When Even the Clearing Houses Start to Malfunction

Financial markets rise and fall based on the perceived value of the products being sold. But there are occasions when market value is affected by the condition of the marketplace itself, and whether the infrastructure that supports the market is structurally sound. This is the situation investors are now facing. There is rottenness apparent in even the largest and most trusted markets, like the US Treasury market, and investors are beginning to question how safe their funds are, or whether the protection being bought is worth anything. Private money is nervous, or it is fleeing the markets altogether. When so many different markets are afflicted by the same creeping structural weakness, it is no surprise that the average investor begins to ask whether Financial Armageddon may be upon us.

There are a number of recent cases where the “system” did not work the way investors expected, especially in the case of the collapse of MF Global, and the less-publicized ruling that banks would not have to pay out the protection they sold investors who bought credit default swaps covering a potential Greek government default. Before we turn to these specific and highly consequential events, we should look at the some of the precedents which reveal a history of rule-changing by banks and regulators that inevitably has worked against the interest of investors.

Rules Can be Changed for the Benefit of the Market Makers

A financial crisis as painful and as dramatic as that of 2008 can tell you a lot about whose interests regulators really are concerned about. When stress in the markets reached acute levels, the regulators changed the rules to benefit the market makers, not the investors. The sell-off in bank stocks in 2008 was becoming so steep that US regulators introduced a rule change that outlawed the short sale of bank shares. Investors were now limited only to buying bank stocks. The losses imposed on those investors who had presciently foreseen problems in the banking industry, and who had protected themselves by selling banks short, were staggering. These investors were penalized for being correct.

The rally in bank stocks following this rule change lasted a month or two, but the selling recommenced – not short selling (which was now illegal), but outright selling of positions by those still invested in the industry. As prices began to test the lows of 2008, regulators in March of 2009 changed the rules again, this time as a result of pressure from the banks and their paid servants in the US Congress. The practice of marking to market trading securities was suspended in the US; banks were now free to ignore what the market would pay for some of their shakier mortgage-backed securities, and were able to put their own price on these holdings. Securities that the market would have bought for 30 cents on the dollar were instantly re-priced on bank balance sheets at 90 to 100 cents on the dollar, creating immediate profit for the banks and allowing them to hide these securities away from public view. To this day, no one really knows how many such securities are owned by US banks, or what they are really worth.

There were of course many other special favors done for the US banks, many of which involved funneling trillions of taxpayer dollars in loans and guaranteed profits to the industry. Notice that the US has been lecturing Europe this past year to adopt the same game plan as a way of coping with its banking crisis. Europe has paid attention. Most of the major stock exchanges in Europe now outlaw short selling in bank shares, and there have been proposals put forward to allow banks to ignore market pricing for government securities. If there were such a thing as a US Treasury for Europe, it would already be lending a trillion or more euros into the banking market to stave off bank collapse. The essence of the crisis in Europe at the moment is to find a way to create a centralized Treasury for the EU, knowing that this will significantly limit the sovereignty of the individual member countries.

MF Global Bankruptcy Reveals Weakness in Registered Exchange Safety

Europe may not succeed in accomplishing this task in time to prevent global economic disaster, because the financial system is now so interconnected that any weakness in the structure impacts unsuspecting and faraway parties. This brings us back to the MF Global fiasco. This UK brokerage firm had extensive business practices in the US, chiefly as a commodity broker, but was never known as a major trader for its own account until the arrival a year ago of a true Master of the Universe – Jon S. Corzine. Corzine made his reputation as a trader at Goldman Sachs, rising to the top of the firm, where he oriented Goldman Sachs away from its traditional investment banking business, to a heavy reliance on trading revenue. Corzine was ousted from Goldman Sachs due to a series of questionable transactions, and went on to a political career as a US Senator and then Governor of New Jersey. His failure to get reelected as Governor last year led him to the position of CEO of MF Global.

