the price of many commodities would have been lower in recent years.  

In fact U.S. Senator Bernie Sanders (I-Vt.) may have committed a crime in his fervor to castigate speculators by leaking non-public crude oil position data to the press and a  recent United Nations report flat out recommended affirmative government action in the markets to “correct” price.

Several panelists at the recent FIA Expo in Chicago made the point that often the loudest supporters of certain reforms be it transaction taxes or position limits are the most ill informed.

So we have a rule the necessity and value of whch three commissioners are uncertain of though there seems to be certainty on the cost, at least $100 million to the industry according to the CFTC, making it a major rule.

Dunn asked Gensler, “How will this rule impact disruptive trading practices and market manipulation and the resources at the Commission’s expense to combat them.”

Gensler said, “this rule is another tool to protect price discovery and promote fair and open and competitive markets, it helps protect against parties having excessive market powers therefore protects against corners squeezes and other manipulative schemes.”

There was more regarding large position reporting, information the Commission already receives, but $100 million seems like a large burden for just another tool. The cost estimate would seem to require the Commission to make a stronger case for the necessity of this rule.

Henry Jarecki, chairman of Gresham Investment Management, a long-time figure in both cash and futures metals markets and the subject of our May cover story gave a lecture in April at Georgetown University titled, “The Relationship Between Commodity Futures Trading and PhysicalCommodity Prices.” 

Jarecki has made his views known not only here but also testifying before the Commodity Futures Trading Commission (CFTC) on several occasions.

While Jarecki definitely has skin in the game — managing a long-only commodity strategy fund — he also has vast experience in both the physical and futures world and understands their dynamics better than most.

He points out that “the dollar values of the world’s physical commodity markets are, in every commodity, many times larger than the value of the associated open interest of futures markets (see table).

As one who has seen arguments on both sides and has observed some pretty specious arguments, I would urge those who truly want to understand the subject to read Jarecki’s piece.

The disconnect of those who would blame speculators, whether making an honest argument or simply reacting to populous demand, is in equating holding derivatives with actual physicals.

Jarecki writes, “one of the reasons it was so easy for the public to believe that commodity investors were responsible for increasing physical prices is that the argument relies on the public’s perception that in the physical world buying pressure inevitably causes price increases. To bolster this, the “impose limits and thus lower prices” forces utilized terminology that confused buying futures with buying physical commodities, and confused a demand for futures contracts with a demand for actual goods.”

 There has been a long debate on the subject of whether speculators, and more specifically long-only index funds,  are to blame for higher commodity prices. There has also been a lot of recommendations to address it but even those who support that argument would not argue that other factors play a definite role in price. Tangible real factors like a significantly weaker dollar, increased demand from emerging economies and a reliance on sources of energy from regions where ongoing suppply is at risk from war and civil unrest. As noted here before, why aren’t we seeing the same energy put forth to address these known factors.

It is astonishing to us that the CFTC has promulgated whole forests of rules related to Dodd-Frank and yet has not defined the entities and products that come under those rules. Seems backwards as noted here recently by our contributor and former CFTC Chairman Philip McBride Johnson.

We are sympathetic with the volume of work the Commission has had to undertake and realize that the definition phase is particularly cumbersome as it must be undertaken in cooperation with multiple other regulators, but it still makes no sense to save the definitions for last.

People and organizations are commenting on these myriad of rules unsure what particular bucket they and the products they offer and are accessing fall into.

A clear set of definitions as a first step could have helped streamline the whole process.

Now there is the chance that rules may be rendered meaningless as there is a real threat that Dodd-Frank could be neutered through a lack of funding. This type of uncertainly is bad for the markets. As is the prospect of defunding the regulators. Markets need clear rules or standards and their enforcement should be even, not based on a resource allocation decision within an agency.

If there are parts of the law people don’t like, work to remove them but don’t turn compliance into a voluntary exercise based on a cost benefit analysis estimating the regulators ability to monitor your activity.

If you recall retiring ALJ George H. Painter went out with a bang, claiming fellow CFTC ALJ Bruce C. Levine had a 20-year old policy of never finding for a complainant. Painter requested his remaining cases be reassigned to a judge outside the Commission in order for complainants to get a fair hearing in the notice announcing his retirement.

The story then took an odd twist when the Wall Street Journal published a piece, which included claims from a civil case involving Judge Painter and his wife that questioned his mental capacity.

The CFTC ruled against Judge Painter’s request, assigning his remaining cases to Judge Levine but would not comment on the underlying claim that the system was biased against complainants and had been for decades. The agency ignored it and seemed to be simply wishing it away.  

Well is was picked up by the Washington Post on Nov. 21, perhaps prompting CFTC  Commissioner Scott O’Malia’s letter to the Post earlier this week where he  references the story. If it weren’t for the link the Post provided or if you hadn’t been following the story you would not have known from O’Malia’s letter what he was talking about.

In it he opines, “If the CFTC’s reparations program has lost its value, the commission should consider other options, including eliminating the program.”

