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.