Hit 'em again? Is LIBOR still being rigged?

When CFTC Chairman Gary Gensler spoke to the annual meeting of the Institute of International Bankers held in Washington on March 4, he discussed, among other timely topics, the continued reliance of the credit markets on the London Interbank Offered Rate (LIBOR), which he correctly asserted is ill-advised.  He mentioned that in 2012 LIBOR was dramatically more stable than comparable measures of volatility.  According to Chairman Gensler, for more than 115 straight trading days the LIBOR three month U.S. dollar rate did not change. 

Perhaps it is time to investigate LIBOR once more, starting where the recent settlements left off.  The marvels of modern word processing could make the burden of issuing new subpoenas a matter of minutes.  The attorneys and investigators that first snagged the liars now have a learning curve behind them.  It could be a perfect example of doing more with less.  And if this unbelievable stability is a sign of unbelievable stupidity or hubris, doesn't it cry out for continued redress?  Perhaps the tuition was too low for the last lesson in civic responsibility. 

Chairman Gensler's public expression of skepticism about this remarkable turn of events implies that his staff likely shares his doubts.  Hopefully, enforcement officials will be able to head off any corps of bankers hammering away at the "delete" buttons on their keyboards and running red-hot shredders.    

High Frequency Trading

High frequency trading -- in which offers to buy or sell exist for small fractions of a second and assets are held for only a few seconds -- has received much attention, especially since it was implicated in the May 6, 2010 "flash crash" of the stock market.  The inconclusive report on that hair-raising event and much of the commentary on the practice since then shows that regulators and market participants do not know nearly enough about how that trading is actually done to sustain wide-spread confidence in the integrity of our markets.

Regulators don't know if the HFT programs commit illegal "wash trades" -- where trading is done without exposure to market risk -- or "spoofing" -- where offers are submitted without intending for them to be accepted.  While much lip-service is given to the need to assure market transparency and other characteristics of sound market management, virtually nothing is actually being done to assure that HFT programs are not committing wholesale violations of the law or exposing markets to catastrophic treats.

HFT advocates claim that these programs provide liquidity to markets and lower spreads between buyers and sellers.  Critics claim that the liquidity is illusory because most offers exist for so short a time that they can't be accepted and that low spreads do not compensate for the enormous systemic risk posed by HFT programs.

The widespread confusion surrounding what to do about HFT programs (but see Commissioner Bart Chilton's speech of October 9, 2010 for a conceptual outline of areas for regulatory action), demonstrates the lack of vision provided by our politicians in managing our economy.  The last financial crisis occurred four years ago and we have barely started to restrain the excesses that caused it.  By the time the necessary regulations are promulgated and enforcement efforts -- no matter how feeble they may be -- are gaining some traction, new causes of new crises will once again have the law enforcement posse scouring the horizon for the dust of those responsible. 

Court vacates CFTC position limits rule

On September 28, 2012, U.S. District Judge Robert Wilkins vacated the CFTC's rule setting speculative position limits on futures, options, and swaps contracts linked to 28 physical commodities, and remanded the matter to the agency for further rulemaking.  The CFTC promulgated the position limits rule on November 18, 2011, as part of its implementation of the Dodd-Frank Act.  The three commissioners voting for the rule -- Chairman Gensler and Commissioners Chilton and Dunn -- believed that Congress had concluded that the limits were necessary to prevent "excessive speculation," preempting any consideration by the agency of the need for the limits.  Although he voted for the rule on the basis that the law required the agency to set position limits, Commissioner Dunn expressed grave doubt as to whether the rule was either necessary or likely to be effective.  Two financial industry organizations -- the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association -- sued under the Administrative Procedure Act, claiming that the Dodd-Frank Act clearly required the agency to make a finding that the limits were necessary before promulgating them.

