With the futures community still reeling from the MF Global debacle, the PFG fraud sent tremors through an industry that could no longer call MF Global a one-off event. In the middle of the storm was the National Futures Association (NFA), PFG’s self-regulatory organization. The NFA had escaped much of the blame that swirled following MF Global, but the PFG fraud raised questions regarding its competence and the function of self-regulatory organizations. Futures sat down with NFA President and CEO Dan Roth to discuss the improved safeguards in response to MF Global and PFG to keep seg funds safe and restore public confidence in the industry.
Futures Magazine: What changes did the NFA institute in the aftermath of MF Global to better protect customer funds?
Dan Roth: After MF Global we formed two committees: A committee of [self-regulatory organizations (SROs)] with the CME and a special committee of our public directors. The first rule changes that came out had to do with trying to impose safeguards regarding firms’ use of excess segregated funds to guard against an inadvertent use of excess funds that ends up costing customers money. We had a whole set of rule changes regarding immediate notification to regulators if the firm draws down its excess by a certain amount along with authorizations for that drawdown by principals of the firm, [as well as] certifications by the firm that they remain in seg compliance. The second thing we worked on … is to try and ensure greater transparency about [futures commission merchant (FCM)] financial information for customers. We will have posted on websites information about how customer segregated funds are being invested. That information was previously filed with regulators, now it also will be posted on our website along with other financial data from the FCMs regarding their capital requirements, their excess capital and their seg requirements, and their excess seg and whether they [engage in] proprietary trading and a raft of information. So in the immediate aftermath of MF Global the initial focus of those two committees was greater transparency of FCM financial information and additional protections regarding the ability of firms to draw down their excess funds.
FM: Have you reaped any tangible benefits from those changes?
DR: The FCM transparency issue was approved in July and that data will be posted on the NFA web site on Nov. 1. The rules regarding drawdown of excess funds have been in effect since Sept. 1.
FM: Given what happened at PFG was there an appropriate amount of urgency in the industry’s and NFA’s reaction?
DR: From our perspective there was a sense of urgency on the part of all regulators: The CFTC (Commodity Futures Trading Commission) and the SROs, which is why within a matter of weeks after MF Global we formed these committees and both of those committees had their recommendation of rule changes ready in March. Relatively speaking, that was a rapid response. Everyone felt a tremendous sense of urgency.
FM: What about after PFG?
DR: Before PFG happened, the SRO committee began looking at ways to make greater use of technology to monitor firms for seg compliance, which is where the idea of the online, view only access for regulators to customer seg bank accounts came up. We were developing that rule before PFG happened. Once PFG happened we took that initial concept and went further and said we have to be able to confirm all seg balances on a daily basis. … We started using the e-confirmation process as part of the annual audit process and that is what uncovered the fraud at Peregrine. So number 1, using the e-comfirmation process; number 2, moving beyond the confirmation process out of the annual audit and making sure SROs have the authority to go in and check at any given time; number 3, developing the system so that all seg depositories — bank, broker/dealers, money market accounts — will report to regulators on a daily basis the funds that they are holding on behalf of FCM customers so we can compare that information with the daily reports we are getting from the FCMs to identify any discrepancies. If there is a depository that won’t file that information with regulators, it is an unacceptable seg depository.
FM: Will this process be automated?
DR: Both accumulation of data and the analysis of data will be automated.
FM: Why wasn’t the PFG fraud caught during the spot audits of FCMs following the MF Global bankruptcy?
DR: The CFTC directed the SROs to go in and perform examinations of certain FCMs for seg compliance. We specifically asked the CFTC whether they wanted those examinations to confirm balances to outside sources and they told us “no.” The directions we were given by the CFTC to conduct those examinations did not include confirmation of balances to outside sources.
FM: In May 2011 US Bank had reported only $7.2 million in its PFG customer segregated account and later altered that number to $221 million. Why was the PFG fraud not discovered at this point?
DR: We should have followed up on that; we could have uncovered this fraud a year earlier.
