Articles Posted in derivatives



United States v. Standard &

By R Tamara de Silva

January 5, 2013

       The Department of Justice filed a civil lawsuit yesterday against one of the of big three credit ratings agencies, Standard & Poor’s (“S&P”) and its parent company, McGraw-Hill, Inc.[1]  The suit alleges that S&P deliberately gave its coveted triple-A ratings to sub-prime debt in order to win fees.  The suit does not address the structural conflicts of interest within the three credit ratings agencies that are Nationally Recognized Statistical Rating Organizations (“NSRO”), nor will it address or cure any of the underlying causes of the credit crisis.  While there are problems with the credit rating agency business model, it will be difficult to prove that S&P knew any more than even the audit committees of the investment firms on whom it relied, or the issuers of debt instruments themselves.  The suit will of course result in the levy of a fine. 
But while S&P’s hands may not be entirely unsullied- far more importantly to the untrained public eye, they are as good a scapegoat as any other.

       S&P is a credit rating agency whose business is to provide credit ratings represented by letters from triple-A to D, in exchange for fees.  Federal laws require that certain institutions only hold investments that have a credit rating of “investment grade,” but most of the financial world relies on credit ratings agencies to weigh and measure risk, risk defined in terms of the credit worthiness of investments and institutions.    S&P is the largest of three credit ratings agencies that is recognized by the Securities and Exchange Commission (“SEC”)
as an NSRO.   From 2004 towards the end of 2008, S&P assigned credit ratings on nearly $4 trillion of debt instruments.  In terms of sheer size and credibility, despite this suit and skepticism of the NSROs particularly in Europe, the world has no credible alternative to credit ratings agencies and specifically nothing to replace, Standard & Poors.

       Keep in mind that almost five years after the worst financial crisis in United States history, the Department of Justice has yet to criminally charge a single culpable senior executive or firm.  If history is any guide, the Justice Department will reach a civil settlement with S&P wherein the firm will agree, without admitting any wrongdoing, to pay a fine that in relative terms, will have as large a fiscal impact on S&P as the cost of one month’s dry kibble would have to the owners of the Grumpy Cat.  The suit asks for a fine in excess of $1 billion but these will typically be negotiated down and the government has not latterly demonstrated a willingness to go to trial with these suits. 
Like so many Wall Street settlements reached over the past ten years,
the cost of the settlement fine imposed will ultimately be a pittance relative to the quarterly earnings of the offending firm-S&P is not likely to become the first exception to this rule.

       There in the gilded annals of academic and economic theory yet remains the tidy axiom that markets are self-correcting.  It is thought that market forces of supply and demand will drive out weaker competitors and bring in new ones through their own determinative natural selection.  It is not necessarily so.  Yet this assumption is an inescapable cliché of economic theory now unfortunately embedded into political discourse.  This axiom ignores the asymmetrical political and economic power of some market participants relative to others,
and the use of regulation to give some participants a structural competitive advantage over others. 
Self-correcting economic behavior occurs famously in the instance of market bubbles like tulip manias, Internet stocks and real estate bubbles, all of which eventually burst.  
However, none of this bursting applies to credit ratings agencies. 

       Credit ratings agencies are often wrong, have been wrong and will not, even under Dodd-Frank, need to be correct, much less try harder to do so,
or for that matter make any effort towards attempting to.   All three credit ratings agencies adjusted their triple-A ratings of debt instruments to less than investment grade at virtually the same time the rest of the world figured out there was a problem with them.  In their defense, S&P points out that credit ratings are, “forward-looking opinions about credit risk. Standard & Poor’s credit ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.” [2]  The problem is that by the time the credit ratings agencies, self-correct, their statements are no longer forward looking or even present looking but much more akin to being told how a movie ends a few months after you have seen it.

       Not that long ago, collateralized debt obligations were repackaged during the credit bubble into investment pools and other mortgage backed securities and collectively adorned with the gold standard of financial ratings, the coveted AAA ratings of the largest credit ratings agencies, Fitch,
S&P and Moody’s.   The credit ratings agencies gave their coveted and in theory elusive triple-A rating to investments that were anything but credit worthy or in the best case,
possessed of a very mixed credit pedigree.  The agencies’ bestowal of triple-A ratings to companies and investment vehicles that were junk and later discovered to be junk, caused losses in the billions and trillions of dollars to everyone who relied on their ratings–essentially everyone.

       The role of the credit ratings agencies, was present from Goldman Sachs’ knowingly selling instruments it bet against in Abacus to Citigroup’s selling of investments it also bet against-all these transactions of a seemingly knowing fraud were adorned with triple-A ratings.  Triple-A ratings played an essential role in the credit crisis- enough to make them arguably the largest “but-for”
causal culprit of the financial crisis. 
But for
the credit ratings agencies bestowal of triple-A ratings on sub-prime debt investments, the credit crisis would not have occurred.   But the financial world does not operate as simply as the liability model used by personal injury lawyers to make someone pay for car accidents or anything resulting in a personal injury.  The financial world is incomparably more complex and the causes of the financial crisis are many.

       In a larger sense, the credit ratings agencies cannot help it.  The fault lies with their business model and that having no competition, they really can be wrong in the largest possible way and not be “wrong” in the conventional sense. 

       The big three credit ratings agencies are bestowed with a monopoly by the government and if the world did not like the big three credit ratings agencies, it would find (with the exception of a few marginal players) that it had precisely nowhere else to go. 
Put another away, even after having the SEC accuse them of consumer fraud, and being about as wrong as they can be, the big three credit ratings agencies still rate 96% of the world’s bonds.  Sort of as Henry Ford was reputed to have said about offering customers the choice of a new model T in “any color so long as its black.”

       What is more, their business model makes the ratings agencies operate within a closed conflict of interest loop. 
The credit ratings agencies are paid by the issuers (who are also their clients) of the securities they were supposed to evaluate-this creates a conflict of interest.

       But the government, or specifically the SEC knew of the conflicts of interest within the credit rating agency business model and approved of them.  In June 2007, the SEC acknowledged that there might be a real problem having the referee in a match being paid by one of the sides-not the investors or the public’s side either.   The SEC asked S&P for documentation of how S&P handled conflicts of interests and after several months of scrutiny, approved of S&P as a NSRO–again, after having vetted the inherent conflicts of interest within S&P’s business model. 

       The ratings agencies have lobbying power in Washington and every interest in protecting their triopoly, which remains, even after the Credit Crisis and the implementation of Dodd-Frank, wholly unscathed.  But really, in the absence of any alternative and near total dependency, the world has an interest in S&P too.

       The most persuasive mitigating factor against charging the S&P or any of the credit ratings agencies with fraud is that they themselves relied on the internal audit committees of their clients/issuers.  The credit ratings agencies relied on the audit committees of their issuer clients, which committees had signed off and attested to the S&P and the other credit ratings agencies about the value and risk profiles of the investments for which they sought ratings.  Ultimately, unless corporate boards are compromised of crony Chia pets distinctly and wholly incapable of bearing any liability or culpability (a very real possibility upon even a cursory scrutiny- and another discussion for another time), they ought to bear the responsibility for misleading the credit ratings agencies, or simply not knowing what they were doing.

       Either the investment banks’ audit committees were not qualified to pass on these investments or the credit ratings agencies were not.  What now seems obvious is that both the credit ratings agencies and the audit committees were not sophisticated enough to understand the investment products they were charged with scrutinizing.  They approved of them anyway.  

       The credit ratings agencies could not give accurate ratings of many of the instruments involved in the housing bubble and credit crisis because of the complexity of the transactions involved and their inability to understand what they were analyzing.  Not knowing what they were doing makes them at least guilty, if they were regular market participants, (which they are not) of criminal fraud.   They may have culpability because they perpetuated a fraud on the marketplace by accepting money and using their position of trust, as a government sanctioned arbiter or investments, to pretend to pass on investments when in reality they did not know what they were examining or did and had a financial incentive to lie.  One thing is certain, were the credit ratings agencies like any number of the two-bit individuals the Department of Justice and SEC have prosecuted, one could say that the prosecution of fraud is not disproportionately tilted towards the smallest financial participants, or at least squarely away from the largest ones.

