By MARY PENG and MICHAEL SMALLBERG
In the wake of two colossal market scandals, several members of Congress have raised doubts about the government’s reliance on the futures industry to regulate itself.
“I’m struggling to understand why we continue to support this [self-regulatory organization] model of regulation when we seem to have one large-scale process failure after another,” said Rep. David Scott (D-Ga) at a July 25 hearing.
At the same hearing, Rep. Tim Huelskamp (R-Kan.) complained to a federal regulator that “we’re relying on outside groups to determine the effectiveness of your regulatory system.”
There has been heightened scrutiny of the futures industry following the revelation that Peregrine Financial Group, a futures broker, had allegedly been defrauding clients for as long as two decades. Just eight months earlier, another futures broker, MF Global, filed for bankruptcy after more than $1 billion in client funds went missing.
The Senate and House Agriculture Committees have both held recent hearings to examine the failures at Peregrine and MF Global. While committee members disagreed about the need for more regulations, Democrats and Republicans, alike, questioned the effectiveness of the self-regulatory system and called for measures to increase the protection of customer funds.
The Project On Government Oversight recently sent a letter to both committees opposing self-regulation for the swaps and futures markets. The letter highlighted the inherent conflicts of interest at self-regulatory organizations that receive funding from the very industries that they regulate.
Under the current regulatory framework, the Commodity Futures Trading Commission (CFTC) delegates its authority to private self regulatory organizations such as the National Futures Association (NFA) to be the markets’ frontline auditors. Several committee members expressed skepticism about the federal regulator’s reliance on the futures association to oversee Peregrine and other futures brokers.
“You’re relying on outside firms, the NFA. [In] your last limited-scope review [of Peregrine], you used [the NFA’s] findings,” Rep. Jean Schmidt (R-Ohio) said to CFTC Chairman Gary Gensler at last week’s hearing. “And yet, you look at certain things in the past that have occurred, that should have put up red flags. If you are the watchdog, then maybe you should do your own internal investigation a little more diligently.”
At the same hearing, Rep. Leonard Boswell (D-Iowa) pointed out that Peregrine’s former CEO had served on a National Futures Association advisory committee, and that Peregrine’s chief compliance officer formerly served as an association auditor, as reported in The Wall Street Journal.
On Wednesday, Sen. Tom Harkin (D-Iowa) noted that National Futures Association had taken multiple enforcement actions against Peregrine beginning in 1996, and had also received numerous tips suggesting that the brokerage was mishandling customer funds.
“One red flag ought to be enough, but if you get two red flags and then three red flags, pretty soon somebody has to start paying attention,” Sen. Harkin said at this week’s hearing. “Then that raises the question: does the CFTC have enough power and authority and personnel to ensure that industry self-regulatory organizations fulfill their responsibilities?”
An National Futures Association auditor was copied on a May 2011 email showing that just over $7 million remained in Peregrine’s customer account, according to the association's records that were provided to Sen. Harkin and reviewed by The Wall Street Journal. A few days later, the association received a “corrected copy” with a handwritten account balance showing more than $200 million in customer funds, according to the Journal.
The association did not explain to Sen. Harkin why it failed to pursue this discrepancy, according to the Journal.
Speaking of red flags, Sen. Charles Grassley (R-Iowa) asked about a new CFTC whistleblower program created under the Dodd-Frank Act. “Do you think that the [CFTC] has done enough to raise awareness in the futures industry…that the whistleblower office exists and what the function of the office is supposed to be to encourage people to come forth?” he asked Gensler at this week’s hearing.
Gensler confirmed that the whistleblower office is up and running but said the consumer outreach program is managed by only two staff members. He acknowledged that the agency can “do more to educate the public.”
Gensler also defended the self-regulatory system, which he noted is “embedded in our oversight” and “enshrined in statute,” while acknowledging that the agency could do a better job of overseeing the front-line examiners from NFA and other self-regulatory groups.
“So what we’re focused on is how to improve [the self-regulatory model], not to uproot the whole thing, but to change it and enhance it,” Gensler said at last week’s hearing.
He noted, for instance, that the agency has already taken steps to “examine the examiners” and to develop an electronic system that would provide auditors with online access to firm accounts.
The bankruptcy of two financial giants in merely eight months has shed light on the urgency of reforming the self-regulatory system to restore consumer confidence.
As POGO noted in its letter, “[i]f we have learned anything from the financial crisis of the past few years, it is that inadequate federal oversight and regulation of the financial industry leads to excessive risk and instability in our economy.”
Mary Peng is an intern at the Project On Government Oversight. Michael Smallberg is an investigator at the Project On Government Oversight.