CFTC Commissioner O'Malia Discusses the Futures Markets: MF Global and High Frequency Trading
Sima Saran Ahuja | Bloomberg Law
Commissioner Scott D. O’Malia of the Commodity Futures Trading Commission (CFTC) spoke at the Center on Financial Services Law of New York Law School. Critical of the CFTC’s recent focus on swaps regulation, Commissioner O’Malia focused much of his speech on futures markets and customers. Specifically, he discussed MF Global, Inc.’s (MF Global) collapse and the subsequent implications for customer protection, as well as his initiatives in the area of high frequency trading (HFT).
MF Global: What Happened?
Putting MF Global’s bankruptcy in the context of futures regulation, Commissioner O’Malia explained that MF Global was an intermediary that executed and cleared futures contracts on behalf of customers. This means that MF Global held customer funds as margin to guarantee futures contracts. According to Commissioner O’Malia, MF Global thus had a “fundamental duty” to segregate futures customer funds and not use such funds for proprietary purposes. In the past three months, however, it has become evident that MF Global may have done just that. For more on MF Global’s collapse and its apparent comingling of customer funds, see Where are MF Global’s Missing Customer Funds: Do Regulators Hold the Answer or Are They Part of the Problem, Bloomberg Law Reports® – Securities Law, Vol. 6, No. 2 (Jan. 9, 2012). In Commissioner O’Malia’s view, MF Global’s bankruptcy and comingling of customer funds may have systemic consequences and should not be treated as an isolated incident. Instead, he argued for the CFTC to take action “to show that violations of segregation will not be tolerated.”
MF Global: Where Are We?
First, Commissioner O’Malia repeated his recent calls for the CFTC to “get to the bottom of how futures customer funds went missing at MF Global.” Although unable to comment on the pending enforcement investigation, he did acknowledge that the CFTC has authorized its Enforcement division to issue subpoenas in the matter.
Second, Commissioner O’Malia discussed the liquidation proceeding’s progress toward transfer of customer positions and funds. Noting that MF Global futures customers have received 72 cents on the dollar, he remarked that this simply was not enough. Moreover, Commissioner O’Malia was critical of the Securities Investor Protection Corporation’s (SIPC) lead role in MF Global’s liquidation and complained that this “relegated” the CFTC to a “supporting role.” To expedite full recovery for MF Global customers, he argued that the CFTC must be given “full access” to relevant books, records, and witnesses. For more on MF Global’s liquidation, see Commissioner Sommers Discusses MF Global Bankruptcy Status and Futures Commission Merchants Oversight, Bloomberg Law Reports® – Securities Law (Feb. 7, 2012).
MF Global: Where Should We Be?
Commissioner O’Malia was emphatic in his view that MF Global was not the result of inadequate regulation. To negate that perception, he cited the Commodity Exchange Act and CFTC regulations, both of which require intermediaries to segregate the funds of futures customers. Commissioner O’Malia remarked that he was thus “puzzled by the [CFTC's] attempts to regain public confidence through new regulation.” He further asserted that the CFTC’s “most recent rulemakings don’t even address MF Global.”
— Rules Do Not Address MF Global
First, Commissioner O’Malia explained a recent rule restricting the universe of permitted investments of customer funds. Commissioner O’Malia, however, commented that he was not aware of any evidence that MF Global’s shortfall was related to investments of customer funds. Second, Commissioner O’Malia discussed a recent rule on the protection of cleared swaps customer contracts and collateral. In his view, this rule does not protect futures customers who bore the brunt of MF Global’s shortfall. For more on Commissioner O’Malia’s comments on recent CFTC rules, see As 2012 Sets In, Attention to regulatory Action in MF Global Investigations Remains Strong, Bloomberg Law Reports® – Securities Law, Vol. 6, No. 5 (Jan. 30, 2012).
— Recommends Roundtables and Hearings
As such, Commissioner O’Malia urged the CFTC to refrain from “ad hoc actions” and instead urged the agency to “articulate a thoughtful, coherent approach to strengthening our segregation structure.” To that end, he recommended that CFTC staff hold roundtables “on the potential vulnerabilities” in the segregation framework. Commissioner O’Malia also encouraged the CFTC to hold hearings based on these recommendations.
— Short-Term Actions: Spot Checks
Dividing the customer protection regulations into pre- and post-bankruptcy, Commissioner O’Malia suggested actions the CFTC can take to ensure compliance with segregation requirements. Acknowledging the CFTC’s recent limited review of intermediary segregation compliance, Commissioner O’Malia asserted that though the review was “a step in the right direction, it’s not enough.” For more on the CFTC’s limited review, see No Material Breaches of Customer Fund Protections Found in CFTC’s Review of FCMs, Bloomberg Law Reports® – Securities Law, Vol. 6, No. 6 (Feb. 6, 2012). To complement the one-time limited review, Commissioner O’Malia recommended that the CFTC institute a system of spot checks for segregation compliance. He elaborated that these spot checks should be coordinated with self-regulatory organizations (SROs), conducted on random dates, and include a range of intermediary types. According to Commissioner O’Malia, spot checks will deter intermediaries from maintaining segregation practices that may be susceptible to shortfalls and would increase public confidence shaken by MF Global’s shortfall.
