From the January 01, 2012 issue of Futures Magazine • Subscribe!

Debate over on rule 1.25

MF Global effect

During the House Agriculture Committee hearings on MF Global on Dec. 8, many members were confused about the role the investments allowed under Commodity Futures Trading Commission (CFTC) rule 1.25 played in the bankruptcy. Because it was possible to invest in sovereign debt, the very instruments that may have caused MF Global to implode, and to execute repurchase agreements, many assumed this was the nature of the problem. Adding to this impression is the fact that MF Global had lobbied against changes that would restrict futures commission merchants’ (FCMs’) ability to invest in sovereign debt and execute repurchase agreements with affiliates.

Apple and orange comparisons aside, the MF Global debacle made it clear that FCMs would have less flexibility in what and where to invest segregated customer funds. Changes were made to broaden the array of FCM investment-eligible instruments in 2000, 2004 and 2005 through rule 1.25, but that was in a much different regulatory environment. This was confirmed on Dec. 5 when the CFTC approved final rules narrowing what FCMs could invest in through rule 1.25. Out were investment in foreign sovereign debt and the ability to loan capital in-house through repos. In was basically guaranteed U.S. Treasury instruments.

CFTC Chairman Gary Gensler stated during the public hearing, "the rule is critical in safeguarding customer money." He added, regarding the practice of FCMs loaning money in-house through repos, "I believe there is an inherent conflict of interest between parts of the firms doing these transactions."

Marc Nagel, COO of Dorman Trading, says the change won’t affect his firm or other smaller FCMs. "Ever since Lehman, we have told our customers that we don’t reach to get yield, we are strictly in Treasuries, overnight yields and IEF 5’s (Fed Funds instrument offered through CME Clearing)," Nagel says. "Whatever they do to 1.25 will make absolutely no difference in our life and I bet you that most small FCMs feel the same way about it. We saw people in the Sentinel case get wiped out essentially because they stretched for yield; we just never have done that."

Newedge General Counsel Gary DeWaal, who co-wrote, along with MF Global General Counsel Laurie Ferber, the comment letter objecting to the rule change a year ago, stands by its argument. DeWaal acknowledges the optics of it aren’t very good now but says there is no evidence to date that MF Global’s problems relate to its 1.25 investments.

"The system is designed to preserve principal," DeWaal says. "At the end of the day we are supposed to be doing a calculation that says ‘here is what we owe customers and here is what we have equal in value to that obligation and that is a 24-7 obligation.’ What is implicit is if you are a broker you hold your customer money inviolate."

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