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.
Showing posts with label financial regulation. Show all posts
Showing posts with label financial regulation. Show all posts
Wednesday, March 6, 2013
Monday, February 18, 2013
Fiscal cliff as constitutional crisis
The news is filled lately with the "fiscal cliff" looming on March 1 and the devastating effects going over the cliff will have on a broad range of public services, such as food inspection, air transportation, and, certainly, financial regulation. The threat of going over the cliff also has widespread negative implications for the private sector. I wrote about some of these problems at the end of January. And we have more recently witnessed financial regulators renewing their pleas to congressional leaders for adequate funding merely to attempt to carry out their missions -- e.g., CFTC Chairman Gary Gensler still trying to inch his meager staff of about 630 toward the 1000 mark. But a new and deeper issue of the governmental dysfunction represented by the "fiscal cliff" has occurred to me recently and caused me to revisit the matter.
Clearly the spectacle of a legislature that cannot even agree on a budget for the federal government -- which thus has to "close down" (to the extent that can even be done) -- is not new. There have been brief government closures, and several near misses, in the past. That threat still exists with the expiration of the current continuing resolution funding the government until March 27. Failure to fund the government for a new fiscal year is deeply dysfunctional to be sure -- true nonfeasance. And history is filled with highly beneficial bills that should have become law but did not through such nonfeasance.
But I cannot recall an instance when Congress passed and the President signed a law which all parties knew when it took effect would be positively detrimental to the nation. This seems to me to be an even deeper level of dysfunction than we have seen before -- malfeasance rather than nonfeasance. Democratic institutions do not function well in the absence of existential crises. But when the legislature creates a synthetic crisis in hopes of scaring itself into action, and then fails to avoid the crisis it has created (or moves the date of the disaster ever onward), the level of governmental dysfunction approaches a constitutional crises in which the very structure of the government prevents it from accomplishing its stated purposes ("provide for the common defense and security", etc., etc.).
If you know of other cases when Congress enacted legislation that it knew would be detrimental to the country, have thoughts on my proposition that this is a deeper and more critical level of dysfunction than the usual nonfeasance we previously experienced, or have any other illuminating thoughts on what this means for the viability of our system of government, the administrative/regulatory state, or any similarly lofty matters, please let me know.
Clearly the spectacle of a legislature that cannot even agree on a budget for the federal government -- which thus has to "close down" (to the extent that can even be done) -- is not new. There have been brief government closures, and several near misses, in the past. That threat still exists with the expiration of the current continuing resolution funding the government until March 27. Failure to fund the government for a new fiscal year is deeply dysfunctional to be sure -- true nonfeasance. And history is filled with highly beneficial bills that should have become law but did not through such nonfeasance.
But I cannot recall an instance when Congress passed and the President signed a law which all parties knew when it took effect would be positively detrimental to the nation. This seems to me to be an even deeper level of dysfunction than we have seen before -- malfeasance rather than nonfeasance. Democratic institutions do not function well in the absence of existential crises. But when the legislature creates a synthetic crisis in hopes of scaring itself into action, and then fails to avoid the crisis it has created (or moves the date of the disaster ever onward), the level of governmental dysfunction approaches a constitutional crises in which the very structure of the government prevents it from accomplishing its stated purposes ("provide for the common defense and security", etc., etc.).
If you know of other cases when Congress enacted legislation that it knew would be detrimental to the country, have thoughts on my proposition that this is a deeper and more critical level of dysfunction than the usual nonfeasance we previously experienced, or have any other illuminating thoughts on what this means for the viability of our system of government, the administrative/regulatory state, or any similarly lofty matters, please let me know.
Thursday, January 17, 2013
Is the correlation between results and compensation tightening at big banks?
The announcement on Wednesday that JP Morgan CEO and Chair Jamie Dimon's compensation for 2012 will be $ 11.5 million -- roughly half of his compensation for 2010 -- may provide some hope that the big banks will begin to bring executive compensation into better alignment with results. Although Mr. Dimon will not have to change his lifestyle because of his pay adjustment, it does show that JP Morgan is taking the "London Whale" fiasco and its continuing fall-out seriously.