Corzine was anxious to duplicate his success at Goldman Sachs, and immediately began redirecting MF Global traders to step up their risk taking activity. He personally initiated and authorized substantial bets on government bonds issued by European countries under the most financial stress: Greece, Ireland, Spain, Portugal, Italy, etc. At Goldman Sachs, Corzine was used to holding on to losing positions for months, and sometimes over a year, until his expected outcome and profit materialized. Goldman Sachs had very deep pockets; MF Global did not. When the MF Global positions turned sour, Corzine discovered that MF Global had such a thin cushion of capital that it did not have the luxury of waiting months for the positions to right themselves. The market sensed the same thing, and began withholding credit from MF Global, credit being the lifeblood of any brokerage firm. The situation quickly became untenable, and MF Global was on the ropes, being shopped around to potential buyers.

By the end of October, it appeared a larger firm was willing to buy MF Global’s basic businesses, but over the last weekend of the month, this firm pulled out of negotiations, announcing to the world (and to clueless regulators), that MF Global had a serious hole in its cash accounts. The Federal Reserve quickly stepped in and discovered over $600 million of client monies were missing. MF Global was promptly shut down. Jon Corzine was forced to resign from the board and from all his executive positions at the firm on November 4, 2011. He immediately hired a criminal defense attorney for himself.

At this point, the first level of embarrassment was directed at the Federal Reserve. MF Global held the coveted status of Primary Dealer to the US government. The Federal Reserve and US Treasury grant such status only to those brokerage firms of impeccable financial reputation and health, because the Primary Dealers are required to bid on and support all US Treasury auctions. They are the interface between the US government and the global bond market. The Federal Reserve has the right to audit the Primary Dealers. How then, did the Fed miss something so basic as a half billion dollar hole in the cash accounts of a Primary Dealer?

Not only were these funds missing, there was good evidence that MF Global had committed an illegal act by commingling customer funds with its own funds, essentially using customer money for its private purposes. This is Brokerage Business 101; any executive of a brokerage firm knows they can go to jail for violating the trust customers have placed in the firm that their invested monies will be used only for investments as they so direct. No wonder Jon Corzine now has a criminal attorney representing him in the ongoing investigations as to where the money went. This has naturally led investors to wonder how safe the US Treasury market really is.

A second level of embarrassment is being shared by the large New York investment banks which helped MF Global go to the bond market for funds when Corzine took over the firm. So masterful was Corzine considered in the financial markets, that investors had to pay a premium to own these bonds, since it was almost a sure thing that Corzine was going to turn this firm around and create another financial powerhouse to rival Goldman Sachs. It didn’t work out that way; in fact the most recent bond issue had not even reached its first required interest payment before the firm went bankrupt. Already this weekend two US pension plans have sued Goldman Sachs, JP Morgan Chase, Citigroup, Bank of America and other underwriting banks for failure to do proper due diligence when marketing these bonds.

The third level of embarrassment is the most serious and involves the Chicago Mercantile Exchange, where MF Global kept over $1 billion in assets in support of their customer’s commodity trading. The CME is the primary regulator for its broker members like MF Global. This is a long-standing practice on the registered exchanges, whereby the exchange “self-regulates” rather than subject itself to regulation by a government agency. Commodity exchanges do answer to the Commodity Futures Trading Commission on policy matters regarding which products they can offer their members, but when it comes to knowing whether MF Global was keeping customer accounts segregated from its own funds, it was up to the CME.

The CME says it did audit MF Global but was deliberately misled by the firm. MF Global had $5.5 billion in customer accounts, but at the time of its bankruptcy on October 31, $663 million was “missing”, presumably used by the firm for its own purposes. CME further states that as of its most recent audit of the firm, all customer monies were accounted for, but immediately after the audit MF Global quietly maneuvered over $600 million out of the customer accounts without the CME being able to detect the deception.

What happened at this point, however, has outraged other members of the CME. The exchange, in dealing with the shortfall, froze all MF Global individual customer accounts at the exchange. Nor would it allow these customers to at least trade against their accounts in order to protect themselves from further market moves. These actions essentially violated the basic premise of dealing on a registered exchange. Because all accounts are collateralized against both existing and potential adverse market rate changes, the exchange provides a nearly fool-proof guaranty that a customer bankruptcy will not impact the other members or any individuals who trade through these other members. The only circumstance that would violate this promise is if market price movements moved so adversely as to overwhelm the amount of collateral that was posted by the member for potential adverse market rate changes. Theoretically, this could happen in an extreme but highly rare market event, and should it happen, the exchange rules require that it “pass the hat” among all its broker members to make up the collateral difference for the bankrupt member. Even in this extreme circumstance, individuals who deal on the exchange would not be affected.