Perhaps he is is correct but if he is, it is probably the result of what most people acknowledge has been a stacked deck, which still reflects poorly on the Commission and the fact that they have not been forthright on the issue. We have expressed empathy for the commission in that this controversy sprung up while they are busy with writing rules for Dodd-Frank but it is not the type of charge — especially given the judicial track record that supports it — that can simply be ignored.

From reader comments  to numerous discussions with lawyers and insiders familiar with these proceedings  it has become clear that the CFTC reparations program has been broken for some time and that people in the know have simply avoided it.  Hell there is ample evidence that the CFTC enforcement team itself has avoided bringing cases before its ALJ’s, choosing other venues where they stood a better chance to bring enforcement cases to. But what of those folks who didn’t get the memo. The retail traders who brought reparation cases before to the CFTC expecting a fair hearing. Don’t they deserve a more detailed response than what was in O’Malia’s letter?

The former President said he agreed with Dodd-Frank in principle but that the regulators needed to push the rules out quickly in order free up lending.

Apparently the Commodity Futures Trading Commission (CFTC) was listening (Commissioner Michael Dunn was in the audience) as they just released a slew of new rules under the Dodd-Frank Act.

President Clinton stated, “The bill, probably out of necessity, left so much up to regulations yet to be published, commented on and approved that one of the reasons we don’t have a lot of  bank lending back in the system today — quite apart for the mortgage overhang — is that people aren’t quite sure yet what their capital requirements will be, what the cost of compliance will be… so on balance I like what I know about the bill, on balance I don’t like anything that is maintaining uncertainty among financial institutions that appear on paper to have $1.8 trillion in cash uncommitted to loans and yet the people are afraid to start loaning because of uncertainties about what the compliance cost will be.”

Not sure if the large banking institutions would agree with the former President when he went on to say even if the cost of compliance ate up a third of that figure that would be OK because at least the remainder could be loaned out.

He also said that bank lending would be preferable to a second stimulus package that has been floated.

Clinton estimated that the hole dug by the financial collapse was roughly $3 trillion, which would be quickly offset if available funds were unleashed on the economy. “If the banks have $1.8 trillion dollars and they all behave like old fashioned mom and pop community banks, in theory they have the capacity to loan $18 trillion tomorrow and this whole thing would be over in a nanosecond.”

Perhaps that is overly simplistic but it should give pause to those folks who believe that legislative gridlock is a good thing. Remember as passing financial reform became more and more difficult this year, more of the details were pushed to regulators, (though CFTC Chairman Gary Gensler says he has clear direction) . Many insiders told us that while any major legislation leaves a lot to the rule writing process that this was doubly so in the case of Dodd-Frank.

Clinton added, “I think the most important thing the Federal Government  could do right now is to get these regulations out, give the banks some certainty. They don’t even have to like everything, just tell them what the deal is and lets calculate the cost and get the show on the road. Every week that goes by is a week that loans aren’t made, businesses aren’t saved, new businesses aren’t started and we are not expanding.”

The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) held a joint round table discussion to gather views from panelists as the two regulators move to start writing rules governing swaps.  Gary Gensler, CFTC chairman, released a short statement before the round table saying, “Requiring swaps to be traded on regulated trading platforms will bring transparency and better pricing to the derivatives markets. This will lower risk and costs for businesses. I look forward to hearing panelist views at today’s round table to inform our rule-writing in this area.”

Panelists were mostly in line with what Gensler is hoping to see transpire, although there was still room for discussion on how SEFs and SB SEFs will operate. Much of that discussion centered around concepts of “fairness,” especially as it pertains to exchange access and disclosure.  While some advocated open access to anyone, many argued for minimum standards to be put in place, much like those in place on futures exchanges like CME Group.  They argued that while this move will mutualize counterparty risk, it will not eliminate it, so the SEFs should work to minimize possible risk.

Panelists stressed, though, their desire to see clear and objective standards put into place.  Instead of leaving things to be subjectively decided, most called for clear lines to be drawn to handle eventualities like how a firms growth will be viewed as well as the procedures for breaking trades and removals from the exchange. While there was an understanding that these markets will change and evolve over time, the prevailing desire among panelists seemed to be for clear answers and concrete guidelines. Not surprising considering the period of volatility, fear and often panic we recently saw.

The regulators have a big job in front of them as they have to define almost everything in this previously secretive over-the-counter market, beginning with determining what a swap is and which will be on what exchanges. Those are the questions that will have to be answered first, before questions of disclosure and registration can be definitively answered. To meet the deadline for new rules, the regulators have said they hope to have proposals of the rules drafted by mid-December.

The first story was that someone keyed in “B” for billion instead of “M” for million on an equity order in Procter & Gamble. P&G was one of the first stocks where odd price behavior was observed, which is probably the essence of that rumor. That has never been confirmed and I am not sure of any system that accept orders that way, most you must enter the numeric value — hence the term fat fingered error (holding down the zero key for an extra beat increasing the order X10, X100 or X1,000). A larger broker dealer that was cited in several stories denied that a fat fingered error by one of its traders was the cause of the crash.