FM: What did NFA learn from those failures to identify what was going on?
DR: Post MF Global we recognized that we have to have greater use of technology as a means of monitoring firms’ compliance with segregation requirements, and we were moving in that direction. Peregrine just upped the stakes. It wasn’t just the May incident by itself, it was MF Global and Peregrine together, which moved us to having daily confirmation of all seg balances.
FM: While having both cases occur in one year has been embarrassing for regulators, they are distinct. Describe the differences between the two.
DR: Both situations involved the misuse of customer segregated funds by an FCM. The nature of the misuse is different in that one involved outright theft; the other one involved a theft as well, but a theft to fund the firm’s ongoing operations and investments. One involves excess segregated funds where the firm is drawing down its excess segregated funds and in the process misused customer funds; the other is more of a blatant outright theft.
FM: Are you frustrated with the investigation of MF Global and the fact that there have been no charges filed?
DR: I have been around for a long time and I have seen numerous instances where the complexity of a criminal investigation and all the demands on the resources of the Federal prosecutors very often result in criminal prosecutions not being brought until the eve of the expiration of the statute of limitations. They are nowhere near that.
FM: There has been a lot of debate regarding creating an insurance fund to protect segregated customer accounts. IN 1985 the NFA studied this. Are you reexamining this? Do you think an insurance fund is necessary?
DR: That question has to be reexamined. The 1985 study examined various methodologies already in place to safeguard customer segregated funds and talked about various possibilities including insurance, but it did not attempt to calculate the actual cost of implementing an insurance program. You cannot intelligently discuss the issue of whether there should be some form of an insurance program without having precise data about what the cost would be. You can’t talk about insurance in the abstract; you have to know what you are buying and what you are paying.
FM: Can you design a compliance strategy that gives end users confidence that customer segregated funds are appropriately protected so that such a fund is unnecessary?
DR: We are talking about public confidence here. One question is: Will an insurance fund bolster public confidence? We are assuming you are talking about a fund modeled after other programs where there are caps on recovery. When you are talking about an institutional marketplace like we have, those caps would need to be sufficiently low that for a large portion of the marketplace that insurance program would do little to bolster their confidence. That is why this has to be studied to figure out where you could draw limits that would impact public confidence. The other part of this [is] what can you do from a regulatory point of view to bolster confidence, with or without insurance. The answer that we have been trying to develop is this concept of daily confirmation of segregated balances so that we are confirming on a daily basis from outside sources that the funds that the FCM claims it is holding, it is actually holding. That doesn’t address all the risk involved in customer segregated funds — there is always fellow customer risk — but regarding potential misuse of customer segregated funds by an FCM, daily confirmation of seg balances should go a long way to providing customers with assurances along with greater transparency about FCM data.
FM: Besides the specific measures to monitor movement of customer funds, have you looked at your general approach to self-regulation?
DR: We have the Berkeley Research Group conducting an examination of the NFA’s audit practices regarding Peregrine, and we look forward to any recommendations they have for how the audit process can be strengthened. We are hoping to get that in November. Another thing that we are doing is that we always have had a number of our staff go through a certified fraud examiners certification process. We have a class of 30 of our staff that are starting that program in the next week or two, and we will continue to send staff to the program on an ongoing basis.
FM: Did complacency play a role in these failures? Did the fact that there had not been breeches in customer seg funds provide a false sense of security? If so, how do you avoid this once things begin to calm down?
DR: I wouldn’t use the word “complacency.” I don’t think anyone in the industry has even been complacent about customer segregated funds; it has always been a core principle. But regulators tend to focus their attention on known weaknesses in the system and that is where you tend to allocate your resources, that is where you tend to spend your time. The failure of those two firms has certainly heightened awareness of those weaknesses but I don’t think we were ever complacent about customer segregated funds.
FM: For several years the types of investments in which FCMs could park customer money have grown. Those investments recently have been restricted under Rule 1.25. Did that go far enough? Should the industry look at the concept of the “float”? Is it proper for brokers to earn interest on excess customer finds?