The CME did not follow through on this rule. Admittedly the shortfall in the MF Global account was not due to an adverse market rate move, but rather to a fraud or deception on behalf of that member. Even so, all other broker members should have received a loss allocation to make up the difference. In fact, the CME had the necessary funds in its own reserve account; it could have made up the difference immediately, and passed the hat later in the day or the next day to replenish its reserve fund.

What happened instead is that the CME grabbed hold of individual investor monies to make up the shortfall – specifically, from those investors who were trading on the CME through MF Global – by seizing their collateral and freezing their positions. This is, as far as anyone can tell, an unprecedented move for a registered exchange when dealing with a broker bankruptcy. It trumpets loudly to individual investors, who are after all the mainstay of the financial markets, that their funds are not safe at the brokers with whom they deal, nor are they safe from the CME itself.

Over 150,000 individual accounts at MF Global have been frozen by the CME as of this past Monday. These individual investors are also asking another question: what happened to the insurance that the brokerage industry said was available to protect individuals from precisely this sort of loss? This insurance is provided by the Securities Investor Protection Corp., which acts like a private version of the FDIC, the federal agency which guarantees the safety of depositors’ accounts at commercial banks. The SIPC was designed to convince individuals it is safe to move their money out of banks, where government insurance protect them, and to brokerages, where private insurance will protect them instead. It now turns out the SIPC may not have enough resources to reimburse all the investors for the amounts insured.

There are major political ramifications for what has happened with MF Global and the CME. Since the 2008 credit crisis, it has been a matter of faith among regulators that what are called “over-the-counter markets”, run by banks and the subject of billions of dollars of losses in 2008 and 2009, should be reorganized into registered exchanges like the CME. The futures exchanges have been clamoring for this for a long time; a former head of the CFTC – Brooksley Born – made this very argument in front of the Congress in 1998 when the Glass-Steagall Act was being overturned. Given the unprecedented losses investors have now suffered as a result of the MF Global collapse, and given the very fundamental failure of the CME to operate in the way it promised, this argument now looks very hollow. Exactly what the regulators should do next, however, is not clear, especially since the exchange will argue that MF Global was a “one-off” event.

But was it really? Knowing how damaging to its franchise its actions would be, why did the CME go ahead and seize individual investor assets? There is much speculation about this, some of it centering on the problem the CME would have faced if it went ahead with its own rules and allocated the losses to its other broker members. Some members may not have been able to raise the money required in a loss allocation, leading to a systemic failure event. Another theory says the CME may have feared that “passing the hat” now might have worked, but at some potential later bankruptcy of another member, the exchange itself might have been jeopardized by following the rules this way. This suggests, however, that the CME is aware of some severe and non-public problems with major market participants, such as banks and other large brokers, and is willing to damage its reputation now to give itself maneuverability should these problems surface at a later time.

For now, the damage has been done. Investors can either choose to continue to deal in futures and options through a broker, knowing now the full extent of the risks involved, or they can exit these markets. One commodities broker has already shut their business down rather than submit their clients to such levels of risk. In a letter to her clients, which is now being spread rather widely around the internet, CEO Ann Barnhardt of her eponymous brokerage company has explained the reasons for shutting down her business. Her main argument is as follows:

The reason for my decision to pull the plug was excruciatingly simple: I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not. And this goes not just for my clients, but for every futures and options account in the United States. The entire system has been utterly destroyed by the MF Global collapse. Given this sad reality, I could not in good conscience take one more step as a commodity broker, soliciting trades that I knew were unsafe or holding funds that I knew to be in jeopardy.