       In theory, the credit ratings agencies exist to level asymmetries of information.  They are also supposed to evaluate risk.  
Unfortunately, the credit ratings agencies have conflicts of interests and they evaluate financial products (like collateralized debt obligations)
that they do not understand.  They were far from alone in not understanding the debt instruments presented to them.  In 2007, even Ben Bernanke thought the risk of sub-prime debt was contained.  The ratings agencies, like most of Wall Street during financial crises seemed to lack fixed ways to measure absolute risk, and as a result during financial crises, when you would most want risk models to work, they too prove catastrophically wrong. 
Moreover, as much as Wall Street was wrong in assessing its risk, so was the government and many of Wall Street’s largest institutions-so why merely pick on S&P?  Unlike all of the players on Wall Street however, the credit ratings agencies are still the only game in town.  The Department of Justice’s civil suit will do nothing to change this.@

R Tamara de Silva

Chicago, Illinois


Facebook’s IPO, NASDAQ and the Illiquid Electronic Marketplace Revisited

By R Tamara de Silva

May 24, 2012

According to the news people, there is blame to be had all around after shares of the largest initial public offering in history, Facebook (FB), lost almost twenty percent of their value in the first three days of being publicly traded. However, the lasting lesson of FB’s IPO is that the financial world’s increasing reliance exclusively on electronic trading often leads to catastrophic problems during critical market events.

Discontent over FB’s IPO is heard from regulators and especially investors who saw the value of the their investment drop, to those who consider that the IPO was priced to perfection at 106 times its last 12 month’s earnings or at 5 times the value of the most valuable (according to market capitalization) company in the world, Apple. The possibility of investing in FB’s initial public offering, as in any other IPO, always bore the risk of buying an IPO at a price above its market price-that is the price it has in the publicly traded market. That said, very public examples of less than elegant IPOs are said, (whether in practice their impact is meaningful or not), to threaten the investing public’s appetite for prospective IPOs. Another concern with FB’s IPO is the possibility that FB, and its lead underwriters including Morgan Stanley, J.P. Morgan, and Goldman, Sachs & Co., failed to disclose material information involving new information about FB’s revenue prospects during the IPO roadshow to all but a handful of their large clients-not the public supposedly because their larger clients had paid for the seemingly “inside information.” Keep in mind that under the federal Securities laws, information about revenue, operations and prospects of a planned IPO are considered “material information” and must be divulged to the public in a very scripted manner. This has already resulted in a class action lawsuit filed for $15 billion in damages to the investing public. Another and more significant class action lawsuit was filed on the third day of FB becoming public, a lawsuit which picks up on the most important aspect of FB’s IPO – the failure of one of the world’s largest and its fastest electronic trading platforms-the NASDAQ.[1 ] Traders and investors who placed orders in FB on the day of its IPO were stuck in limbo as the electronic exchange that calls itself, “the power behind 1 in 10 of the world’s securities transactions” froze and stopped working. NASDAQ’s software issues constitute neither a reasonable failure nor an excusable one. Let the world take note that we will rue the end of the trading floor and open outcry as FB’s IPO demonstrates how we are hostage to electronic software that like all software will fail or have glitches and show us how worthless electronic markets are when they are completely illiquid and we are held hostage to them.

All market transactions involve a degree of risk. In the law as in the markets, there is a presumption, albeit rebuttable, that the greater the amount of information a market participant has, the better able the participant is to assume and understand the risk behind a transaction. Information is valuable in decision making until such time that too much information leads to diminishing returns because the amount of information incapacitates the decision-maker and prevents him from making a decision. Risk increases dramatically when a market participant’s information about price and order execution becomes nil. This is precisely what happened to the traders of close to 30 million shares of FB on the day of its IPO because of a software glitch at the NASDAQ.
What happened on the day of FB’s IPO to most of the traders of FB shares is a condition little understood-the state of high illiquidity along with a lack of transparency. Transparency refers to the degree of information that is available. In a perfectly transparent market all relevant information about a market transaction from the price, order size, order flow, trading volume, identity of the traders/counterparties, all bids and offers available, etc. would theoretically be discoverable.

Transparency’s value in the marketplace is best explained by its absence- a condition of opaqueness. Lack of transparency in the financial markets is called opaqueness. The environment that led to the past credit crisis was opaque. In the past mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth. The participants in instruments that led to that last crisis operated in a very opaque if not downright murky environment. The mortgage related securities being traded from brokers to banks and between banks were not pegged to the value of anything tangible and often marked by model to myth. One could make the case that they were not even derivatives because their value was effectively not derived from an underlying anything.[ 2]

Illiquid and opaque markets occurred during FB’s IPO. The opposite of illiquidity in the market is liquidity. Liquidity is the lifeblood of well functioning trading markets. In its simplest terms, liquidity is the ability of a market participant to trade at his or her price-that is to get in and out of the market at their chosen price. A history of the financial markets shows that liquidity requires a broad based collection of market makers to keep markets liquid. The more market participants the better. Without market makers, we see wide illiquid market spreads. These wide bid offer spreads in turn lead to market maker defection, to volume decreases and unfavorable trading markets for the public at large.

The regulated futures market, long a stepchild of the financial markets, with open outcry and electronic trading is the most liquid and transparent market in the world. It has been remarkably free from systemic financial crisis . . .with the exception of a certain salad oil scandal. All over the world at any given time, the value and the price of an S&P500 futures contract are known. What is more impressive is that during all major crises from the market crashes to presidential assassinations, the futures markets with open outcry have maintained their liquidity and their ability to absorb even the world’s crisis level order flow or volume-without a glitch.

But most people, even corporate governance committees at financial exchanges conflate volume for liquidity-they are completely distinct. Most of the trading volume now on the largest domestic trading exchanges is in the form of electronic trading or more precisely in the equity markets, it is in high frequency trading. High frequency trading is spreading from securities to other markets like futures, currencies, derivatives, and debt instruments and to the overseas exchanges. To put this in perspective, in 2003 high frequency trading accounted for only 5% of all trading volume while today it is well over 70%.

High frequency trading firms (“HFTs”) utilize a series of algorithms to take advantage of the computers’ speed and proximity to the marketplaces to get information about orders and price before every other market participant. Three types of institutions comprise the trading volume of HFTs and are what is meant by HFTs: 48% proprietary high frequency trading firms, 46% investment banks and 6% hedge funds. Investment banks often have dual roles in owning proprietary high frequency trading firms and directing investment bank trade to and from these firms.

The physical exchanges like NYSE, NASDAQ and CBOE lease out space to HFTs that allows them to place their supercomputers directly next to the supercomputers of the exchanges thereby giving the HFTs advantages of milliseconds and microseconds-to see price and order information (inside information) before anyone else that is not paying for co-location and does not have a supercomputer with algorithms at the physical exchange. Their proximity to the servers at the physical exchanges give them an insurmountable advantage which they utilize to “trade,” or effectively front-run everyone else’s orders. Any argument that we have a level playing field in terms of price and order information in the market today is simply false.

It should be said that for the majority of the time and in non-crisis conditions, HFT works and is the major revenue generator for the electronic equity exchanges. It is argued that HFTs, like their human counterparts, are market makers in that they provide price discovery. I am profoundly skeptical of the argument that HFTs are pure market makers as this term has historically been understood because they are not active market makers. HFTs are quintessentially passive, largely using their location and software advantage to detect volume and to see order flow before everyone else and to react to it. Their market making activities are essentially different from the floor trader and floor broker who will take an unqualified risk even in the most volatile times, HFTs make markets passively by reacting to other people’s activities that they are able to see happening before anyone else can. HFTs hold their market positions for milliseconds up to a few hours. Often HFTs fish for what order flow is out there by sending out false quotes to induce a reaction and therefore gauge the type of order flow that is out there in milliseconds before retracting its bids and offers-long before anyone would react to them…things non HFTs simply cannot do and what would on the trading floor be called the jailable offenses front-running and trading on inside information…but I digress.

The fact is most volume on equity exchanges like NASDAQ and NYSE are the result of electronic order flow and HFTs. However, these “traders” or algorithms are historically the very worst market-makers when crises occur because unlike their human counterparts, they largely bolt-withdrawing and canceling bids and offers en masse. Hence in times of crisis, in the marketplace dominated by HFTs, liquidity not just lessons, in the absence of human market makers, it largely disappears. What this means for all other traders and the public is that they cannot execute their orders or trade when a market crisis occurs.

This is what happened during the Flash crash of May 6, 2010 wherein the Dow dropped almost 1,000 points (the biggest intraday loss in history) losing nearly 10% of its value in seconds along with most of the 8,000 individual stocks and exchange traded funds, some of which traded 60% below their value of seconds prior before ultimately recovering. A September 30, 2010 report by the joint staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, that studied the causes of the Flash crash found that the presence of electronic trading and its interaction with HFTs during that crisis eroded liquidity, “the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets.”[3 ]

In the case of FB’s IPO, and according to sources including the trading database developer Nanex LLC, HFTs caused the NASDAQ to have to delay the opening of trading on FB because of “excessive quote cancellations,” adding that this is “ironic enough, it was mostly HFTs that benefited later when NASDAQ quotes stopped coming from the Securities Information Processor (SIP) which transmits quotes for everyone who doesn’t get the premium direct feeds.”[ 4] In other words, NASDAQ’s software could not handle the volume of bids, offers and cancellations from HFTs before FB’s opening.