— Middle-Term Actions: Pre-Bankruptcy Customer Protection
Improved Customer Disclosures
Commissioner O’Malia suggested that improved customer disclosure requirements will facilitate market discipline and segregation compliance. Specifically, he suggested that the CFTC use a recent regulation requiring swap dealers to “know their customers” as a model to draft regulations whereby customers can “know their intermediary.” Underpinning this recommendation is the fact that MF Global was able to change its risk profile dramatically without disclosure to customers. To prevent such drastic intermediary action, Commissioner O’Malia contended that “customers need to have enough information to understand the risk profile of an intermediary and to evaluate risk profiles across intermediaries.”
Systemic Identification of Weaknesses in Segregation
To ensure segregation compliance, Commissioner O’Malia advocated for a systematic identification of weaknesses in the CFTC’s segregation requirements. To that end, he again suggested public roundtables and careful examination of discrepancy reports that alert the CFTC to possible intermediary under-segregation.
Strengthening SRO Supervision of Intermediaries
Explaining that SROs are the front-line supervisors of intermediaries, Commissioner O’Malia suggested that, in light of the MF Global collapse, the CFTC should review SRO supervision practices. First, he suggested that the CFTC determine whether SRO examinations are occurring frequently enough. Second, Commissioner O’Malia urged the CFTC to review whether SROs need to “expand the scope and intensify the depth” of examinations. In addition, the CFTC should consider whether SRO examination requirements should be updated or expanded to provide specific guidance as to how an SRO could ensure that an intermediary had sufficient internal controls to guard against segregation violations.
Strengthening Commission Oversight of SROs
While SROs oversee intermediaries, the CFTC oversees SROs. As such, Commissioner O’Malia encouraged the CFTC to continue its work on enhancing the usefulness of intermediary audited financial statements. He further suggested that the agency also consider the use of technology to enhance SRO supervision. To effectuate this, he suggested partnering with industry participants with better technological resources.
— Long-Term Actions: Post-Bankruptcy Customer Protection
Commissioner O’Malia emphasized the post-bankruptcy issues with customer protection, underscored by MF Global. Conceding that only Congress has the power to address such issues, he nonetheless offered recommendations the CFTC can make to Congress to amend the Bankruptcy Code.
Greater CFTC Involvement in Bankruptcies
In Commissioner O’Malia’s view, in cases such as MF Global, where a dually-registered securities broker-dealer and futures commission merchant are placed into a SIPC liquidation proceeding, the CFTC must have a greater voice in the bankruptcy. This will ensure that futures customer interests are not subordinate to those of securities customers. To that end, Commissioner O’Malia suggested that Congress grant the CFTC authority to appoint its own trustee to exclusively represent the interests of futures and swaps customers.
Customers First: The Super Lien
Commissioner O’Malia next recommended that Congress “clearly and specifically confirm that customers are always first in line.” Advocating against creditors coming ahead of customers, he argued that all money in segregated customer accounts should go toward customer claims. In the event of a shortfall, he further argued that an intermediary’s proprietary assets must also first go to customers. Commissioner O’Malia also suggested that Congress alter the pro ratadistribution requirements of the Bankruptcy Code. Finally, he suggested that recent calls for a government insurance scheme replicating SIPC would not resolve restoring customer accounts, in an expedited fashion, should a shortfall occur.
High Frequency Trading: Problem and Solution
Commissioner O’Malia next discussed the topic of HFT. He noted that trading on exchanges like the New York Mercantile Exchange shifted to electronic platforms in 2006. Since then, while trading technology has significantly evolved, CFTC oversight has not.
— Technology Advisory Committee
In the summer of 2010, Commissioner O’Malia reestablished the Technology Advisory Committee (TAC) to focus on trading technologies such as algorithmic trading. Soon after TAC convened, the equities and derivatives markets fell by an “unprecedented” $1 trillion. The crash spurred TAC to generate several recommendations focusing on pre-trade risk controls to prevent a similar crash, including: (1) pre-trade quantity limits on individual orders; (2) a “kill button” on existing orders; and (3) clear exchange cancellation policies for erroneous trades and orders. Despite making these recommendations, TAC identified a fundamental problem: there was no market consensus on what constituted automated trading, algorithmic trading, or HFT. Accordingly, Commissioner O’Malia announced the creation of a TAC subcommittee “to specifically focus on defining and identifying HFT within the futures, swaps and options markets.”
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