The Rot Spreads to the Over-the-Counter Market

A somewhat similar situation has occurred in the over-the-counter market for Credit Default Swaps (CDS). These products are largely the province of the major global banks, with JP Morgan Chase, Goldman Sachs, Citigroup, and Bank of America issuing over half of all the CDS protection now outstanding in the market. The buyers of these products are other banks, pension plans, insurance companies, universities, endowment funds, mutual funds, and other large institutional players who are willing to pay a fee for protection against the default of one or more of the issuers of bonds they may own. Lately, that has meant that these institutional investors have been purchasing protection against default risk in Greek, Spanish, Portuguese, Italian, and other European debt. The amounts are stupendous; nearly a trillion dollars of such insurance has been issued, well beyond the amount of such debt outstanding in the market.

There was considerable euphoria in the markets over the most recent EU package designed to deal with the Greek debt problem. The EU promised to deliver another badly-needed cash infusion to the Greek government – badly needed just to make the next interest payment on their debt – in exchange for Greece imposing yet more domestic economic austerity on its people, and for the banks holding the debt agreeing to take a loss on the existing debt they own. This latter part is important, because it is the first time the EU has focused on debt relief for Greece, by forcing the banks to absorb some of the cost of dealing with the problem.

The banks, of course, have resisted this fiercely, first because it sets a dangerous precedent for dealing with other government debt, and second because the banks do not have the capital to absorb significant losses on their Greek debt holdings. To deal with this second problem, the EU did a survey of European banks to find out what the loss would be if the banks were forced to take a 50% haircut on Greek debt. They came up with a number somewhat larger than €100 billion. There was a lot of argument among analysts that this was too small, but the EU was prepared to pay this amount to the European banks to “ease their pain.”

Then another complication arose. Most of these banks had purchased protection against default for some portion of their Greek portfolio, through Credit Default Swaps. The main providers of this protection were the large US banks that dominate the CDS market. These banks did not want to pay out huge sums of money to the European banks in a Greek default; moreover, these banks control the industry arbiter on whether an event constitutes a default that would force a pay-out under a CDS contract. This industry body – the International Swap and Derivatives Association – ruled rather conveniently for the big US banks that the Greek default as proposed by the EU was “voluntary”, and as such a pay-out under the CDS product was not required.

The product that was sold to the European banks was not called the Credit Involuntary Default Swap. Any reasonable reading of the ISDA contract underlying the product would conclude that a 50% haircut on Greek debt constituted a default whether it was voluntary or not. Besides, most banks felt there was nothing involuntary about the regulators forcing banks to accept a huge loss on their Greek debt.

The consequence of all this has been that the CDS market has been thrown into complete turmoil. The product is not in fact operating the way investors assumed from years of previous practice and from the wording in the legal contracts for such swaps. The situation is rather similar to what has happened on the CME; in this case it is institutional investors, not individual investors, who are discovering that the protections they thought they had do not exist. The market makers – the sellers of the product – have unilaterally announced that they are keeping all those billions of dollars of fees they received when selling this protection, but they will not necessarily deliver what they promised when a default occurs.

Why the big players in the market would destroy such a lucrative business in so short-sighted a way is open to question. They may well fear going bankrupt themselves, not necessarily because they must pay out on a Greek default, but because they would have to pay out next on a much bigger Italian default. Alternatively, these banks may simply feel entitled to do whatever they want to do. After all, these banks were able for years to declare profits on their housing securities when housing prices were going up, which led naturally to very large bonuses for the banks involved. The minute the market turned sour, these banks very conveniently were allowed to suspend mark to market, and avoid taking losses.

Given the fact that the CDS product now appears to be deeply compromised, institutional investors are voting with their feet. They no longer have the hedges against default that they thought existed on their European debt, so their only option is to sell the debt itself. This is exactly what has been happening in the past few weeks, and this explains why there have been such steep increases in interest rates for the debt of Italy, France, and now Germany. You might call this the law of unintended consequence; certainly when the EU regulators commenced their latest rescue package for Greece, they never dreamed it would result in a noticeable sell-off for all European government debt.

