CME Group Executive Chairman Terry Duffy has led the Chicago Mercantile Exchange as chairman since before it became a public company, before its common clearing link with the Chicago Board of Trade, before the CBOT merger, before the acquisition of the New York Mercantile Exchange, before there was such a thing as CME Group and when most trades were still executed in a pit on the trading floor. But with all those monumental changes that occurred under his leadership, his greatest test may be building back trust in the industry itself, trust that was shattered when MF Global violated customer segregation rules. We sat down with Duffy to talk about what happened and potential changes that may come out of the MF Global crisis.Futures Magazine: Knowing what we know now, do there need to be changes made in the industry? How do you regain the trust of people using the markets?
Terry Duffy: I would say that if people have viable alternatives to the way the industry is conducted today they should be on the table. What cost [would those alternatives put on] participants of the marketplace? And then I would say, how many times has the current system failed the industry participants in the last 75 years? And now tell me what are you going to do that makes the current system better than it is with your recommendations? We had one incident in 75 years where someone decided to do this. I believe, and I said this in my congressional testimony, the fines and the penalties need to be stiffer for anybody that dips into customer funds for their own benefit. What is the biggest misdirect, and nobody has said this except for me, is when you do a repo the securities have to be in the customer segregated fund account before the cash comes out. That is the law. And when you reverse it, the same thing has to happen, the cash has to go into the account before the securities are released. Nobody has [asked] if that ever happen. Did MF Global make sure the securities were in the person’s individual seg account before they took the money out in the repos? There should be nothing missing if the securities are in there. Where are the securities? Where are the 1.25 regulated CFTC securities? Why are they not being replaced? That is the way the law reads, it has to be there before the cash comes out.
Duffy testimony to House Agriculture Committee on Dec. 8, 2011
Duffy testimony to Senate Committee on Agriculture on Dec. 13, 2011
FM: You say the fines need to be harsher, but is there anything else that can be done to make sure these firms are compliant?
TD: Of the $5.5 billion that was held at MF Global, CME had $2.2 billion. When MF Global collapsed and there was X amount of money missing, whether it was $700 million or $1.2 billion, CME still had $2.2 billion. Not one penny was missing from CME at the clearinghouse level; the money was missing at the firm level. That is an important distinction to show how we were managing the business from our end for our clients. Others have said that is a good example of [why] funds should be held at the clearinghouse level and not at the firm level.
FM: What do you think of that?
TD: It needs to be fleshed out more because I am sure there are some people who would be adamantly opposed to that, but there are ways that you could do both. Maybe there is a hybrid of both. Maybe there are certain clients that should have their funds held at the clearinghouse level vs. other clients that can keep them at the firm level. Maybe there could be an opt-in to do it. There are things like that that are very much acceptable to CME. I am concerned about every account, [but] some of the smaller farmer/rancher accounts that are bona fide pure hedgers may need to have a different distinction than some of the other participants in the marketplace. I say that because they are smaller accounts, they are pure bona fide hedge accounts, there is no speculative trading going on, they’re basically just hedging their crop or hedging their livestock risks. They are normally smaller accounts with smaller positions; maybe they should have a different distinction. There are many people in the world that count on this constituency in order to eat, in order to be productive; one of the greatest assets this [country] has is it farming and ranching community. Maybe there are certain things we need to do to segregate them out differently. Bring them into the clearinghouse. And maybe there is an insurance type of [program] you can have for that smaller constituency, but [insuring] $158 billion in customer segregated [funds] would [require] a pretty enormous premium, and I don’t know that anyone would entertain that. But if you wanted to entertain something smaller for this particular constituency, that may make sense, and if others want it maybe they have to opt-in to it at a cost. I don’t have all the answers but these are some of things we are [thinking about]. I am trying to get feedback out of Washington and every member of Congress — I testified three times in nine days — and everyone started out saying ‘I have farmers and ranchers as part of my constituents calling me about this.’ I get it loud and clear. This is a big part of the business, not from the revenue side but from an importance of contracts [standpoint] and making certain that they have confidence in their ability to hedge their products for the food production of the United States and for exports. I would be very supportive of looking at doing certain things for the farmer/rancher who is looking for additional protection.
FM: There is some confusion over the shortfall. If total seg funds were $5.5 billion and the secured close to $5 billion, why is the shortfall $1.2 billion? Do you understand this discrepancy?
TD: We said we don’t believe it is $1.2 billion. That has not changed. We know that 72¢ on the dollar has gone back to every participant. We know that the trustee is holding [more than] $1 billion to date. So we believe that the shortfall in seg funds is somewhere between $700 million and $900 million depending on the clawbacks or things of that nature that the SEC says that were comingled from securities monies into the seg pool. Some people believe there was securities money from the broker/dealer side that was in the customer seg that they are trying to clawback.
FM: The SIPC trustee didn’t seem up to speed on futures operations. Did this delay what could have been a speedier recovery of customer funds?