Judge Wilkins disagreed with both parties, finding that the Act was ambiguous as to whether the agency needed to predicate its rulemaking on a factual finding that the position limits in the rule were necessary to prevent excessive speculation or that Congress had already made this finding when it passed the Act and the agency was without discretion as to whether the limits were necessary.  Judge Wilkins found that the agency proceeded under the mistaken impression that the statute clearly required it to promulgate the position limits rule, regardless of whether the agency found the limits necessary.  He therefore vacated the rule and remanded the issue to the agency to reconsider the rule on the basis that the Dodd-Frank Act is ambiguous concerning whether the agency has discretion to make a finding on the necessity for position limits.

This is the first judicial vacatur of a CFTC rule promulgated under Dodd-Frank.  It will undoubtedly be followed by others, given the extreme complexity of the task and the vigorous opposition the agency faces from a well-financed and sophisticated industry.

Judge Wilkins' opinion in Civil Action No. 2011-2146 can be downloaded from opinion  

Culture change is a top priority for the futures market

Corporate America desperately needs a serious ethical overhaul, and that includes the financial sector.  Leadership, from the board of directors and the CEO down through the layers of an organization, is essential to establishing and maintaining an ethical corporate culture.  Management must continuously stress the need for ethics through every available channel of communications -- speeches, articles, training, leadership conferences, compensation systems, recruitment and retention policies, and the like.  Corporate structure must reflect a commitment to ethical behavior.  The Board of Directors should have a committee charged with independently monitoring the ethical climate of the organization.  Employees should have a channel of communications separate from the chain of command and reporting directly to top management through which they can raise critical ethical issues without fear of reprisal.

CFTC Commissioner Bart Chilton presented a compelling keynote speech at the Hard Assets Investment Conference in Chicago on September 21 advocating several critical actions to improve the distressing ethical climate in the financial sector.  The full text of his remarks is available on the CFTC's website.  Essential points he recommends include:

• Aligning compensation systems to stress risk management over periods of time that reflect an emphasis on sustainable growth rather than immediate profit;

• Recruiting and hiring a workforce receptive to balancing risk and assuring that a drive for profits does not overwhelm other considerations; 

•  Providing sufficient funding to the CFTC through a user fees similar to those used to fund other financial regulators; and

•  Focusing regulations on 
• a corporate structure that emphasizes independence and diversity of viewpoints and skill sets among its directors;
• ownership rules that reduce the chance of conflicts of interest;
• internal and external business conduct standards that clearly demarcate acceptable practices;
• preventing conflicts of interest through limitations on proprietary trading by banks, with careful distinction between hedging risk and proprietary trading; and
• requiring registration of high frequency traders and insuring that they test their algorithms before using them for trading and include a "kill switch" to shut them down if they seriously malfunction.

Some of Commissioner Chilton's recommendations are already contained in draft or final rules, although implementation and operational experience will undoubtedly provide essential data to guide revision and further development.  In any case, his suggestions deserve serious consideration over what will be a long period of rehabilitating the reputation of the financial sector. 

Should the CFTC enforce the prohibition on wash trades against high frequency traders?

"Wash trades" -- trades that give the appearance of a sale and purchase of a futures contract, but do not expose the parties to market risk, or that leave the parties in the same position after the trade as before it -- have been illegal for many years.  Wash trades send false signals to the market, making it appear that there is more interest in a contract than there actually is.

Many high frequency trading programs commit wholesale wash trades, sometimes even accepting their own offers.  Whatever may be the benefits of HFT -- a topic of intense debate -- they come at the price of these wash trades.

Should the CFTC seek to enjoin or otherwise penalize wash trades committed by HFT programs?  Perhaps the enforcement process would enable the agency to evaluate HFT programs more rigorously and put the advocates of the programs to their proof.  Should programmers be required to cleanse HFT programs of features that induce wash trades?  The objections to wash trades seem to be the same whether they are executed in the old-fashioned, paper-based systems, or at lightning speed by computers.  And, in any case, the law articulated by Congress and the courts doesn't seem to support any distinction premised on the environment in which the trades are conducted or on alleged countervailing benefits to the market.

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.

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.