Some Commonalities Now Are Evident

Any reasonably intelligent and informed protestor at the Occupy Wall Street demonstrations – and there are many – could have written the letter that Ann Barnhardt wrote. It doesn’t matter that the OWS crowds come predominantly from the left side of the political spectrum, and that Ann Barnhardt approaches her politics from the right. Rush Limbaugh has picked up on her letter and read parts of it on his program, but he just as easily could have been reading a manifesto from the people at Zuccotti Park.

People from all political slants are seeing a corrupt and broken financial system, operating with impunity, stealing money outright from individual and now institutional investors, with the Obama administration doing absolutely nothing to prosecute the malefactors or fix the infrastructure problems. Behind all of this they see the machinations of the big banks and financial interests.

Whether this is a correct interpretation of what is going on can be argued. One might also say that both the CME and the large US banks have acted according to their instinct for self preservation, and that to have done otherwise would have threatened their existence down the road by setting a dangerous precedent. This argument has some merit, because these institutions must have known of the damage to their brand and their product by taking the action they did, yet they went ahead at great cost to their long term revenue stream. This is in truth an even more dangerous and worrisome conclusion than the simpler suggestion that these companies are nothing but thieves. It is a lot easier to believe that some players in the market are operating in a criminal manner, than to believe that the system is suffering from some problems that could easily lead to a catastrophic economic collapse.

But consider this: all along, the banks have “threatened” a catastrophic economic collapse if they were not given yet another bailout from the taxpayers. What if they were being sincere in their fears? They must have some sense of the linkages among all the big financial players, and the systemic risk that binds them together in health or havoc. If they truly believe that the failure of one of their number will drag down all 25 of them, then it is not just a few individual investors who have given thought to the fact that Financial Armageddon is now closer than ever.



pension funds exposed to European/Greek Debt????

OMG. What a dire warning numerian and what specific ruling that CDSes on sovereign debt do not have to be paid in full? I'm missing something somewhere, although this circle jerk of sovereign debt, insuring against default, I can believe could come crashing down upon us.

We about screamed here during the so called "financial reform" for not looking at contagion and removing, making illegal, so many of these derivatives.

Everyone, you should read this article.

Forget Reform

Interesting article. I think we are now beyond any meaningful reform. The financial 'system' is corrupt and rotten to the core with no meaningful checks and balances -once markets don't clear confidence evaporates and market failure is inevitable.

It is a system established and evolved historically to siphon off value from the rest of us and does not add any value to the real world that the majority of us live in. It is indeed an 'enchanted' world of deceit and fraud at all levels that is moving to an end point of systemic failure.

The CDS product failure is getting more press now

The most recent article on this topic, and the role ISDA played in allowing the big banks to renege on the basic promise and purpose of the product, is one posted Friday on MarketWatch.


ISDA ruling

Ah, thanks, we wrote about the 50% CDS haircut on CDS, but I thought it was just for Greece and a special arrangement, vs. a ruling, generally. Still, which is more evil? Having triple the CDSes out there are bond sell offs?

SROs/CME Group and the worst entitlement mentality

Excellent AAA++ blog by Numerian! I have one clarification or question -- about CME Group as distinguished from the former CME or Merc. CME Group is the head of the Medusa monstrosity.


Rubens' head of Medusa (wikimedia commons)











Image (public domain) from Wikimedia Commons webpage, Peter Paul Rubens' Medusa

It's evident that the Medusa can only be slain by removing the head from the body. The body is the global financial system, and the head is CME Global. It's like a dragon -- sooner or later, it must be slain, and with this kind of dragon, there's only one way to do it.

From Wikipedia article 'CME Group' --

CME Group Inc. (NASDAQ: CME) owns and operates large derivatives and futures exchanges in Chicago and New York City, as well as online trading platforms. It also owns the Dow Jones stock and financial indexes. The exchange-traded derivative contracts include futures and options based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, rare and precious metals, weather and real estate.

The corporate world headquarters are in the Chicago Loop financial district The corporation was formed by the 2007 merger of the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). On March 17, 2008, it announced its acquisition of NYMEX Holdings, Inc., parent company of the New York Mercantile Exchange and Commodity Exchange, Inc (COMEX), which was formally completed on August 22, 2008. The four exchanges now operate as designated contract markets (DCM) of the CME Group.

