Mark your calendar for Barclays' compliance with CFTC order

The CFTC issued an order on June 27, 2012, requiring Barclays to implement numerous undertakings aimed at strengthening the reliability of its submissions to the calculation of LIBOR.  Barclays must establish policies, procedures, and controls not later than August 27 to assure compliance with the order.  For example, every six months Barclays is required to conduct an internal audit of the basis for its LIBOR submissions and each year the bank must retain an independent auditor to review its submissions.  Barclays must report to the Commission every four months, starting 120 days from the date of the order, on its progress toward compliance with the order.  A report explaining Barclays' compliance -- with copies of the relevant controls, procedures, and policies -- is due within 365 days of the order.

This case is a landmark in the enforcement of the Commodity Exchange Act.  The CFTC thus has a unique opportunity to demonstrate its commitment to following through on its enforcement program.  I have marked my calendar to check with the CFTC on Barclays' submissions, so that we may have a real-time view into the mechanism of post-judgment supervision by the agency.  I will report the progress and results of these observations in this space.

Should the Commodities Futures Trading Commission be replaced by a single administrator?

The original purpose of establishing the Commodity Futures Trading Commission as an "independent" regulatory body was to "insulate" it from some of the more turbulent political currents in Washington.  The Commission consists of five Commissioners, no more than three of whom may be from the same political party.  The complexity and speed of the modern derivatives environment argues for a regulator structured for high efficiency.  Congress is the appropriate venue for making high level political choices.  While statutory implementation also calls for policy trade-offs, the opportunity to submit comments on proposed rules -- which, under the law, must be considered by the regulator -- allows for generous public input to the rule-making process.  Congressional oversight of the agency and judicial review of new rules also militate against the potential bias a single administrator might introduce.  A regulator with a politically divided leadership imposes a second round of political negotiating on the process of implementing a statute, with a corresponding delay and potential diffusion of focus in new regulations.

Would the regulation of derivatives be better served by an agency with a single leader -- perhaps appointed for longer than a single presidential term, such as five or ten years?  

Seventh Circuit denies trustee's claim to property transferred out of segregation and posted as collateral for a $312 million loan

On August 9, the U.S. Court of Appeals for the Seventh Circuit denied the claim of the liquidation trustee for the failed FCM, Sentinel Management Group, against the Bank of New York Mellon for more than $300 million that Sentinel had illegally removed from customer segregation accounts and posted as collateral for a loan from BNY.  app. ct. op.  The trustee, Frederick Grede, argued that BNY's lien on the funds should be voided and the funds returned for distribution to creditors because BNY was complicit in the breach of segregation.

Sentinel used the segregated funds to secure overnight loans that at one point exceeded $500 million.  The loan proceeds were used to finance, among other things, customer redemptions and Sentinel's proprietary trading.  Eventually, a BNY official began to question how Sentinel -- with a capitalization of roughly $3 million -- could post security worth 100 times that amount without using property to which others had a claim.  But he allowed himself to be fobbed off with a vague answer from his subordinates.

Both the District Court and the Court of Appeals showed the traditional reluctance -- embodied in the case law -- to impose a duty on a bank to supervise the propriety of its customers' actions.  The Court of Appeals noted that Sentinel could electronically desegregate funds without significant knowledge or involvement of BNY and that BNY's electronic system handled hundreds of thousands of transfers each day.  Neither the District Court nor the Court of Appeals was willing to consider BNY's conduct sufficiently egregious to void its lien, despite BNY's suspicions about the source of Sentinel's loan collateral.

The most disturbing aspect of this case -- detailed in the District Court's opinion (441 B.R. 864 (2010)) -- is that it portrays a deeply dysfunctional system.  Nobody was "minding the store" while Sentinel played fast and loose for several years with hundreds of millions dollars of customer funds:

• the NFA received monthly forms and annual audited financial statements that should have alerted it to Sentinel's irregular practices;

• the CFTC received the same information as the NFA but also did not detect Sentinel's scheme;

• independent auditors did not detect Sentinel's nefarious activities; 

• BNY did not follow up on its suspicions about the source of Sentinel's collateral; and

• Sentinel's customers -- many of whom were sophisticated FCM's -- entrusted large sums of money to Sentinel, which  offered the facially ridiculous claim that it had "constructed a fail-safe system that virtually eliminates risk from short term investing."

Every element in the system designed to protect customer funds failed.  This fact -- which will recur frequently in other situations we examine -- indicates that the system is due for a serious overhaul.  

    

Introduction

This blog will examine the evolving world of derivatives in hopes of generating constructive ideas as to how to achieve a better balance between innovation and reliability in the markets.  Recent events, such as the Libor rate fixing scandal, the failure of MF Global, and the collapse of the Peregrine Financial Group, have lend Congress -- among many others -- to question whether the present market structure provides sufficient customer protections to enable effective hedging of risk.  In the coming weeks, I will invite comment on the state of the derivatives markets and provide my own impressions and suggestions in an effort to elicit concrete contributions toward developing more stable and effective markets.