TD: I don’t have domain expertise in this. We did a lot of things to speed up the process to get as much money back into the customers’ hands as possible by pledging the $550 million to the trustee. We had a liquidation facility on day one for people who wanted to liquidate, so that was a misdirect [to say] that people could not liquidate their positions. We also moved 36,000 accounts within four days of the collapse of MF Global to other brokerage firms and, in doing so, if you had an open position we gave 60% of the margin associated with the opening positions. Two weeks after that we gave 60¢ on every dollar for people who had cash only accounts, two weeks after that 72¢ on every dollar was returned to every MF Global customer from non-sufficient funds to cash only accounts to small accounts and accounts with large [balances]. It moved relatively quickly for the size and scope of what happened here. When you are out whatever the money is, one day is too much and I get that, but overall when you look at it in retrospect compared to other bankruptcies, this was a pretty expedient return of a good chunk of the money.
FM: Aren’t there some people with physical holdings who are not at 72%?
TD: Some people are not at 72% because there are warehouse receipts related to gold and silver, and there are some that don’t have 72% because they have warehouse receipts on grains that have loans against them. If you have a loan that you have a warehouse receipt on, that is still MF Global’s property. So the trustee said if you want to buy that back, we will give you 72% of that also.
FM: Several people in the industry suggested that CME should have made customers whole and take over all their claims. Was this considered?
TD: There is $158 billion in customer segregated funds. For CME to step in and say ‘we’ll take whatever the shortfall is to MF Global,’ what kind of moral hazard [message] does that send to the rest of the clearing member firms? That we are willing to go on the hook for $158 billion, so anytime you get in trouble you dip into seg funds and you say [the CME] will make it good. Does that make any sense? The CME did not cause this. I succinctly went through that at the Congressional hearings and nobody refuted my testimony, including Jon Corzine and [MF Global Holdings President and COO Bradley Abelow, and CFO Henri Steenkamp] when they were asked ‘did you go to the CME at 2 o’clock in the morning and tell them to stop looking for the accounting error, that you transferred $900 million of customer money to the broker dealer. Did you tell that to them?’ Their answer was yes, which means they didn’t refute that they violated the exchange rules.
Duffy testimony to House Agriculture Committee on Dec. 8, 2011
Duffy testimony to Senate Committee on Agriculture on Dec. 13, 2011
FM: The CME as the Designated Self-regulatory Organization (DSRO) for MF Global got criticized for being late to catch this. What changes, if any, should be made on that level?
TD: If people have viable solutions that could enhance the system, CME Group is open to listening to them. But what is important is that we had one incident in 75 years where somebody admittedly said they transferred funds out of the customer seg into their broker dealer. They also falsified reports of $200 million. We tied out 90% of the Wednesday’s monies against third-party validations, and that is against banks and other participants, to make sure the seg money was whole. So we have Wednesday’s (Oct. 26) money on Friday, 90% of it is tied out to say it is there and the firm is saying ‘we have $200 million excess’ and then they say, ‘oh by the way’ — after they admit that they transferred the money to the broker/dealer — they say ‘here is the real report from last week.’ We validated that the money is there on Wednesday so one can only surmise that something happened on Thursday and Friday before the bankruptcy. It is known that there were wire transfers overseas for large sums of money and they admitted that they transferred the money, but they didn’t tell us that until Sunday; they said it was an accounting error. So we are looking for a $900 million accounting error, with the CFTC not alone. We are talking about something that happened in a 48-hour period. The money was there Wednesday, it is not there Friday but we don’t know that until Sunday because you don’t get the report until a day later; to tie out a segregation report you cannot do it on a real-time basis because you have to validate it against banks and other records to make sure that money is really there. It takes 24-36 [hours] to validate and that is where we were Friday. We had 90% of Wednesday’s money tied out, saying the money was there. And it was there.
FM: Do you think the 1.25 rule was the problem?
TD: No. I think they dipped into customer segregated funds to make their other obligations good and were hoping to put the money back, but the candle burned out. That is my opinion.
FM: Could the last 10% not validated have been a problem?
TD: We were finishing it up, we had 90% validated of $5.5 billion, we had a report that shows they had [in] excess of $200 million; so far things are looking pretty good for Wednesday. The transaction was going to go through with Interactive Brokers and then all of a sudden there is a $900 million accounting error and everybody [is looking] for the accounting error. And then they say to us it is not an accounting error. That is the story here. It is not about what the CME did or didn’t do; it is people telling us that they took $900 million and moved it to their broker/dealer.
FM: Obviously it is the firm that is at fault here but the CME is its DSRO.
TD: Agreed. But when people are hell bent on doing things that are improper, they will find ways to do things that are improper. I have given a very succinct timeline to Congress. Read my testimony — that shows that we fulfilled our obligations as a DSRO.
Duffy testimony to House Agriculture Committee on Dec. 8, 2011
Duffy testimony to Senate Committee on Agriculture on Dec. 13, 2011
FM: Can you talk about the testimony you gave regarding the MF Global official who said Jon Corzine knew of certain transfers?