At this point, it would not be logical for the exchanges to commission independent research and study into the true impact of HFT on price discovery, liquidity and volatility and what this means to their markets because the volume of trades generated by HFTs constitutes their major source of revenue. The exchanges now have a conflict of interest between their vital public functions of providing price discovery and liquidity and their bottom line.[5 ] Both the SEC and CFTC noted in their joint report into the Flash Crash of May 6 2010 that “high trading volume is not necessarily a reliable indicator of market liquidity”. As I stated above, liquidity erodes or disappears in a market crisis where there is a prevalence of HFTs because volume comprised of quotes and price information recorded in the milliseconds (1/1000th of a second) if not microseconds (1/millionth of a second and the current speed of many HFTs) that can be withdrawn and cancelled before ever being in danger of being executed is not only not known with certainty to be recorded, but it is “noise” in terms of its impact on price discovery and it is simply not executable liquidity.

There was a time just a few years ago when the largest exchanges in the United States were de facto public utilities. They provided the most crucial of all functions to the world, they established the price of all the metals, grain, oil and bonds the world needed to exist. Price discovery and the liquidity provided by their trading members to the world was a vital service to the world economy. The equity exchanges existed primarily to provide equity capital to businesses through the exchange in ownership of shares traded at the exchange. Now the exchanges are by and large public companies with elaborate corporate structures and well paid corporate boards whose concern has shifted away from assuring the most liquid and crisis-free markets in the world to layers of decisions made by committees all with the view to revenue and deliberately not thinking outside of the revenue generating box. This is not a problem in principle except in this case it will be because the exchanges in protecting their primary revenue source, the HFTs, will no longer function as they once did and the public will suffer. Future crises will likely result in crippling illiquidity that will harm the trading public and result in massive financial losses.@
R. Tamara de Silva
May 24, 2012 Chicago, Illinois
R. Tamara de Silva is an independent trader and lawyer
1. Case 12 cv 04054 Phillip Goldberg v. NASDAQ, OMX Group, Inc. and the NASDAQ Stock Market LLC-which I am attaching here: Goldberg v. Nasdaq .pdf

2. But if they were, their value was not discoverable, or perhaps not verifiable. The values of mortgage securities were not marked to market, they were not pegged to an underlying asset, and if they were, no reasonable allowance was made for unfavorable movements in the value of the underlying assets.


5. According to one credible source, one of the Chicago exchanges has established its own HFT that will likely compete with its customers and the investing public.

Why MF Global’s Last Days May Have Been CriminalBy R. Tamara de Silva December 19, 2011

Last Thursday December 15, 2011 was MF Global Holdings Ltd.’s and MF Global Inc.’s Chief Executive Jon Corzine’s third time to testify before Congress. He may not have faired all that well in light of Chicago Mercantile Exchange Group Chairman Terrance Duffy’s testimony on December 13, 2011, which seemed to contradict Corzine’s previous testimony. Corzine adjusted his testimony on December 15, 2011 to account for the seeming contradiction. However, how well Corzine may have done to avoid perjury or any role in a possible fraud remains to be seen. A closer examination of Corzine’s testimony and the events leading up to MF Global’s bankruptcy on October 31, 2011 suggests problems. If there is any purpose to be achieved in having Corzine testify again, lawmakers should focus their questions towards the failed purchase of MF Global by Interactive Brokers and all customer agreements, including emails between MF Global and account holders leading up to the purported transfers of $175 million and $700 million in as yet missing customer segregated funds and the firm’s use of a type of repurchase agreement.

Were the Transfers Legal?

In my first article on MF Global, I suggested that the $1.2 billion missing from customer segregated funds may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (as they did in fact as yield curves doubled rapidly in some issues) during the last weeks of October, and that funds were transferred to cover margin in customer funds held in European debt. In this scenario, as I suggested, nothing illegal would have occurred because CFTC Rule 1.25 had been amended to permit the investment of customer segregated funds in foreign sovereign debt.

Moreover, if the money was transferred legally and without any fraud, but simply lost in the market, there may not be any right to recover the money by MF Global’s customers in bankruptcy proceedings. The use of customer segregated funds for margin payments on repo-to-maturity (“RTM”) transactions are not illegal and hence unlikely, without anything else, to be recoverable in bankruptcy.

An alternate illegal scenario is that MF Global may have engaged in some late stage embezzlement of customer funds that were supposed to be segregated from MF Global’s accounts and never commingled with any other funds. [1] One way this may have occurred is if the funds were transferred out of customer segregated funds for a legal purpose but without the customers’ meaningful consent or, more likely, with an intent to deceive the customer.

MF Global was permitted to invest customer funds, and borrow customer funds so long as the dollar value of the funds taken from the customer segregated accounts remained the same-the accounts were kept intact. For example, if MF Global used customer funds by transferring a specific amount of money out of customer segregated accounts; it was required to simultaneously deposit something of equal value in these accounts to equal the dollar value of what had been taken out.

If MF Global transferred customer funds out of segregated accounts as a loan to MF Global to cover margin calls in existing positions in sovereign debt, (perfectly legal) [2], it may however, be fraud and intent to deceive on its part if MF Global knew it could not repay the money. This fraud may have occurred if MF Global knew (and it would be interesting to argue how it did not) that it sought to legally borrow from customer funds, knowing that it was de facto insolvent and could not replace the money.

In other words, an acceptable use of customer segregated funds for margin payments may not exist if at the time MF Global made the transfers, it was insolvent or in the midst of a crisis where insolvency was around the corner to be seen. Even if MF Global asked for and obtained the consent of its of customers, or consent was not required according to customer agreements, and it legally borrowed the money from customers by replacing it with other collateral (collateral such as commercial paper, as permitted by CFTC Rule 1.25), the transfers would still be illegal because MF Global would be deceiving its customers-knowing it was already insolvent. Even though the rules likely permitted the replacement of funds with other collateral (and the collateral was used) MF Global’s actions are arguably illegal because they were deceiving their customers knowing they would not be able to make the customers whole. Meaningful deception like this would be fraud and embezzlement in which case, the funds could be clawed back in bankruptcy proceedings-Please note that I am speculating a bit in specific statements about bankruptcy proceedings and do not specialize in this area of law.

Changing testimony or selective recall?

On December 8, 2011, Corzine testified before the House Agriculture Committee that he had “no idea where the money is” and that “I know I had no intention to ever authorize the transfer of segregated moneys. I know what my intentions were.”

On December 13, 2011, Corzine testified that, “I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue.”

On December 13, 2011 Terrance Duffy testified before the Senate Agriculture Committee. In Mr. Duffy’s testimony he said that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global’s broker dealer operations, that Corzine knew all about the transfers and likely authorized them.

On Thursday November 15, 2011 Corzine repeated that he did not authorize any illegal transfers, pointing to his General Counsel and Treasurer as the people who would know about the transfers. However, he was able to recall the $175 million transfer enough to tell the Committee that Duffy likely meant a loan advance from customer segregated funds to MF Global’s European operations. Remember that all his previous testimony was to the effect that he, “was totally stunned to learn customer money was missing…did not learn about it until October 30, 2011…etc”- in this context it seems a tad odd for him to suddenly develop a very specific recall about one event of October 28, 2011. Sadly, this was wholly lost on the Committee, which asked not one follow-up question.

In addition to Mr. Duffy’s testimony that a MF Global back office employee said Corzine was aware of the transfers, the Committee alluded to evidence that the Chief Financial Officer of MF Global’s North American operations (presumably Christine Serwinski) said that Corzine knew about the transfers. If so, there are at least two or more MF Global employees and officers who contradict Corzine’s sworn Sgt. Shultz testimony.

Not being perfectly honest with FINRA

On December 8, 2011, Steve Luparello, the Vice Chairman of the Financial Industry Regulatory Authority (“FINRA”) also testified before the House Committee on Agriculture about MF Global’s collapse. According to Mr. Luparello, MF Global was not completely candid with the Chicago Board of Options Exchange (“CBOE”) and FINRA. In late September 2010, MF Global assured both regulatory bodies that it did not have any positions in European sovereign debt.[3] MF Global did in fact have positions in European sovereign debt during this time but because according to GAAP accounting rules, positions held in RTMs are treated as sales and not liabilities, MF Global did not violate the law in hiding its credit and risk exposure to RTM, which are liabilities in the real, non-accounting world. Technically, MF Global was able to get away with it, at least for a time.

A little background may be helpful and a story of another failed firm, Lehman Brothers that generously indulged in a cousin of RTMs, the Repo 105. The Repo 105 was utilized by Lehman Brothers, among other firms that did not survive the last financial crisis including Washington Mutual, Northern Rock and some that did like Citigroup.

