MFG was Bad. PFG is even worse.

Let’s cut to the chase: PFG makes the futures industry look really, really bad. The best thing that can be said about this debacle is that missing client funds are denominated in millions instead of billions. That’s about it. From MFG, we learned that rehypothecation means that brokers can use client funds as margin for their own trading activities (see here and here), as long as they kept them ‘segregated.’ Such segregation is likely pretty easy right up until the margined trades start losing money, at which point settlements have to be made. In fact, it is worry about those settlements that causes firms to require collateral in the first place. This brings to mind the quote in the latest Economist about the LIBOR scandal, “With traders, if you don’t actually nail it down, they’ll steal it.” But in MFG’s defense, all indications are that the violation of segregation happened pretty shortly before the firm’s collapse. This is little consolation to account holders, but at least we can say that under the (admittedly ridiculous) regulations permitting rehypothecation in place at the time, many parties, regulators included, got blindsided.

But PFG is entirely different. According to recent press reports, in 2010, they claimed to have over $200m in segregated deposits at US Bank, and PFG sent a confirmation to the NFA to that effect. Now it turns out that, in fact, PFG had less than $10m on deposit at the time, and that was in 2010! How does that number go unchecked for at least a year and a half? Did they submit a note from their mother with it, too? Maybe they used nice words like ‘Please’ or ‘Ma’am’? Starbucks gift cards? At the very least, shouldn’t the external auditor have checked it? The NFA? The CFTC? The CME? Anyone?  I’m not sure where to start describing my confusion about this. This just seems so simple to catch, and yet it wasn’t caught.

Which leads to the obvious question: how can anyone trust the futures markets? How far have we really come from the bucket shops that featured so prominently in ‘Reminiscences of a Stock Operator?’ Yet these markets are vital to the operation of the modern economy. Without modern futures markets, the amount of risk borne by everyone in the commodity chain would increase dramatically. Farmers couldn’t hand their risk off to elevators through forward contracts because elevators wouldn’t be able to hedge the risk arising from the forward contract. Tyson’s wouldn’t be able to offer forward prices on their chicken to Wendy’s because they not only couldn’t hedge the feed exposure, but they wouldn’t even know what future feed prices will be. The result would be much higher operating costs for everyone.

What can be done? For the time being, I think that the CME and the ICE should once again open their wallets, first as a sign of bona fides to those who lost money; second to lobby for the extension of SIPC-like protection to futures and options accounts. I have to admit that I was shocked to learn that those protections don’t exist. Second, could everyone (CME, ICE, clearinghouses, NFA, CFTC, auditors) please sit down around the same table (I bet Senator Grassley could arrange a table…) and figure out whose responsibility it was to pick up the phone to US Bank and why it didn’t happen? Third, could that person, their co-workers, or someone please lose their job? Fourth,could someone from PFG go to jail?

Sadly, only the fourth will happen.


It’s called free-riding…look around, it’s common.

Heritage Foundation Vice President David Addington, who first reported on the rule on his blog Tuesday evening, said there are two problems with the new fee. First, he said it’s likely the 15 percent fee will be passed on to consumers. Second, he said it’s inappropriate for the government to be putting its “thumb on the scale,” helping out the fresh-tree sellers and not the artificial-tree sellers.

“If it’s one thing I think the free market could handle, it’s letting people decide what kind of tree they want to buy for Christmas,” Addington told

Source: Fox News.

While it sounds ominous and like a (hide the children!) tax increase, this is simply a marketing program, like the Milk Board, producers of the ‘Got Milk?’ commercials, or any one of a number of other marketing boards. While Addington above is correct, in that tree producers could promote purchasing live trees by themselves, there is a strong incentive not to do so because of free-riding.

Imagine that there are two producers of live trees, Dasher’s and Dancer’s. Both firms believe that such a marketing campaign is beneficial, and therefore agree to start running commercials that promote live vs. synthetic trees. But Dancer realizes that he benefits from not only his own commercials, but Dasher’s as well. Therefore, if Dancer reduces spending by 10% on his own campaign, but the loss in sales is shared, Dancer is better off in reducing spending on the campaign, assuming that Dasher continues his campaign. Soon, Dasher will make the same realization, and probably also be quite angry at Dancer’s shirking, causing Dasher to reduce his marketing spending. The result is a spiral to zero.

Now, imagine that instead of only two firms, there are thousands, and the incentive to free-ride off the campaigns of others is even greater. That is why such marketing boards are created, they are a mechanism to force all firms to participate in activities with broad benefits.





Another two-handed economist post…

Producers of cotton, wheat flour and livestock feed are searching for ways to avoid losing U.S. Census Bureau reports critical to their industries that are slated to be discontinued due to budget cuts.

A coalition of agricultural trade associations met Wednesday with the top economist of the U.S Department of Agriculture to discuss attempts to save the reports. Time is running out to find a solution, as some will be stopped after next month.

source: Morningstar.

I agree that these reports are very important to the markets. I’ve long said that the abundance of USDA and Census information on agricultural production and consumption greatly levels the playing field between the largest traders and other participants in the markets. Because of these reports, and others that NASS is now having to reconsider, there is a huge amount of data available to even the lowliest, brokest, land-grant university-based analyst. Nevertheless, the major players still have more information.

But reading the article brings two thoughts to mind. First, if these reports truly are so important to such major actors in the industry, then how can they not be worth $80,000/year to an industry association as a whole? That is the cost of one secretary in their DC office. Alternatively, if these are so important, why doesn’t the United Soybean Board (who receives the national check-off for soybean sales, $82m in 2010) or a coalition of state wheat associations and/or marketing programs fund these?

More fundamentally, why is agriculture different? While I know that the Energy Information Administration provides copious amounts of data on oil and other energy markets, other commodity markets (base & precious metals) seem to function fine without the large investment in public data generation and dissemination. This is not to say that I’m opposed to these reports, or think that they are a bad idea. Just some questions and observations.