A Senate hearing scheduled to examine implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act evolved into close scrutiny of the SEC and CFTC’s handling of the collapse of the major derivatives broker MF Global. Chairs Mary Schapiro and Gary Gensler were closely questioned by committee Chair Debbie Stabenow (D-MI) and ranking member Pat Roberts (R-KS) about the agencies’ oversight of the failed firm.
MF Global traded both securities and commodities derivatives, although the securities side was small, consisting of only about 400 accounts. According to reports, the firm held huge long positions on European sovereign debt, up to several times the size of the firm itself. Following a disclosure in early September that FINRA had required it to supply additional capital, the firm was successively downgraded by Fitch and Moody’s. The crisis came to a head on October 31, when the SEC and CFTC announced that they had been informed of deficiencies in customer futures segregated accounts, and that the Securities Industry Protection Corporation (SIPC) would initiate liquidation of the firm.
Following the collapse, as positions were being transferred, it came to light that customer funds that were supposed to be segregated were misappropriated by the firm for proprietary trades. A month later, customer funds are still missing, although exactly how much is in dispute; estimates range from $600 million to $1.2 billion.
According to Chairman Schapiro, MF Global hid its misuse of customer funds through the use of repurchase agreements, or repos. In a repo, one party sells securities to another for cash, along with an agreement to repurchase the securities later. Specifically, according to Chairman Schapiro, a form of repo called “repo-to-maturity” was used. In this instrument, the repo close date is the same or later than the maturity date of the underlying security. Under FASB accounting rules, this type of repo is allowed to be off the balance sheet. Ms. Schapiro said the SEC is examining whether this arrangement should be allowed to continue.
The firm’s failure highlighted significant differences between the two agencies in their oversight of brokerage firms. For example, where the SEC had independent oversight of the firm through FINRA, the CFTC only had oversight through self-regulatory organizations. It was reportedly FINRA’s insistence that MF Global infuse additional capital that led to the firm’s downgrade.
Another difference in oversight regimes is that customer funds invested in securities are protected by SIPC – up to $500,000 per customer – but funds invested in commodity futures are not. According to SIPC, commodity futures contracts are ineligible for protection, unless in portfolio margining accounts and defined as customer property under the Security Investor Protection Act.
Asked by Senator Kent Conrad (D-ND) why there was protection for securities but not futures accounts, Chairman Schapiro replied that the regime was established before her time and she didn’t know, but it was something that Congress could consider.
A final difference in oversight is that agency regulation permits different types of investment of custodial funds. According to the agency heads, the SEC allows only instruments backed by the full faith and credit of the United States, whereas the CFTC allows “four or five” different types of investments, including sovereign funds under certain circumstances.
In response to questioning by Senator Amy Klobuchar (D-MN), Chairman Gensler explained that the CFTC had granted an exemption in 2000 allowing segregated funds to be invested in sovereign debt, if the customer provided funds in the currency of that sovereign. The CFTC had actually proposed a rule in September of 2010 to narrow down that exemption, but withdrew it because of the press of Dodd-Frank rulemaking and disagreements among commissioners, said Mr. Gensler. The CFTC is now considering two rules to narrow permissible investment of customer funds.
The CFTC chairman took the opportunity to press the need for additional funding for the agency. Funding was recently set at $205 million, the same as the 2010 level. Of this, $50 million is ring-fenced, to be used only for investment in information technology. Because of the ring-fencing, said Mr. Gensler, the agency will have to come up with $15 million in cuts.
The agency has 700 staff members, according to Mr. Gensler, which is just 10% above the agency’s peak in the 1990s. The futures market has grown fivefold since that time, and additionally the CFTC has been handed oversight of the swaps market. The debt crisis in Europe is a stark reminder that we need to complete financial reform, said Mr. Gensler.
The difference in funding levels between the agencies, and the additional oversight resources that that funding provides, came into sharp contrast when Chairman Gensler expressed surprise at Chairman Schapiro’s comment that the SEC has 400 examiners. The CFTC, said Mr. Gensler, has only 20.
This post was contributed by my colleague Lene Powell