This is how it worked and how a liability (a loan) can be transformed into a revenue-generating event (a sale)…if you are an investment bank that is. Lehman entered into repo transactions with offshore banks. Lehman would sell (though actually a loan) a bundle of toxic assets such as sub-prime mortgages and dubiously collateralized debt obligations to the bank. This transaction is characterized on the books of Lehman as a sale. Lehman agrees to buy back or repurchase (hence the term ‘repo’) the toxic assets at a later date (maturity). In this way, Lehman moves loans and bad assets off its balance sheets towards the end of each financial quarter-removing liabilities dramatically improves a balance sheet- as if they do not exist. Then Lehman reports the sale as a revenue-generating event, in effect moving by way of example, $39 billion off its balance sheet in what is a liability, and reporting it as a sale of $39 billion. It is fraudulent twice over in that Lehman does not disclose on its financials that it has an obligation (a debt to buy back) to pay back the amount loan and it reports the loan as revenue.

In effect, this is what MF Global did with FINRA and CBOE. However, the regulators caught MF Global’s exposure to European sovereign debt and told MF Global to keep substantially more money in reserves because of what FINRA identified in May 2011 as a $7.6 billion risk exposure. MF Global appealed to the SEC and because of the appeal process, it was only in August that FINRA and the CBOE were successful in getting MF Global to put up more money for its European debt exposure and utilization of RTMs.

An accounting error

Also on December 15, 2011, the oversight panel of the House Financial Services Committee released a CME Group document the CME had given to the government containing a detailed log of its dealings with MF Global between October 24, 2011 and October 31, 2011. According to this document, Christine Serwinski, the Chief Financial Officer for North America at MF Global, and its Assistant Treasurer, Edith O’Brien, told a Mike Procajlo, an exchange auditor at 1:00 a.m. on Oct. 31, 2011 that the customer money was transferred on Oct. 27 and Oct. 28 and possibly Oct. 26, 2011. “About $700 million was moved to the broker-dealer side of the business to meet liquidity issues in a series of transactions on Thursday, Friday and possibly Wednesday,” Serwinski told Procajlo about eight hours before the firm filed for the eighth-largest bankruptcy in United States history.

Barely three days prior, on October 28, 2011, MF Global had submitted a statement to the CME showing that it had $200,178,912 in excess cash in its customer segregated funds as of the close of October 27, 2011.

On October 30, 2011, an official from the CFTC informed Procajlo that a draft statement of the value of MF Global’s customer segregated funds, showed a deficit in customer segregated funds for the day ending October 28, 2011. MF Global’s Assistant Controller, Mike Bolan and its General Counsel, Laurie Ferber said they believe the customer-funds deficit is “an accounting error.” Ms. Ferber had told the CME on October 25, 2011 that rumors about problems stemming from MG Global’s European debt trading were not accurate.

On December 15, 2011 Mr. Duffy told the House Committee that this so called accounting error was “a telling sign that regulators were being kept in the dark” about MF Global’s customer accounts. What was Corzine doing during all of this?

Acquisition by Interactive Brokers

While the exchange was trying to get to the bottom of the accounting error, whose magnitude would not be revealed until the evening of October 30, 2011 as being $900 million, Corzine and other MF Global officials were trying to close a deal to sell MF Global to Interactive Brokers Group, Inc. On that same day, October 30, 2011, MF Global issued a press release at 6:00 p.m. announcing that it had reached a deal with Interactive Brokers.

Corzine as CEO of MF Global negotiated the potential sale of his firm to Interactive Brokers. The first question involved in any sale of a going concern involves the determination of an acquisition price. Corzine would have had to know what the assets and liabilities of MF Global were (the balance sheets) to even begin to negotiate a price. The deal was happening at the exact same time of the transfers.

It is beyond the bounds of credibility to argue that MF Global did not have regular if not daily accounting of cash balance sheets and that Corzine did not see them. If Corzine knew what the company was worth, during the very days in which at least $900 million in customer segregated funds was lost, he must have at a minimum known about the company’s impending insolvency. How then could he not have known of the transfers?

In addition, as a matter of course in the futures industry, MF Global likely had to report the total daily amounts carried in segregated funds to the CME-it certainly had to do so from October 24, 2011 onwards. This computation is performed as a matter of course every single day at every futures broker.

Corzine’s testimony before Congress would have us believe that hundreds of millions of dollars were moved around without the knowledge or approval of the MF Global’s CEO and CFO all while the balance sheets were being scrutinized for an acquisition by Interactive Brokers, which Corzine spear-headed.

Corzine has sworn under oath that he did not know anything about the missing money until October 30, 2011. This is simply not possible.

Suggestions for House and Senate Committees

Further education about the industry is in order. Both the House and Senate soft-peddled the issues, and perhaps unintentionally avoided important questions and asked almost no meaningful follow-up questions, allowing Corzine to stretch the bounds of credibility in evasiveness. Further questioning should focus, among other things, on the representations made by MF Global to Interactive Brokers on October 24, 2011-October 30, 2011.@
R. Tamara de Silva Chicago, Illinois December 19, 2011
R. Tamara de Silva is a securities lawyer and independent trader
2. Remember CFTC Rule 1.25 which had been amended to allow the investment of customer segregated funds in foreign sovereign debt, was amended back after the fall of MF Global to disallow the investment of customer segregated funds in foreign sovereign debt.

Was Corzine’s Testimony About MF Global Truthful?
By R. Tamara de SilvaDecember 13, 2011

Testimony before Congress today revealed that MF Global had illegally transferred $175 million out of customer segregated funds towards its European broker-dealer operations before it went into bankruptcy proceedings and very much under Jon Corzine’s stewardship. On December 8, 2011 and again today before Congress, Corzine testified under oath that he was not aware of any illegal transfer. Today’s testimony of Chicago Mercantile Exchange Group Chairman, Terrance A. Duffy suggests that Corzine did know about the transfer.

My last article on MF Global stated that $1.2 billion in losses may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October, or alternatively, that MF Global had engaged in some late stage embezzlement of customer funds that are supposed to be segregated from MF Global’s accounts and never commingled with any other funds.[1]

It now appears that Jon Corzine may be the best example of the why it makes sense to invoke the Fifth Amendment if you are not inclined to be anything other than completely honest because you simply will not get away with anything other than complete honesty under oath. Corzine testified before the House Agriculture Committee December 8, 2011 and today before the Senate Agriculture Committee. Today, according to the testimony of Chicago Mercantile Exchange Group (“CME”), Chairman Terrance A. Duffy, Corzine may have lied.

In Corzine’s December 8th testimony, he essentially hems and haws and states that he cannot recall much of anything, things were chaotic during the last days of MF Global, he was completely lacking in mens rea, would not have authorized any transfer of customer money out of segregated funds, does not have all the records after he resigned and certainly did not intentionally do anything wrong. Nothing other than attempting to mislead Congress and lying.

On December 13, 2011, Corzine testifies that, “I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue.”

Also on December 13, 2011 Terrance Duffy, Jill Sommers, Commissioner of the CFTC and James Giddens, MF Global’s bankruptcy trustee also testified before the Senate Agriculture Committee.

In Mr. Duffy’s testimony he says that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global’s broker dealer operations (I am speculating that this was likely done to meet margin requirements on European debt bets that the firm thought would bounce back in time before anyone was the wiser) that Corzine knew all about the transfers. If Corzine knew about the transfer of $175 million, his testimony to the House Committee of December 8, 2011 wherein he stated that he knew nothing about it was untruthful. Corzine may well have already perjured himself.

Remember that on October 26, 2011, the CME had performed a spot audit on MF Global. On October 24, 2011, the CME initiated a heightened scrutiny of the segregated customer fund reporting of MF Global as a result of MF Global’s market risk. Beginning on October 24, 2011, the CME’s daily audits verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be.

On October 26, 2011, the CFTC also went into MF Global to make sure that what MF Global reported to be holding in customer segregated funds matched bank balances. The CFTC’s spot audit showed that no money was missing.

On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global’s stock collapsed and it its bonds began to trade at distressed levels. Corzine utilized all MF Global’s credit lines and tried to secure a sale of the firm to Interactive Brokers. On October 26 or October 27, 2011 MF Global provided reports to the CME and CFTC that it had a $200 million surplus in customer accounts. In reality on October 27, 2011, it was covering up a $200 million deficit in customer funds.

Five days later on October 31, 2011, MF Global filed for bankruptcy. But MF Global had already lied to both the CME and CFTC and violated CFTC rules and committed fraud and embezzlement.

On the morning of November 2, 2011, the CME announced that MF Global may have transferred money “
in a manner that may have been designed to avoid detection insofar as MF Global
 did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011.” [2]

The first hint of missing customer funds came out in press report on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts. [3]

There are in excess of $158 billion in customer-segregated funds in the United States. The futures markets unlike the securities markets have existed without any meaningful problem or shortfall in domestic customer segregated funds and without needing the existence of any protection like SIPC until October 31, 2011. It is inarguable that the futures markets have been the most crisis-free well functioning markets in the world and remain so. It is unfortunate that because of Jon Corzine these markets may now be portrayed as somehow unsafe for the investment of public funds.

