Last week, Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), appeared before the Senate Agriculture Committee, chaired by Sen. Debbie Stabenow, D-Mich., at a routine oversight hearing. As with most agency oversight hearings, this one was revealing because of the questions that were and were not asked, as well as because of Gensler’s answers.
I vaguely recalled that there is some question as to Gensler’s continued tenure as chairman, but it was still surprising to learn that his term expired last spring. Through a quirk in the law, he can stay in the absence of a replacement through the end of this year. Observers doubt his prospects, because Democrats have made a cause of alleged speculation in oil futures, while Republicans are sympathetic to industry complaints that regulation is increasing costs and opening the industry to greater foreign competition.
Gensler has tried to redefine himself as the regulator who gained $1.25 billion in settlement proceeds from the London Interbank Offered Rate (Libor) scandal, rather than as the regulator who enabled his old boss at Goldman Sachs, Jon Corzine, to increase dramatically the leverage of MF Global and to make a losing bet on highly rated EU sovereign debt, which lead to the diversion $1.6 billion in funds that customers had assumed were securely segregated.
Gensler asserts that he recused himself from the MF Global investigation with the approval of staff. The contrary argument would be that the time to have recused himself was when Corzine sought approval to adopt a Goldman Sachs-style business plan, and the test of a leader is to do the right thing, not to seek the protection of staff by virtue of a technicality.
In her opening statement, Stabenow emphasized the importance of the agency using its extraterritorial authority wisely. Gensler has argued that the AIG case demonstrated the importance of regulating derivatives activities, conducted offshore, or at least establishing that the foreign authority can regulate them, because the risk tends to migrate to the United States.
American legislators have somehow been lobbied by German bankers who tell them that the European Union is not going to adopt comparable regulations to those mandated by Dodd-Frank, and American banks are complaining that they are losing share to competitors in London and Asia. It’s a one-two punch, and both Sen. Saxby Chambliss, R-Ga., and Rep. Spencer Bachus, R-Ala., have brought these messages back from trips to Germany.
Several Democrats complained that the CFTC has been unable to implement position limits to curb speculation in energy derivatives, and they charged that 80 to 90 percent of the trading is accounted for by speculators. Sen. William “Mo” Cowan, D-Mass., the appointed replacement for former Sen. John Kerry, charged that, “The hedge funds have doubled their best on oil futures, and this may be impacting oil prices.”
Gensler responded that the Commission has found no significant price movement attributable to this activity, but the agency is trying to deal with the action of a federal district court that invalidated the regulation on the grounds that the CFTC is exceeding its authority. Gensler stated that the Commission has adopted a two-front strategy of both appealing the ruling and looking at alternative language that could obviate the objections of the court.
Ironically, in one area, the Europeans have adopted a stricter rule by requiring two days of margin to be posted for some transactions for which the CFTC requires only one, and in this case, Gensler blithely suggested that maybe this would lead to some transactions being shifted to the United States, further jeopardizing the credibility of his claim that all of the major jurisdictions are working to put regulations in place that will protect the global financial system from threats that could lead to destructive insolvencies.
The highlight of the hearing, so to speak, was the exchange with Sen. Pat Roberts, R-Kan., on measures the CFTC is proposing to implement the customer protection provisions of the Dodd-Frank Act. Roberts began by complaining that the Commission is taking an ad hoc approach to regulation, which creates costly uncertainty for the industry, and that the CFTC is acting without conducting required cost/benefit analyses.
He asked Gensler specifically whether such an analysis had been done with respect to the effect of the “residual risk” rule on the agricultural sector.
Gensler sought to assure Roberts that the agency will look at the rule “through the lens of cost and benefit,” and that the purpose of the rule was to protect customers from having a Futures Commission Merchant (FCM) use their funds to cover the exposures of other customers, but the senator was not satisfied.
Roberts complained further that FCMs, the firms customers use to execute their hedging transactions, “must be in compliance with margin deficiencies at all times, but option values and margins are currently not available in real time, so initial margins would likely have to double.” He asked why the CFTC would propose a rule that is practically impossible to comply with and increases the cost and risk exposure of customers.
Gensler responded that the issue is who should bear the risk, and he promised the Commission would take a serious look at the 120-odd comment letters it has received on this issue.
During the congressional hearings on MF Global, witnesses revealed that customer funds can be moved around by FCMs to be used to cover customer deficiencies or to be invested on behalf of the firm. Many customers were shocked to hear this, because they thought that they had separate accounts, similar to those of mutual funds. They learned that CFTC rules provide for a practice with the Orwellian name, “legal segregation with operational comingling” (LSOC).
What?! It turns out that the segregation feature only takes effect if the broker goes bankrupt, but by that time the money might have been lost in a foreign jurisdiction, as was the case with MF Global.
Perhaps even more disconcerting is that customer groups are ambivalent in their attitudes toward this practice. Some of them are willing to tolerate the comingling of funds as a means of holding down transaction costs (assuming the firm makes money on its investments and doesn’t lose the funds).
Gensler expressed surprise at what he has learned from the comment letters about the imbalances that occur among customer accounts during a given trading day. Rather than being mortified at having been caught comingling funds, it seems that firms are brazenly defending the practice and resisting calls for them to put up sufficient margin to protect against defaults in their obligations to customers.
Watch this space for updates as the struggle unfolds among an array of interest groups, all claiming to be aggrieved by the CFTC.
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