The next set of rumors have surrounded the CME Group’s E-mini contract and talk that large sell orders in the E-mini S&P 500 set the markets lower. The CME released a statement  noting, “CME Group markets functioned properly yesterday despite significant market activity due to global macroeconomic conditions and apparent problems that resulted in the cancellation or ‘busting’ of securities transactions by The NASDAQ Stock Market and the NYSE Arca in coordination with all other UTP Exchanges.”  

 There doesn’t seem to me much to that rumor beyond equity market participants’ automatic reflex of trying to blame the futures markets for their problems. Anyone remember the 1987 crash?

Commodity Futures Trading Commission Chairman Gary Gensler has not ingratiated himself to the industry since taking the post but did defend it in testimony before the House Committee on Financial Services yesterday regarding the “flash crash.”

 In fact Gensler —  perhaps unintentionally, perhaps not — took a shot at the equity side with the following comment during his testimony: “…Requiring that stop orders have a limit avoids the potential that such stop orders could be executed no matter how low the market goes. This requirement for all stop orders to convert to limit orders prevents, for example, any stop orders from being posted at a price unreasonably below the market, such as orders at a price of one cent.”

 He rather humorously points out that though futures markets exhibited volatility, it did not produce the type of crazy anomalies that can create a loss of confidence in the markets. It is hard to understand someone making the case that a drop in an index can cause one of the equities within it to exhibit unrealistic prices, which occurred in several stock such as Exelon going down to a penny.

 In fact, one of our technical analyst contributors commenting on this noted”… I found that in all cases, major indices and futures markets stopped going down in the right place implying there was universal symmetry.”

 A more likely contributing factor is the NYSE Euronext’s mini circuit breakers called “Liquidity Replenishment Periods (LRPs). The LRPs are initiated during high volatility in specific securities.

 By all accounts — and so far there have been few — the LRPs did their job. The exchange turns off its auto execution function for stocks in LRP mode and orders are directed to the DMM (Designated Market Maker). The NYSE did not bust any trades and none of the ridiculous prints occurred on the NYSE. The problem is that when they go to LRP mode in certain issues, other exchanges no longer direct orders their way. This means they are no longer part of the National Best Bid/Offer (NBBO) and the overall market is less liquid as a result. One of the initial recommendations being bandied about is that these mini circuit breakers, as the LRPs are called, should be universal across all equity markets.

 Perhaps that is a solution but we need to know how this happened before offering solutions.

 One thing that should be clear is that markets that produced non realistic prices should not be blaming markets that didn’t.

I was expecting an arid presentation in Ben Stein mode, but it was not to be. Gensler was lively and witty. He stood firm on his conviction to regulate the OTC markets, equating what these instruments did to our financial system to what Mrs. O’Leary’s cow did to Chicago in the Great Fire. He shared barbs with John Damgard, the FIA president who is renown for his humor, answered questions from a somewhat hostile audience straightforwardly and even commended them for how they weathered the financial crisis. “While no TARP money was used to cover market exposures on cleared futures transactions, AIG had to be bailed out in part to cover uncollateralized and uncleared derivatives contracts,” he said in his speech.

This speech wasn’t breaking news. He has used the Chicago fire metaphor before, stating that the result was stronger building codes. And he’s said repeatedly that the multi-trillion dollar OTC market remains largely unregulated and the most important parts of financial regulation must include that largely “standardized” OTC derivatives be centrally cleared and that dealers be regulated. Gensler stated “In some cases, even when a dealer may have been part of the larger regulated financial institution, its derivatives business was not explicitly regulated.” AIG’s financial derivatives group is a good example. Gensler believes requiring those groups to have sufficient capital, post collateral on transactions and be “subject to stringent record-keeping requirements” would prevent the out-of-control trading on the other 20-25% non-standardized OTC derivatives.

Of course he brought up the whole “transparency” issue, but I’ve become cynical of this push, especially as hedge funds are no more “transparent” today than they were after Long-Term Capital Management or Amaranth. And surely there are rules and regulations in place that require that a company must be diligent in its oversight. AIG’s derivatives unit was making insanely large profits to the dismay of other units within the firm that weren’t living up to the bewitched corporate heads. Haven’t we seen this before in Barings, or a better example, Enron? High returns typically mean high risk is taking place. So what the hell were the overseers of AIG doing? Lehman Brothers is another example of Wall Street leadership largesse: according to the court-appointed examiner, allegedly Lehman chief Richard Fuld goosed the financial statements to show better results.

Although I applaud Gensler’s somewhat reasoned approach to regulate a large, unwieldy and highly lobbied group, especially when it’s a world he came from (Goldman Sachs), I’m still dubious. Seems to me the “smartest guys in the room” were doing their job: making money for the company. If they were committing fraud, they should go to jail. Period. But for Congress to work around the system to make it look like something is being done is flawed. The focus should be on the top executives and boards who were collecting checks while looking the other way. To use Gensler’s metaphor, ignoring the leadership oversight issue would be like new building codes that demand brick structures be built, but turn a blind eye to the inspectors who ignore poor wiring because they get a piece of the action.