The answer to Corzine is not more regulation but as I have written before, a simple amendment of CFTC Rule 1.25 to prohibit the investment of customer segregated funds in foreign sovereign debt-this amendment has already occurred. It was Corzine himself who lobbied for the change in Rule 1.25 to allow for customer-segregated funds to be held in foreign debt instruments.

Regulation can never rule out the rogue actor or sociopath and must not try because there really are not that many around-Corzine being a case in point. What is least needed is a reactionary and wholesale change in the regulation of the futures markets.@

R. Tamara de Silva Chicago, Illinois December 13, 2011
R. Tamara de Silva is a securities lawyer and independent trader
2. 3.

MF Global’s Missing Customer Funds and Its Implications on the Futures Industry

By R. Tamara de Silva

November 28, 2011

Abstract: The collapse of MF Global is an unfortunate and watershed event for the futures industry. The regulated futures markets, long a stepchild of the larger financial markets, have been the most liquid, transparent and crisis free markets in the world. They have been remarkably free from any systemic financial crisis. . .with the exception of a certain salad oil scandal (almost 50 years ago) and until now with MF Global. With former Goldman Sach’s CEO Jon Corzine’s takeover and bankruptcy of what had been one of the largest and oldest commodity trading firms in the world, the crisis-free reputation of the futures industry is sullied. At the crux of MF Global’s fall is CFTC Rule 1.25 which requires that, futures commission merchants (“FCMs”), like MF Global, are allowed to invest and collect interest on customer funds, in excess of customer funds, used as margin for customer trades. Rule 1.25 was amended in 2004 to allow FCMs to invest in sovereign debt (among five other investment vehicles) so long as these vehicles maintained the highest credit ratings by the three credit ratings agencies. If MF Global went into customer segregated funds, which are supposed to separated away from the firm’s assets, to meet the FCM’s own margin calls, then Corzine and as yet unknown agents will face criminal charges. If however, customer funds were invested in foreign sovereign debt, as firms are allowed to do under CFTC Rule 1.25 and these investments lost over $1.2 billion in value, then there is no criminal liability, only perhaps civil liability. The accounting firm PricewaterhouseCoopers, may face civil liability. A cursory look at all other similar crises from Refco and Griffin Trading (in the futures industry) to Lehman Brothers and rogue trading at UBS, demonstrates that MF Global is unique-this may be the first time in history that customer segregated funds were not properly segregated by an FCM. In any event, $1.2 billion in customer funds would not have been lost had CFTC Rule 1.25 not have been amended in 2004.[1] MF Global’s demise has broader implications, other than legal culpability for accounting firms, the effectiveness of self-regulatory organizations and prospective regulation of the futures industry. Lastly, in order to ensure that the futures markets do not have another MF Global, CFTC Rule 1.25 must be amended back to reverse its amendment in 2000 and 2005.


James Man started a sugar trading business in 1783, that became Man Financial and ultimately, the publicly traded MF Global, some 230 years later. In March 2010, a former Goldman Sachs CEO, Jon Corzine became CEO of MF Global joking with not some insignificant degree of obviously unjustified hubris that “I hadn’t heard of this company a week ago.” Would that he had remained in ignorance.

It was Corzine’s stated goal to transform MF Global from a commodity broker into an investment bank with a large proprietary trading operation similar to the one Corzine ran at Goldman in the 1990s. The luster of Corzine’s Goldman pedigree was not lost on the Financial Industry Regulatory Authority (FINRA) as they granted Corzine a waiver, from having to have a license to run MF Global. By way of some background, every person in the futures industry has a license, especially everyone interacting with clients.

On October 26, 2011, the Chicago Mercantile Exchange (“CME”) performed a spot audit on MF Global. This audit merely verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be. The CME had performed a full audit in January 2011. On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global’s stock collapsed and it its bonds began to trade at distressed levels.[2] Corzine utilized all MF Global’s credit lines and tried to secure a sale of the firm to Interactive Brokers. Five days later on October 31, 2011, MF Global filed for bankruptcy. There is yet no reason to think that any customer funds, which are supposed to be safeguarded from a futures brokerage going bankrupt by virtue of their being completely segregated, would be in jeopardy.

However, on November 2, 2011, the CME announced that MF Global may have transferred money “
in a manner that may have been designed to avoid detection insofar as MF Global
 did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011.” [3]

The first hint of missing customer funds was released on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts.[4]

Almost one month later, no one can account for where the money has gone. The CME verified that customer money was accounted for on October 26, 2011. It looks as if the money was moved out of customer segregated accounts in the amount of what is now considered to be well over a $1.2 billion shortfall, or the money was lost in trading losses and positions in…you guessed it, sovereign debt. It is possible that legally segregated customer funds could have been lost, in a titanic liquidity squeeze. If this is the case, then no violation of the law that requires customer funds to be segregated occurred.

The illegal scenario is if customer segregated funds were commingled with MF Global’s funds. If MF Global went into what are supposed to legally segregated customer funds, that must be completely separated and never used by MF Global either for its own purposes or that of other customers, then fraud and embezzlement would have occurred. Almost one month afterwards, no one outside of MF Global knows which scenario occurred.

Applicable Rules

The key difference between FCMs and securities brokerages is that FCMs, unlike securities brokers, are required by law to keep their customer funds segregated from the FCM’s own funds. It is in this way that FCMs have been able, with comparatively few exceptions, to ensure that customer deposits are completely protected from all losses an FCM may incur due to its own proprietary trading. Before MF Global, the requirement that FCMs segregate customer funds completely from their own funds largely prevented FCM customers from losing money due to an FCM bankruptcy.[5]

Having customer segregated funds completely separated and safe from an FCM’s own funds and operations meant that protections like SIPC were not needed in the futures world as they are in securities. SIPC on the other hand restores funds to customers with assets in securities brokerage firms.[6] The National Futures Association (NFA) and the CFTC require FCMs to report the amount they carry in customer segregated funds to the clearing house of the FCM’s designated self-regulatory organization (DSRO)-in MF Global’s case, the CME.

In the case of MF Global, five principal rules applied. CFTC Rule 1.20, 1.23, 1.25, 1.32, 30.7 and Section 4d(a)(2) of the Commodity Exchange Act (“CEA”).

CFTC Rule 1.20 holds that customer funds are to be segregated and separately accounted for.

(a) All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers. Such customer funds when deposited with any bank, trust company, clearing organization or another futures commission merchant shall be deposited under an account name which clearly identifies them as such and shows that they are segregated as required by the Act and this part. Each registrant shall obtain and retain in its files for the period provided in §1.31 a written acknowledgment from such bank, trust company, clearing organization, or futures commission merchant, that it was informed that the customer funds deposited therein are those of commodity or option customers and are being held in accordance with the provisions of the Act and this part: Provided, however, that an acknowledgment need not be obtained from a clearing organization that has adopted and submitted to the Commission rules that provide for the segregation as customer funds, in accordance with all relevant provisions of the Act and the rules and orders promulgated thereunder, of all funds held on behalf of customers. Under no circumstances shall any portion of customer funds be obligated to a clearing organization, any member of a contract market, a futures commission merchant, or any depository except to purchase, margin, guarantee, secure, transfer, adjust or settle trades, contracts or commodity option transactions of commodity or option customers. No person, including any clearing organization or any depository, that has received customer funds for deposit in a segregated account, as provided in this section, may hold, dispose of, or use any such funds as belonging to any person other than the option or commodity customers of the futures commission merchant which deposited such funds.
(b) All customer funds received by a clearing organization from a member of the clearing organization to purchase, margin, guarantee, secure or settle the trades, contracts or commodity options of the clearing member’s commodity or option customers and all money accruing to such commodity or option customers as the result of trades, contracts or commodity options so carried shall be separately accounted for and segregated as belonging to such commodity or option customers, and a clearing organization shall not hold, use or dispose of such customer funds except as belonging to such commodity or option customers. Such customer funds when deposited in a bank or trust company shall be deposited under an account name which clearly shows that they are the customer funds of the commodity or option customers of clearing members, segregated as required by the Act and these regulations. The clearing organization shall obtain and retain in its files for the period provided by §1.31 an acknowledgment from such bank or trust company that it was informed that the customer funds deposited therein are those of commodity or option customers of its clearing members and are being held in accordance with the provisions of the Act and these regulations.
(c) Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person, or be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held: Provided, however, That customer funds treated as belonging to the commodity or option customers of a futures commission merchant may for convenience be commingled and deposited in the same account or accounts with any bank or trust company, with another person registered as a futures commission merchant, or with a clearing organization, and that such share thereof as in the normal course of business is necessary to purchase, margin, guarantee, secure, transfer, adjust, or settle the trades, contracts or commodity options of such commodity or option customers or resulting market positions, with the clearing organization or with any other person registered as a futures commission merchant, may be withdrawn and applied to such purposes, including the payment of premiums to option grantors, commissions, brokerage, interest, taxes, storage and other fees and charges, lawfully accruing in connection with such trades, contracts or commodity options: Provided, further, That customer funds may be invested in instruments described in §1.25.