TD: I testified in the House Agriculture Committee on Thursday. On Saturday I got a phone call from our counsel saying that the House Financial Services Committee had requested we submit a succinct timeline prior to their upcoming hearing. We put together the timeline that is now public. When my staff gave me an advance copy of the timeline that was going to be submitted, I saw the information about the conversation our people had with MF Global staff during the weekend of MF Global's bankruptcy. It included the information about one of MF Global's employees saying that Mr. Corzine was aware of a wire transfer of $175 million out of customer segregation accounts. Had I had this information before, I would have included it in my original testimony to the House Agriculture Committee. However, when I saw that item and was aware we would be giving it to the Financial Services Committee, I also said we should include it in the Senage Agriculture Committee, which was to be held the day before. We needed to be as transaparent as possible and I did not want us to be seen as withholding information from Congress.
FM: Do there need to be any new rules or was this just a freak event that they just didn’t pay attention to the existing rules?
TD: MF was in clear violation of CME rules. They told us they violated the rules.
FM: You were a broker on the floor, perhaps executing hedges for customers damaged by this. How difficult has this been for you? Have any of your former customers contacted you?TD: I have talked to many of MF Global’s customers and we have [returned every] call. You have to remember there are 36,000 accounts. We have returned every call that we have gotten from MF Global clients. Is it difficult? You’re damn right it is difficult. I am very upset and offended that someone violated the trust of this industry that I have put 31 years of my life into, and others have put in even longer. I find it distasteful that people have [a] lack of respect for rules. I am passionate about it.
FM: What is your opinion of the Commodity Customer Coalition? They seemed to play the lead role in advocating customers be made whole. Would customers be at or near 72% if not for them?
TD: James Koutoulas and John Roe have done a very good job, and I absolutely agree with their position that customer segregated funds should have priority over general creditors or anybody else. Now I am not a bankruptcy judge and I am not ruling on it — this is my opinion. I am sympathetic to that because I believe it. I also said in congressional testimony [that] segregated funds don’t have SIPC insurance, they don’t have FDIC; they have the trust of the system, so they should come first.
FM: Do you think it was possible to make customers whole from the assets of MF Global Holdings and take customers out of the process immediately?
TD: That is what should have happened. They should have made the customers whole and then dealt with their problem. The customer segregated clients did not cause the European sovereign debt problems that led to the demise of MF Global. They had nothing to do with that. The bond holders were well aware of the sovereign debt positions, the shareholders were well aware of the sovereign positions; the FCM had nothing to do with the sovereign debt positions, so yes I do believe those customers should have been made whole.
FM: What are your other clearing member customers saying to you?
TD: I haven’t talked to a lot [of them]. I talked mostly to RJ O’Brien because they took the bulk of the accounts. I have been working with them to get the accounts moved over and to get people back in business. That was really my focus; it wasn’t more about what do we do next. …My focus has been on dealing with clients, dealing with the issue at hand. I haven’t gotten to what are the next steps other than what I said about bringing some of these separate accounts to the clearinghouse level. That would eliminate any potential for fraud at the FCM level and they would be protected. Would they be completely protected? No, because as you know, segregation works where if one rogue trader takes down the whole operation everybody is at risk. They would at least eliminate one of their risks, which is what happened at MF Global. That is something we should entertain. I have talked to end-user farmer/producers who have asked me if I would entertain that and I said I would because that is what they want.
FM: Some in the industry have recommended adopting a SIPC-type insurance program. What is your opinion on that?
TD: It should be something that we look at for smaller accounts [held by] the end-user agribusiness type of people that are hedging corn crops and livestock production. But to do a SIPC-type [program] for $158 billion, the premiums would be so astronomical that it would be very difficult.
FM: What about having segregated funds placed in a third-party repository?
TD: If there was a third-party custodial, that is something we would have to look into. I am not for it or against it; I would have to understand it more. I would have to see how the mechanisms work. I know how the mechanisms work at the clearinghouse level; I don’t know how they could work at a third-party custodial level because you are dealing with multiple exchanges [as well as] with accounts trading on foreign exchanges.
FM: Is this something that can derail the industry? Going forward what do you see for the industry?
TD: The industry has done a lot of good over the last 50 years. [It] educated a lot of people on the benefits of risk management; they understand the difference between capital formation and risk management now. As bad as this is I don’t think it derails the industry in any way, shape or form. Hopefully the monies will be returned to the MF Global participants who lost it. That should be everyone’s concern, but these are global markets that people need to manage their other businesses on and I don’t see that going away. If [the U.S. Government] didn’t have a liquid futures market, the cost of issuing U.S. debt would add to the taxpayers’ liability dramatically. These are critical markets, [and] people don’t understand what the fallout would be if they weren’t here. Milton Friedman said before he passed away that if we didn’t have futures markets today we would have to invent them. That is how critically important they are to the fabric of the global financial system.
I don’t want to [underestimate] how bad this event was, but I do believe the industry will move forward and continue to grow. The benefits truly outweigh one bad apple, and we had one bad apple in 75 years [that] has gone down this path.