DR: FCMs are profit-making ventures and they have to be able to earn a reasonable return on their investment. To the extent that you restrict their ability to make money by investing customer seg funds, that may be the appropriate thing to do, but it will increase fees and may ultimately further reduce the number of FCMs. When you further reduce the number of FCMs you reduce competition, increase fees and concentrate systemic risk.
FM: How has the relationship between the NFA and CFTC changed since MF Global? Have your individual roles and how you communicate change?
DR: Nothing has changed. There is not a day that goes by where we are not in contact with the CFTC — regulatory issues, enforcement issues, etc. I can say one thing is changing, it is the manner in which the CFTC performs it oversight for SROs because even before MF Global they moved away from annual enforcement reviews.
FM: When you first began to look at additional responsibilities in the OTC swaps world, the record of futures SROs appeared strong. Have the problems at MF Global and PFG forced you to alter your approach to regulating swaps? Where are you in regard to preparing for these additional responsibilities?
DR: Our regulatory role in respect to swaps falls into several different categories: The first is the registration process. We have been focusing on hiring the staff and training our other staff and preparing modules for our staff to follow regarding the submissions and preparing to review them when they come in December.
FM: You have said these failures have been more about enforcement than not having appropriate regulations. Have enforcement procedures improved?
DR: What I said was you can have all the rules that you want, but at the end of the day it comes down to enforcing them. Writing rules is not a cure for anything if you are not enforcing them. Fraud is fraud. It is not like there was not a rule saying you can’t steal customer seg funds. There are three components to any enforcement program: You have to have good rules on the books, you have to be able to detect violations of those rules and when you detect those violations you have to take appropriate enforcement action. The breakdown here was in detecting the rule violations, and we used standard audit practices including written bank confirmations that did not detect the fraud that was going on in Peregrine. That is why we have moved toward the daily confirmation process of seg balances. It wasn’t failure of the rules; it was failure to detect violations of the rules.
FM: The concept of self-regulation has come into question since both these failures occurred. What services does the NFA provide as a SRO — both in terms of education and enforcement — that would be more difficult for the CFTC (or some other more centralized regulator) to deliver?
DR: It certainly would be resource-intensive for anyone to duplicate what we are doing. Just this week we have done workshops for firms that will now be required to be registered as CPOs in New York, Chicago, San Francisco and London. We did a workshop for swap intermediaries, CPOs [commodity trading advisors]…that will have to become registered as result of their swap activities. We have done webinars for those categories explaining the registration process; we have had hundreds of firms participate in those. We will have in the next eight weeks a number of workshops for swap dealer firms to familiarize them with the registration process. Those are all different types of educational programs we have put on for members or perspective members to try and get them ready for these changes. That would be difficult for the CFTC to try and duplicate. It is easier for an SRO to work through that process than a government agency.
When you work for a self-regulatory body you have two jobs: For the overwhelming majority of members that want to comply, make sure they understand what they have to do and how they can do it; and two, for those members who don’t want to comply, your job is to identify them as quickly as you can and get rid of them. The former job is more in the nature of a membership organization than a government regulator.
FM: Have you added staff?
DR: Our budget for this fiscal year calls for a 27% increase. A lot of that is driven by swaps. You can’t build these systems without additional IS resources. Our current staffing levels are at 320.
FM: We speak with CTAs all the time who introduce customers, who are pretty unfamiliar with futures, to the industry. Up until a year ago, they would hold out the regulatory structure of the industry — customer segregated funds in particular — as a selling point. What can you say to those investors weary of what has occurred in the last year?
DR: The two things that I can tell them [are] by all means, [perform] due diligence on the FCM [with whom you are choosing to do business. We are putting as much information on our web site as we can to help them with that due diligence process to try and make the FCMs’ financial condition as transparent as possible. Number two, I would remind them that as we move toward the daily confirmation of customer segregation balances from all types of depositories [it] will be a tremendous enhancement to guard against any potential misuse of customer funds by an FCM.