But some commentators believe that the bank did not go far enough. Slate's Agnes T. Crane argues that Dimon should have been relieved of his Chairmanship. Whether this should have been done as an additional sanction or simply as a matter of sound management restructuring, the benefits of separating the two offices that Ms. Crane point out are real. And Bloomberg's Jonathan Weil faults the Bank's report on the London trading scandal for not analyzing how the Bank's Chief Investment Office morphed from a risk management operation into a speculative powerhouse -- a transformation urged by Mr. Dimon.
Still, a journey of a thousand miles ... . There are many chapters yet to written in this, and the many other, trading scandals that came to light last year. It is difficult, however, for those who maintain even a shred of optimism about whether the US financial sector can be salvaged in its present form not to see this as a ray of hope -- dim and flickering, perhaps -- but still as step in the right direction.
But some commentators believe that the bank did not go far enough. Slate's Agnes T. Crane argues that Dimon should have been relieved of his Chairmanship. Whether this should have been done as an additional sanction or simply as a matter of sound management restructuring, the benefits of separating the two offices that Ms. Crane point out are real. And Bloomberg's Jonathan Weil faults the Bank's report on the London trading scandal for not analyzing how the Bank's Chief Investment Office morphed from a risk management operation into a speculative powerhouse -- a transformation urged by Mr. Dimon.
Still, a journey of a thousand miles ... . There are many chapters yet to written in this, and the many other, trading scandals that came to light last year. It is difficult, however, for those who maintain even a shred of optimism about whether the US financial sector can be salvaged in its present form not to see this as a ray of hope -- dim and flickering, perhaps -- but still as step in the right direction.
Monday, December 3, 2012
What are the benefits to considering the costs and benefits of regulations?
Many statutes require agencies to do some sort of analysis of the costs and benefits of a proposed regulation when promulgating a new or revised regulation. Section 15(a) of the Commodity Exchange Act requires the CFTC to "consider the costs and benefits of the action of the Commission" in light of "(A) considerations of protection of market participants and the public; (B)
considerations of the efficiency, competitiveness, and financial integrity of futures markets; (C) considerations of price discovery; (D) considerations of sound risk management practices; and (E) other public interest considerations."
The meaning of this Delphic reiteration of what appears to be the agency's statutory duty in the first instance will be hotly contested in the courts, as opponents of regulations argue that it requires as close to an exact quantification and comparison of costs and benefits as possible and proponents of regulations claim that it gives the Commission discretion to do anything not unreasonable. The immense scope and novel features of the financial system addressed by the Dodd-Frank Act and the corresponding regulations makes it all but impossible to give the wording of section 15(a) any but the most general meaning. But reasonable judges can, and do, differ, and a long season of litigation seems to await each of the rules before they become final.
Congress cannot be expected to act with the clarity and dispatch of the Executive branch. But before enacting requirements such as section 15(a) in the future, Congress may wish to revisit the wording of the orders from the Combined Chiefs of Staff to General Eisenhower appointing him Supreme Allied Commander on the eve of the invasion of Europe: "You will enter the continent of Europe and, in conjunction with the other United Nations, undertake operations aimed at the heart of Germany and the destruction of her armed forces."
considerations of the efficiency, competitiveness, and financial integrity of futures markets; (C) considerations of price discovery; (D) considerations of sound risk management practices; and (E) other public interest considerations."
The meaning of this Delphic reiteration of what appears to be the agency's statutory duty in the first instance will be hotly contested in the courts, as opponents of regulations argue that it requires as close to an exact quantification and comparison of costs and benefits as possible and proponents of regulations claim that it gives the Commission discretion to do anything not unreasonable. The immense scope and novel features of the financial system addressed by the Dodd-Frank Act and the corresponding regulations makes it all but impossible to give the wording of section 15(a) any but the most general meaning. But reasonable judges can, and do, differ, and a long season of litigation seems to await each of the rules before they become final.