Section 4d(a)(2) of the Commodity Exchange Act also states that customer funds must not be commingled with funds of the FCM nor ever be used by an FCM for any purpose such as margining other customer accounts or that of the FCM itself.

Section 4d(a)(2) of the CEA and related Commission regulations require that, among other things, all funds deposited with an FCM to purchase, margin, guarantee, or secure futures or commodity options transactions and all accruals thereon, be accounted for separately by the FCM and deposited under an account name that clearly identifies them as such, not be commingled with the FCM’s own funds, and be held for the benefit of customers.4 The segregation requirements are intended to prevent an FCM from using customer property to margin the trades of other customers or of the FCM itself. Further, the Division has interpreted the segregation requirements to preclude any impediments or restrictions on the FCM’s ability to obtain the immediate access to customer funds. The immediate and unfettered access requirement avoids potential delay or interruption in securing required margin payments that, in times of significant market disruption or otherwise, could magnify the impact of such market disruption and impair the liquidity of other FCMs and clearinghouses. [8]

The stage was set for MF Global on February 3, 2005, when the CFTC published proposed amendments to its Rule 1.25, which governed what types of investments an FCM may make of customer segregated funds. Before 2000, FCMs and designated clearing organizations (“DCOs”) were only permitted to invest in United States debt (including municipal and state debt).

CFTC Rule 1.23 allows FCMs and DCOs to collect interest in the customer-segregated funds they hold.[9]

The provision in section 4d(a)(2) of the Act and the provision in §1.20(c), which prohibit the commingling of customer funds with the funds of a futures commission merchant, shall not be construed to prevent a futures commission merchant from having a residual financial interest in the customer funds, segregated as required by the Act and the rules in this part and set apart for the benefit of commodity or option customers; nor shall such provisions be construed to prevent a futures commission merchant from adding to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in §1.25, as it may deem necessary to ensure any and all commodity or option customers’ accounts from becoming undersegregated at any time. The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. A futures commission merchant may draw upon such segregated funds to its own order, to the extent of its actual interest therein, including the withdrawal of securities held in segregated safekeeping accounts held by a bank, trust company, contract market clearing organization or other futures commission merchant. Such withdrawal shall not result in the funds of one commodity and/or option customer being used to purchase, margin or carry the trades, contracts or commodity options, or extend the credit of any other commodity customer, option customer or other person. [10]

On May 17, 2005, the CFTC published final rules that further amended Rule 1.25 to allow for the practice of FCMs using repurchase agreements called “repos” with customer funds. A repo is simple the sale of a security (typically a government debt) tied to an agreement to buy the securities back later. A reverse-repo is the purchase of a security tied to an agreement to sell back later. Repos are essentially loans secured against a security. The interest rate received is called the repo rate. The party that sells a security agreeing to buy it back in the future at a higher price later is engaging in a repurchase agreement. The party that agrees to buy the security and sell it back in the future is engaging in a reverse repo.

The use of repos by MF Global would have permitted the firm to leverage customer deposits, although it is unknown that they did. However, leverage of 30:1 or greater, through the use of repos would have resulted in larger losses if the repos were in sovereign European debt.

CFTC Rule 1.25 governs the investment of customer funds by an FCM.

(a) Permitted investments. (1) Subject to the terms and conditions set forth in this section, a futures commission merchant or a derivatives clearing organization may invest customer money in the following instruments (permitted investments):
(i) Obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities);
(ii) General obligations of any State or of any political subdivision thereof (municipal securities);
(iii) General obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities);
(iv) Certificates of deposit issued by a bank (certificates of deposit) as defined in section 3(a)(6) of the Securities Exchange Act of 1934, or a domestic branch of a foreign bank that carries deposits insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes or bonds;
(vii) General obligations of a sovereign nation [emphasis added]; and (viii) Interests in money market mutual funds.

CFTC Rule 1.32 specifies how FCMs are required to compute the value of customer segregated accounts on a daily basis.

(a) Each futures commission merchant must compute as of the close of each business day, on a currency-by-currency basis:
(1) The total amount of customer funds on deposit in segregated accounts on behalf of commodity and option customers;
(2) the amount of such customer funds required by the Act and these regulations to be on deposit in segregated accounts on behalf of such commodity and option customers; and (3) the amount of the futures commission merchant’s residual interest in such customer funds.
(b) In computing the amount of funds required to be in segregated accounts, a futures commission merchant may offset any net deficit in a particular customer’s account against the current market value of readily marketable securities, less applicable percentage deductions ( i.e., “securities haircuts”) as set forth in Rule 15c3-1(c)(2)(vi) of the Securities and Exchange Commission (17 CFR 241.15c3-1(c)(2)(vi)), held for the same customer’s account. The futures commission merchant must maintain a security interest in the securities, including a written authorization to liquidate the securities at the futures commission merchant’s discretion, and must segregate the securities in a safekeeping account with a bank, trust company, clearing organization of a contract market, or another futures commission merchant. For purposes of this section, a security will be considered readily marketable if it is traded on a “ready market” as defined in Rule 15c3-1(c)(11)(i) of the Securities and Exchange Commission (17 CFR 240.15c3-1(c)(11)(i)).
(c) The daily computations required by this section must be completed by the futures commission merchant prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31.

CFTC Rule 30.7 covers the treatment of foreign futures or foreign options and the investment of customer funds in foreign instruments.

(a) Except as provided in this section, a futures commission merchant must maintain in a separate account or accounts money, securities and property in an amount at least sufficient to cover or satisfy all of its current obligations to foreign futures or foreign options customers denominated as the foreign futures or foreign options secured amount. Such money, securities and property may not be commingled with the money, securities or property of such futures commission merchant, with any proprietary account of such futures commission merchant, or used to secure or guarantee the obligations of, or extend credit to, such futures commission merchant or any proprietary account of such futures commission merchant.
(b) A futures commission merchant may deposit together with the secured amount required to be on deposit in the separate account or accounts referred to in paragraph (a) of this section money, securities or property held for or on behalf of other customers of the futures commission merchant for the purpose of entering into foreign futures or foreign options transactions. In such a case, the amount that must be deposited in such separate account or accounts must be no less than the greater of (1) the foreign futures and foreign options secured amount plus the amount that would be required to be on deposit if all such customers were foreign futures or foreign options customers under this part 30, or (2) the foreign futures or foreign options secured amount plus the amount required to be held in a separate account or accounts for or on behalf of customers pursuant to any law, or rule, regulation or order thereunder, or any rule of any self-regulatory organization authorized thereunder, in the jurisdiction in which the depository or the customer, as appropriate, is located.
(c) (1) The separate account or accounts referred to in paragraph (a) of this section must be maintained under an account name that clearly identifies them as such, with any of the following depositories:
(i) A bank or trust company located in the United States;
(ii) A bank or trust company located outside the United States:
(A) That has in excess of $1 billion of regulatory capital; or (B) Whose commercial paper or long-term debt instrument or, if a part of a holding company system, its holding company’s commercial paper or long-term debt instrument, is rated in one of the two highest rating categories by at least one nationally recognized statistical rating organization; or (C) As designated;
(iii) A futures commission merchant registered as such with the Commission;
(iv) A derivatives clearing organization;
(v) A member of any foreign board of trade; or (vi) Such member or clearing organization’s designated depositories.
(2) Each futures commission merchant must obtain and retain in its files for the period provided in §1.31 of this chapter an acknowledgment from such depository that it was informed that such money, securities or property are held for or on behalf of foreign futures and foreign options customers and are being held in accordance with the provisions of these regulations.
(d) In no event may money, securities or property representing the foreign futures or foreign options secured amount be held or commingled and deposited with customer funds in the same account or accounts required to be separately accounted for and segregated pursuant to section 4d of the Act and the regulations thereunder.
(e) Each futures commission merchant which invests money, securities or property on behalf of foreign futures or foreign options customers shall keep a record showing the following:
(1) The date on which such investments were made;
(2) The name of the person through whom such investments were made;
(3) The amount of money so invested;
(4) A description of the obligations in which such investments were made;
(5) The identity of the depositories or other places where such obligations are maintained;
(6) The date on which such investments were liquidated or otherwise disposed of and the amount of money received of such disposition, if any; and (7) The name of the person to or through whom such investments were disposed of.
(f) Each futures commission merchant must compute as of the close of each business day:
(1) The total amount of money, securities and property on deposit in separate account(s) in accordance with this section;
(2) The total amount of money, securities and property required to be on deposit in separate account(s) in accordance with this section; and (3) The amount of the futures commission merchant’s residual interest in money, securities and property on deposit in separate account(s) in accordance with this section. Such computations must be completed prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31.[13]

Rule 1.25 was amended in 2005 in part because of lobbying by the FCMs, including ironically support from MF Global’s current General Counsel.

