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Confidence Lost in Brokerage Regulation?

Confidence Lost in Brokerage Regulation?
NGFA says Peregrine and MF Global disasters solidify investor uncertainty in regulatory oversight.

In testimony at two separate hearings over the last week, the National Grain and Feed Association told Congress that the cumulative effect of the MF Global Inc. and Peregrine Financial Group insolvencies and the misappropriation of customer funds has created a "huge loss of confidence" in the adequacy of current rules to protect customer funds, as well as the adequacy of regulatory oversight.  

NGFA says Peregrine and MF Global disasters solidify investor uncertainty in regulatory oversight.

The NGFA said the PFG incident, in which more than $200 million in customer funds allegedly were fraudulently misappropriated for a variety of illegitimate purposes over an extended time period, demonstrated that the MF Global incident was not a one-time incident and that serious risk to customer funds remains.  The "cumulative effect" of the MF Global and PFG failures within a relatively short time – and "especially the failure of PFG at a time when regulators presumably were on heightened alert for problems" – has reiterated the need for steps to be taken to "begin restoring confidence and to bolster protections for segregated customer funds," the association said.

At a hearing conducted Aug. 1 by the Senate Agriculture Committee, Diana Klemme, vice president and director of the Grain Division at Grain Service Corp., Atlanta, Ga., said the discovery of long-term fraud and misappropriation of customer funds at PFG "removed all doubt" that systemic change and more effective regulatory oversight are needed. 

Klemme cited an example of a typical country elevator with 4.2 million bushels of open short futures positions in July that had sent $9.4 million in margin calls to its futures commission merchant – all based upon the assumption that these customer funds will remain segregated and safe.  She also noted that commercial hedgers such as these also depend upon their lenders to have confidence in the system, since they provide much of the money needed to finance such margin calls. 

"We consider the loss of customer confidence in the system to be (a situation that is) both urgent and unsustainable," said Klemme, whose firm is an introducing broker servicing primarily country elevator clients.     "The financial industry, Congress and our regulators all must recognize that trust and confidence are not easily regained.  It will take real change, protection of customer funds, real-time transparency and significantly improved (regulatory) oversight – and not after endless regulatory debate and finger pointing."

During a separate hearing conducted July 26 by the House Agriculture Committee, John Heck, senior vice president of The Scoular Company, Omaha, Neb., and a member of the NGFA's Executive Committee, highlighted a series of legislative, regulatory and other policy recommendations submitted by the NGFA in late June to the House and Senate Agriculture Committees, as well as to the Commodity Futures Trading Commission. 


"These recommendations involve several significant changes in customer account structure; reforms to the U.S. bankruptcy code to enhance customer rights and protections; and the potential extension of insurance coverage to commodity futures customers," noted Heck, who also is chair of the NGFA's Finance and Administration Committee and co-chair of association's MF Global Task Force.

Heck and Klemme in particular cited the following NGFA recommendations:

U.S. Bankruptcy Code Reforms:  1) Harmonize the Commodity Exchange Act, CFTC regulations and the bankruptcy code to provide greater clarity and avoid interpretive inconsistencies in future FCM liquidations; 2) strengthen the CFTC's authority to appoint a trustee to represent exclusively the interests of commodity customers; 3) put customers first-in-line for distribution of funds, ahead of creditors, with all proprietary assets of affiliates used to reimburse segregated customer accounts first; 4) expressly authorize establishment of commodity customer committees to represent their interests in an FCM liquidation; and 5) strengthen the "safe harbor" provisions of the bankruptcy code to not limit the powers of trustees to recover funds, regardless of the intent behind the transfer of customer funds.

Fully Segregated Customer Accounts:  Establish a new type of account structure for use by FCM customers on a voluntary basis that will shield customer assets from pooled losses in the event of an FCM bankruptcy.  Currently, the Commodity Exchange Act and U.S. bankruptcy code provide for pro-rata distribution of all customer property held by a failed FCM. 

Insurance for Commodity Futures Customer Accounts: Because the full-segregation structure discussed previously ultimately may not prove to be practical for all market participants, the NGFA recommended enactment of legislation (if necessary) to provide that insurance coverage to protect against FCM bankruptcies be extended to commodity futures accounts.  Such insurance currently is provided to securities account customers through the Securities Investor Protection Corporation.  "Details involving the appropriate level of coverage and funding will need to be determined," Heck testified.  "But we believe the added customer protections provided will be perceived as significant and meaningful in today's environment."


CFTC Recordkeeping Proposal under Dodd-Frank Law:  The NGFA also used the opportunity provided by the House hearing to restate its opposition to the CFTC's proposed regulations that would require any member of a commodity exchange – including country elevators that are members of the CME Group, Kansas City Board of Trade or Minneapolis Grain Exchange – to record all communications with producers and other commercial firms that could result in a cash transaction. 

Among other things, the CFTC's proposal even would require such entities to record telephone conversations with farmers about a forward cash contract – despite the fact such contracts specifically are exempted from the CFTC's jurisdiction under the Commodity Exchange Act. 

"Taken to the extreme, a country elevator manager's conversation behind the stands at the high school football game on Friday night with a farmer in the community about buying cash grain the next day would be required to be recorded," the NGFA said.  "Clearly, this would constitute a huge expansion of the CFTC's authority in the cash marketplace."

The NGFA also noted that the proposal would create a bifurcated cash marketplace in which some grain purchasers would be required to record communications and maintain records, while others that are not members of a commodity exchange would be exempt – creating significant competitive issues.

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