Congress cannot be expected to act with the clarity and dispatch of the Executive branch. But before enacting requirements such as section 15(a) in the future, Congress may wish to revisit the wording of the orders from the Combined Chiefs of Staff to General Eisenhower appointing him Supreme Allied Commander on the eve of the invasion of Europe: "You will enter the continent of Europe and, in conjunction with the other United Nations, undertake operations aimed at the heart of Germany and the destruction of her armed forces."
Monday, November 5, 2012
What is the value of internal compliance systems?
Internal systems of compliance monitoring have recently presented us with an alarming collection of spectacular failures. For one example among many, the compliance office at Barclays was alerted to irregularities in the Bank's submissions to the calculation of LIBOR, and a senior compliance officer promised to raise the issue with senior management, but did not do so.
Internal compliance systems suffer from intrinsic conflicts of interest. Like the Chancellor of England, who served as the "King's conscience," compliance officers serve as the conscience of the company. But the King could, and sometimes did, behead the Chancellor -- a lesson that is not lost on modern compliance officers. On the other hand, truly independent monitors of corporate probity are cumbersome, expensive, and may lack expertise and inside knowledge of the corporation.
Until corporate incentives -- mainly, but not exclusively, executive compensation -- are more closely aligned with ethical practices and legal constraints, the role of the corporate compliance program will be relegated to overseeing routine technical matters and correction of lower-level ethical lapses. Stronger protections for whistleblowers, carefully targeted criminal prosecutions, meaningful statutory revisions to the financial system, and similar techniques, must all be brought to bear in a coordinated manner if these incentives are to be changed in an effective way. It remains to be seen if recent efforts in these areas are sufficient and sufficiently timely.
It is not in the nature of organizational compliance programs to be crowns of laurels, but neither can we tolerate them being corporate fig leaves.
Internal compliance systems suffer from intrinsic conflicts of interest. Like the Chancellor of England, who served as the "King's conscience," compliance officers serve as the conscience of the company. But the King could, and sometimes did, behead the Chancellor -- a lesson that is not lost on modern compliance officers. On the other hand, truly independent monitors of corporate probity are cumbersome, expensive, and may lack expertise and inside knowledge of the corporation.
Until corporate incentives -- mainly, but not exclusively, executive compensation -- are more closely aligned with ethical practices and legal constraints, the role of the corporate compliance program will be relegated to overseeing routine technical matters and correction of lower-level ethical lapses. Stronger protections for whistleblowers, carefully targeted criminal prosecutions, meaningful statutory revisions to the financial system, and similar techniques, must all be brought to bear in a coordinated manner if these incentives are to be changed in an effective way. It remains to be seen if recent efforts in these areas are sufficient and sufficiently timely.
It is not in the nature of organizational compliance programs to be crowns of laurels, but neither can we tolerate them being corporate fig leaves.
Monday, October 15, 2012
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.
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.
Monday, October 1, 2012
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
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
Sunday, September 23, 2012
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:
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.
Saturday, September 15, 2012
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.
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.
Monday, September 10, 2012
End of fiscal year crisis anticipated
Fiscal year 2012 will end on September 30. It has become the custom for Congress to enter a holding pattern for about a quarter of a fiscal year, putting the government on life support with successive short-term continuing resolutions, which maintain spending at the levels of the expired fiscal year until a permanent appropriation is provided. There is every reason to expect this pattern to continue this year, especially in light of the presidential election in November.
The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation. The House Appropriations Committee has recommended about $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation. The Senate Appropriations Committee recommends the full $ 308 million requested by the President.
The Dodd-Frank Act radically expanded the CFTC's jurisdiction. The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency. And, of course, old-fashioned fraud and other market abuses continue unabated. Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve. Agency personnel levels are barely equal to those of 1995.
Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country. The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.
The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation. The House Appropriations Committee has recommended about $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation. The Senate Appropriations Committee recommends the full $ 308 million requested by the President.
The Dodd-Frank Act radically expanded the CFTC's jurisdiction. The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency. And, of course, old-fashioned fraud and other market abuses continue unabated. Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve. Agency personnel levels are barely equal to those of 1995.
Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country. The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.
Saturday, August 25, 2012
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.
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.
Sunday, August 19, 2012
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?
Sunday, August 12, 2012
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:
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
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.
- 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."
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