The principal changes to Rule 1.25 that would have likely affected, or one should say enabled the fall of MF Global involved reverse repos, transactions within FCM that are also broker-dealers (“BDs”) and possibly the elimination that investment in money market funds carry the highest credit rating.

Before 2005, CFTC Rule 1.25(b)(4)(iii) imposed concentration limits as to both the issuer and the counterparty in reverse repos, which limits are different from the concentration limits on direct investments. After 2005, the concentration limits would apply to all investments in securities, whether obtained pursuant to direct investment or pursuant to reverse repos.

After 2005, FCMs that are also broker-dealers were allowed to engage in-house transactions involving the simultaneous exchange of customer cash or customer-deposited securities for securities held by the FCM also in its capacity as a broker dealer. What this means is that an FCM can seemingly do both a repo and reverse repo at once-taking both sides. FCMs acting also as BDs would enable the exchanging of securities for a customer so that what is not acceptable as margin at a specific clearing firm would be exchanged by the FCM for another security that would be acceptable.

Another revision of CFTC Rule 1.25(b)(2)(i)(E) eliminated the requirement that FCMs and DCOs that invested customer funds in Money Market Mutual Funds (“MMMFs”) invest only in MMMFs that carried the highest ratings by the credit ratings agencies.

Criminal or Civil Liability Contingent on Fraud

The criminal or civil liability, if any, of Corzine and his agents at MF Global, will likely rest on whether customer funds were properly segregated and not commingled with FCM funds, or whether they were converted for use of MF Global. The later situation would involve not just fraud, but also embezzlement-it would constitute a criminal violation of CFTC and SEC rules, et. al. The difference between civil liability and criminal wrong-doing is illustrated by looking at the tale of three FCMs, Refco, Griffin Trading Company and Lee B. Stern & Co.

Refco was once the largest futures brokerage at the CME but will be remembered as possibly the shortest IPO in history. Refco raised and lost over $1billion in investor capital before it went public in August 2005 and bankrupt in October of 2005.

Refco was co-founded by Tom Dittmer and Ray Friedman in 1969. Amid some regulatory scuffles, Dittmer resigned and was replaced by a new CEO, Phillip Bennett.
An internal audit of Refco revealed that Bennett had taken $430 million from Refco’s and manipulated Refco’s financials to disguise his taking. Refco’s accounting firm, Grant Thornton after a complete audit, and all the investment banks that handled the IPO, including Goldman Sachs, and Bank of America Corp., after their due diligence, missed the $430 shortfall. Federal authorities were alerted of the missing funds by Refco’s own internal audit. Bennett repaid all of the money but the public had lost faith in the company. Investors sold billions of shares worth of Refco and the resulting liquidity run forced the firm into bankruptcy.

The Justice Department filed criminal charges against Refco principals Phillip R. Bennett, Tone N. Grant, Santo C. Maggio and Robert C. Trosten for fraudulently hiding trading losses of both Refco’s and of its customers, and fraudulently manipulating financial statements to secure a leverage buyout of the firm and subsequent IPO.[15] In addition to obtaining guilty pleas and convictions against all of them, the government recovered obtained over $33,000,000 in forfeiture actions against five other Refco officers, including Tom Dittmer. There were also civil suits and a class action.

By contrast, no criminal charges were filed against any of the principles of Griffin Trading Company, a futures commission merchant, that collapsed overnight on December 23, 1998 as a result of the trading losses of one of their customers in London, John Ho Park, lost nearly $10.3 million on December 21 and 22, 1998. Griffin Trading Company was founded by Farrel J. “Tex” Griffin, a former assistant U.S. attorney, and Roger S. Griffin (the two are not related). Some customer funds in segregated accounts were lost in London, but there was no question of criminal liability because customer funds in the United States were segregated and never commingled. Unlike in Refco’s case, no one at Griffin committed any fraud.

In the case of Griffin Trading, all customers with money held in the United States did not suffer because their funds were held in segregated customer accounts. Customers of Griffin that had funds in London lost their money because at the time the Securities and Futures Authority’s Client Money Rules (“SFA Rules”) did not prohibit the use of one customer’s money to cover another customer’s losses. Although SFA Client Money Rule 4-55 did require that customer accounts be segregated from the firm’s account, there was no prohibition on their being commingled with other customer accounts in one pool. This arrangement is typically called having one omnibus account (segregated but pooled account) as opposed to separate sub-accounts for each customer, as required by law in the United States. As a result, customers sued Griffin Trading in bankruptcy proceedings for money lost in the U.K.[16]

On October 22, 1992, two rogue bond traders at the Chicago Board of Trade (“CBOT”) made unauthorized trades (they exceeded their trading limits) and forced the clearing firm Lee B. Stern & Co. to default on a $8.5 margin call to the CBOT’s Clearing Corporation. The two rogue traders caused a loss to the FCM that exceeded its net worth by $2 million. Lee Stern made up for the shortfall personally, saved the firm and ensured that no customers lost any money-although his firm did lose its clearing status and was never again a member of the Chicago Board of Trade Clearing Corporation.

In the history of financial futures and FCM, customers have seldom if ever lost money even because of rogue trading by FCM employees or other customers because the FCMs, historically at the immediate behest of the exchange clearing house, have made sure that customers were made whole.

Were this not the historic practice within the futures industry and in theory an FCM’s entire customer segregated account pool (segregated and not commingled as it may be) would be jeopardized and placed at risk by the trading of one customer making trades they cannot cover and are too large for the capital reserves of the FCM to cover. To put this in perspective, the futures industry has, other than for the very few examples above, had good risk practices.

What happens with MF Global depends on what happened to the missing money and whether it was segregated also not commingled after the CME’s spot audit of October 26, 2011.

Liability of PricewaterhouseCoopers

Some ironies are worse than others. The CFTC has subpoenaed Pricewaterhouse Coopers (“PwC”) presumably for any information is may have about Mf Global’s missing customer funds. PwC advertises what lessons auditors should have learned from the collapse of Lehman Brothers on their website.[17] PwC gave MF Global an unqualified (clean) audit opinion on May 20, 2011. MF Global’s bankruptcy is now considered to be the eighth largest in United States history.

One cannot help but wonder at times what use are auditing firms in terms of catching or preventing large financial crisis…ever? Grant Thornton issued an unqualified audit of Refco before its IPO. Lehman, AIG and a host of other financial titans received unqualified audit opinions preceding their failures and bankruptcies.

Are accounting firms like credit ratings agencies in that it is not in their interest to issue qualified opinions because they would in so doing drive themselves out of business? Or are they like the credit ratings agencies (MF Global was downgraded to junk after it filed for bankruptcy-so the ratings agencies were all over this after the fact), and incapable of understanding the securities and market risks of the firms they are paid to pass judgment over?

In their defense, PwC might have been dealing with a rogue trading situation-perhaps Corzine himself, some late stage commingling and embezzlement of customer funds or perhaps just over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October.

Future Regulation Must Rescind Changes to Rule 1.25

The risk free rate of return is the yield on 30 day United States T-bills. Had MF Global been prohibited from investing customer funds in sovereign European debt or using internal repos (assuming they have done either or both), then their customers’ money would be inarguably safer at all times. Customer segregated funds held in T-bills or other United States debt instruments are safer than they would be invested in anything else. The CFTC must amend all the changes to Rule 1.25 that went into affect on 2004 and 2005, including the permission to invest in foreign sovereign debt that became law in 2000.

Regulating What Cannot Be So

The CME is MF Global’s “primary regulator.” Many argue that it is the exchange’s role to have better policed MF Global. However, to impose this burden on the CME is not necessary because it is the CFTC that proposed and finalized all the rules to allow for an FCM’s investment of customer funds by the use of repos and in a foreign sovereign debt.

No one has a greater interest in avoiding events like Corzine’s MF Global than the CME. To be fair, the exchanges have historically maintained a stellar track record as self-regulatory organizations that police their member firms, whether clearing members or non-clearing member firms. The case of MF Global is of monumental significance to the entire futures industry because it may tragically portray the investment of public funds in the futures markets as somehow unsafe and unprotected.

Regulation can never rule out the rogue actor or sociopath. Whatever costs Corzine was determined to incur upon the world in his quest to self-glorification by making a 230 year firm, a proprietary trading desk, the world must take solace in one simple fact-there are not that many Corzines.

