CFTC under attack over residual interest rule

December 24, 2013 06:43 AM
Blog first appeared in DanCollinsReport on Oct. 4, 2013

There hasn’t been a lot of coverage of this week’s House Agriculture Subcommittee on General Farm Commodities and Risk Management preliminary hearings to reauthorize the Commodity Futures Trading Commission (CFTC), which is too bad because it was pretty explosive.

The primary purpose of the hearings was to explore ways to improve customer protections but the panelists participating used it to hammer away at the CFTC’s residual interest rule proposal.

Rarely do you hear a regulator criticize a fellow regulator but the National Futures Association President and CEO Dan Roth was sharp in his criticism of the CFTC on this matter. He pointed out that the rule—which isn’t really a new rule but a new interpretation of an existing rule—would not have prevented either the MF Global debacle or the Peregrine Financial Group fraud, in fact one of the panelists pointed out how it could have doubled the losses of customers of MF Global.

In the end Roth stated simply, “It is a bad rule.”

Subcommittee Chairman Rep. K. Michael Conaway (R-Tex) may have set the stage in his opening remarks by stating, “When crimes occur it is essential that our justice system acts diligently and decisively.”

The topic of criminal prosecution came out at several points in the hearings. Roth pointed out while a lot can be accomplished with civil penalties, “The strongest deterrent [to acts of fraud] is criminal prosecution.”

CME Group Executive Chairman Terry Duffy said criminal prosecution was in order in the MF Global case.

Perhaps most bold was James Koutoulas co-founder of the Commodity Customer Coalition who noted that the Department of Justice did not seem to pursue criminal prosecution despite “a mountain of evidence” and should look into whether MF Global executives perjured themselves in previous testimony before this committee.

Koutoulas pointed out that the leadership at MF Global was allowed to continue to run the company after the MF Global Inc. unit was split off into a SIPC bankruptcy despite nearly $1 billion missing in customer funds.

Unfortunately, none of the committee members asked the panelists more specific follow-up questions on what criminal prosecution should have occurred. I know of at least one panelist that would have been happy to add some meat to that bone.

They seemed content to talk about criminal prosecutions generally but did not seem appropriately curious about specific crimes that occurred in the MF Global situation and why a more vigorous prosecution did not take place.


What was apparent from the testimony is that that the CFTC doesn’t particular feel a need to understand how these markets work and don’t care to seek guidance from people much more knowledgeable than them.

They are required to do a cost benefit analysis of all rule proposals but it is clear from this and other rules they have put out that they do not take this requirement seriously.

Michael J. Anderson (Anderson testimony), representing the National Grain and Feed Association, testified that the CFTC could not have fulfilled its obligation to do a serious cost benefit analysis. He provided an example of a typical grain elevator business having to hedge $5 million in corn, wheat and soybeans. He noted that with current rules their margin requirements would be $920,000; if the residual interest rule is enacted they would be required to post an additional $1 million, more than doubling their margin requirement. And in the case of MF Global that means they would have stood to lose more than double.

Theodore of L. Johnson, President, Frontier Futures, Inc., said that all regulation should have a cost benefit standard, adding, “The benefit of the residual interest rule is less clear but the cost is real and substantial.”

Roth pointed out that the CFTC did not contact the NFA on the residual interest rule. “They didn’t seek our input,” Roth says.

Think about that for a second. The NFA is basically the point of contact as a regulator for all regulated entities in the Futures market. They perform audits, visit firms, and confirm segregated balances. They are much more involved with the day to day regulation of these markets yet the CFTC does not confer with them on a rule of this magnitude? While it would be fair to criticize the NFA for not catching the 20-year PFG fraud earlier, it was improvements in its oversight that revealed it. Those changes, as opposed to the CFTC rule, would not have created a potentially worse scenario.

Perhaps most enlightening and disturbing about the testimony offered is the complete lack of interest by the Commission of industry concerns.

According to several panelists the CFTC simply stated that their “hands were tied,” because the rule clearly states that no customer segregated funds can be used to back another customer. This despite a 39-year history of interpreting this rule differently. Roth noted that it was odd the commission misinterpreted a rule for 39 years.

Agriculture Committee Chairman Frank Lucas (R-Okla.) sat in on the hearing and was struck incredulous when the panelists confirmed to him that the CFTC had not consulted with the U.S. Department of Agriculture over its concerns with this proposal and were not optimistic that the CFTC would change the rule. (Later in the hearing Roth did state that he was “Optimistic reason would prevail”). Lucas Letter

In an earlier post I suggested that the CFTC had become out of touch and out of control. The lack of willingness by the Commission to engage the industry’s concerns as demonstrated by the testimony of the panelists at this hearing seem to confirm this.

Lucas asked Duffy what would be impact of the rule five to 10 years out. Duffy responded that he had met with all the major Ag producers and they ensured him that it would not take that long, they would be out of the market in five to 10 minutes.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.