A wholesale revision of the futures regulatory regime would be unfortunate and ineffective because no regulatory regime or social science model can account for the irrational or mad actor-nor must it ever try.@
R. Tamara de Silva Chicago, Illinois
R. Tamara de Silva is a securities lawyer and independent trader

Any questions about this article should be directed to
1. Unless Corzine or his agents deliberately stole this money out of customer accounts, which no one not even the CME has either confirmed or denied.
2. The fact that European sovereign debt was reaching crisis levels began to be apparent to most of the world in 2009 and MF Global’s 40:1 leverage and exposure to it should have signaled a red alert to its auditor PwC…but strangely did not seem in any way troublesome to PwC-certainly not worthy of actually pointing out or giving a qualified opinion!
3. 4.
5. Please see discussion of Griffin Trading Company and Refco cases 6. It is important to remember that SIPC protection does not apply in cases involving fraud or rogue trading like with Barring Bank’s Nick Leesen. Were SIPC in play with MF Global, it would not cover losses causes by any fraud or malfeasance on the part of MF Global-were any found to have occurred.
7. 8. 9. It is important to keep in mind that the yield received by the FCMs and DCOs investment of customer segregated funds has historically been a large profit center for them.
10. 11. 12. 13. 14. 15. United States v. Bennett, 485 F.Supp.2d 508 (2007)
16. In re Griffin Trading Co., 245 BR 291 (2000)

By R. Tamara de Silva October 25, 2011

On October 24, 2011 the Federal government announced that it would revise the Home Affordable Refinance Program (“HARP”). HARP was originally launched in March 2009 as a $75 billion plan to put a stop to the foreclosure crisis. HARP was supposed to prevent millions of the 9 million American homeowners facing foreclosure from defaulting on their mortgages and losing their homes. Yet as of this past July, HARP has only helped 865,000 of the 9 million homeowners who must refinance their home loans or soon default.

The housing crisis is by all accounts far from over. The bottom has yet to be reached in the housing market and one cannot but wonder how mortgage defaults would be affected were the Federal Reserve not to keep interest rates continually suppressed. Recently, Moody’s announced that foreclosures will rise to unprecedented levels in 2012, enveloping 30% of all mortgages and totaling over 1.5 million defaults.

Yesterday, President Obama went to Nevada to sell his reincarnation of HARP. The specifics of the new HARP (“HARP2”) are as follows:

• The mortgage must be owned or guaranteed by the government owned, Freddie Mac or Fannie Mae.
• The mortgage must have been sold to Fannie Mae or Freddie Mac on or before May 31, 2009.
• The mortgage cannot have been refinanced under HARP previously unless it is a Fannie Mae loan that was refinanced under HARP from March-May, 2009.
• The current loan-to-value (LTV) ratio must be greater than 80%-it is not capped, in other words, there is no loan to value restriction on qualification.
• HARP2 only allows alteration of the interest rate and term of the loan-it is not possible to take cash out by refinancing.
• The borrower must be current on the mortgage at the time of the refinance, with no late payment in the past six months and no more than one late payment in the past 12 months.

The Federal Housing Finance Agency estimates that 800,000 to 1 million homeowners could take advantage of HARP2-it is being far more modest in its estimations of HARP2.

In support of HARP2, the White House’s own blog offers the following statement:

Nearly 11 million Americans are underwater on their mortgage, meaning they owe more to the bank than their homes are worth. In fact, homeowners have lost $7.25 trillion in home equity–the difference between the actual value of a home and the balance of what’s owed on the mortgage–since the peak of the housing bubble in 2006. This loss in home equity is devastating for a family’s financial security, and makes it more difficult to take out other loans, save for a bigger house, or build a nest egg for retirement. It also means families are making payments that are higher than they would be if their mortgage was based on the actual current value of their home, giving them fewer dollars to spend on other economy-bolstering goods and services.

The government began interfering with the housing market by aggressively advocating the idea that every American should own a home for the past twenty years-this advocacy, leaving aside its dubious philosophical underpinning has not gone entirely well. The federal government forced and incentivized loans to be written to lower income earners and particularly in what it deemed economically disadvantaged urban areas. The government played an active role in setting the table for the housing bubble by being so enamored of the idea that homeownership be perfectly democratic, that it dictated the writing of sub-prime mortgages, even as housing prices went straight down. This was not a one party campaign either because legislators on both sides of the political aisle enacted policies that encouraged home ownership at all costs even with low FICO scores, little or no money down, and little or no supporting documentation.

One argument against using HARP2 to prop up the housing market by preventing people that are headed to default from going through foreclosure is that housing is not an engine of economic growth per se. Housing does not grow the economy-it is the result of an already growing and prosperous economy. Housing is not a consumer durable nor is it an investment like gold or a retirement or savings account. The housing market drove the economy in terms of construction, furnishing and development, etc. However, consumer consumption in terms of the use of unrealized equity as its driver, drove the economy in an unsustainable manner. A significant proportion of all underwater mortgages likely resulted from home equity loans being taken to fuel purchases and the consumption of consumer goods, the homeowners could not otherwise have afforded to buy and should not have bought in the first instance. To the extent that this credit driven spending drove economy, it was always doomed to have a shelf-life.

In any functioning marketplace, the forces of supply and demand without interference will dictate price. Price is one of, if not in many instances the single most relevant information provided in any approximation of an efficient market. “What did you pay for that?” is more than vaguely related to “what is it worth?” While the price paid for a piece of art is not often a precise indicator of what it is worth, it is a good starting point. However, regardless of the price paid for a Monet or a November Soybean contract, the more important question soon becomes, “what is it worth?” If I owned a bushel of November 2008 soybeans, I could look at the spot or cash market and know immediately what the value is of what I own. A stock portfolio consisting of listed stocks has an immediately discoverable value because listed stocks are marked to market everyday as buyers and sellers determine through the trading market, what listed equities are worth at any given moment. The owner of a financial instrument unlike the owner of a Monet, has an after market to which he can go to instantly determine the value of the instrument and where he can sell it.

When the government props up the housing market by either artificially suppressing interest rates or putting more money into keeping bad loans from defaulting, the government is preventing price discovery. We will never know the effect of all the foreclosed homes coming to market because we are postponing their doing so. The housing bubble’s bursting is being delayed in order to forestall the pain it will inevitably cause. Yes, many homeowners will be renters and banks will face massive write-offs. Had this been allowed to happen two years ago, we would have now seen what housing is actually worth because the market would have absorbed the foreclosed properties already.

In many instances, the savings from refinancing will not be appreciable enough to prevent the inevitable default-it may postpone it.

Also, according to many analysts, the average savings for a refinanced underwater mortgage will not be appreciable. A homeowner saving $800 in mortgage payments a year is unlikely to use their extra $66 a month to appreciably stimulate the economy or perhaps even appreciably improve their lives. It may all be too little too late.

By allowing for the re-financing of mortgages with LTVs of 80-1000% or more, we are arguably creating yet another housing bubble. Moreover, we are prolonging the end of a recession in some part felt by a sharp and consistent decline in consumer spending since February 2008.

We are also, rewarding irresponsible banks and borrowers while penalizing anyone who saves by keeping interest rates so low as to even allow for a HARP2. Someone will pay for HARP2-shareholders of banks or taxpayers or both. HARP2 will allow participating lenders to offload default risk onto the federal government and to the extent that they are allowed to do so, taxpayers will pay for HARP2 as part of the increasing Federal Deficit.

What the White House is selling to prospective voters in advance of an election, as a way to keep people in their homes, is really just a way to temporarily mask an untold number of mortgage defaults which will ultimately have to be absorbed by the market.

Markets that punish prudence, savings and its more productive participants by shifting through taxes and debt the economic consequences of the irrational and less productive, are not free markets. Ultimately, incentivizing bad choices by punishing goods ones will affect economic growth more significantly than allowing a bubble to burst.

Consider Henry Hazlett’s Broken Window Fallacy as opposed to Paul Krugman’s argument that the terror attack of 9/11 that took over 3,000 lives and destroyed the World Trade Center, could constitute an economic good. What Hazlett illustrates in the story of a baker’s broken window that the glazer’s gain of getting to fix the window is the loss of money by the baker who may have spent the money he has to spend on fixing the window, on a new suit-giving the economic gain to a tailor-the end result of which was no net economic gain. In the end, many economic events lead to no net gain. HARP2 is such a story.

The history of the financial markets is replete with the occurrence of bubbles from the tulip bubble, the South Sea bubble, the Stock Market bubble of the 1920s, the Internet bubble and the Japanese bubble-but to name a few. Ultimately when excess supply was absorbed by the market, the forces of supply and demand ensured that price returned to an equilibrium. The world did not end, recovery began. It is time that the government allow the housing bubble to burst instead of infusing it with helium so that the economy may at last recover.@
R. Tamara de Silva October 25, 2011
Chicago, Illinois