On February 10, 2010, CME announced its purchase of 90% of Dow Jones Indexes including the Dow Jones Industrial Average.

CME Group owns 5% of BM&F Bovespa, the São Paulo stock exchange operator. BM&F Bovespa owns also 5% of CME Group.

The CME Group bases prices for US gasoline on Brent Crude (a European pricing index) rather than West Texas Intermediate Crude (a US-based gauge of supply and demand), which many believe is responsible for artificially high gas prices for US consumers. Neither the US government, nor the Comodities Futures Trade Commission have jurisdiction to alter this practice, and so it is believed to enrich oil and gas companies at consumers' considerable expense.

In short, CME Group represents an unsustainable exponentiation of the Enron phenomenon -- a nightmarish exponentiation of the myth of privatization as panacea for whatever ails the world.

In the MF Global scandal, CME Group has operated to provide an appearance of effective regulation, and the great sin of the CFTC is that they fell for the myth of self-regulation, which turns out to be nothing other than a con-artist scam. All this has been in pursuit of a pseudo-libertarian will-o-the-wisp that commerce and finance need no governmental regulation, a Randian fantasy-world where productive people (the middle class and the entire working class) can afford to ignore and even denigrate all democratic political process.

The simple truth is that CME Global is too big not to be subject to extreme anti-trust action, regardless of political price. CME Group is a clear signal of the failure of corporate globalism's monster-child, namely global finance capitalism created by the unimpeded flow of capital across all borders, rendering powerless all national and regional regulatory systems.

This is the fundamental problem of globalism at this time of global crisis -- the myth that self-regulation by profit-making institutions can ever take the place of governmental regulation. It's a nearly impossible project, because a system of global capital has evolved that essentially promotes corruption, thus holding individual integrity hostage to a system that rewards irresponsibility and even sociopathic behavior. Nevertheless, it's a project that must be undertaken.

Since the 2008 credit crisis, it has been a matter of faith among regulators that what are called 'over-the-counter markets', run by banks and the subject of billions of dollars of losses in 2008 and 2009, should be reorganized into registered exchanges like the CME. The futures exchanges have been clamoring for this for a long time; a former head of the CFTC – Brooksley Born – made this very argument in front of the Congress in 1998 when the Glass-Steagall Act was being overturned. Given the unprecedented losses investors have now suffered as a result of the MF Global collapse, and given the very fundamental failure of the CME to operate in the way it promised, this argument now looks very hollow. (Numerian)

To clarify, if I understand the situation correctly, Brooksley Born was advocating for exchanges regulated by governmental agencies such as the CFTC  -- not for the concept of exchanges regulated by huge and essentially monopolistic global SROs (self-regulating organizations) such as CME Group. That concept rather than Brooksley Born's arguments before Congress is what now look very hollow. This is pretty clear if we remember that her testimony before Congress was back in 1998.

The following is from article 'An Unmitigated Disaster' by Theodore Butler at SilverSeek.com, posted 11 November 2011.

Let me cut to the chase here and pinpoint the real problem – the CME Group. I know I have continuously criticized the CME, even calling it a criminal enterprise on many occasions, but in truth I may have understated the case. Yes, I would agree that the immediate cause of the MF Global bankruptcy was MF Global itself; but what turned it into a disaster of unprecedented proportions was the CME Group. The CME Group was the front line regulator for MFG, responsible for auditing and insuring the safety of customer funds and for guaranteeing those funds in a worst case scenario. The CME failed at every turn. Not only did its auditing fail miserably, the CME failed to step up to the plate to safeguard customer funds after it was discovered that $600 million was missing. ... I know that the federal commodity regulator, the CFTC, has been negligent in the case of MF Global as well, but that does not mitigate the CME’s failures.

Of the twin failures by the CME in the MF Global bankruptcy, clearly of more significance is its failure to stand up and guarantee that all MFG customers would be immediately made whole by the clearinghouse system run by the CME. The clearinghouse system, a consortium of financial firms whose collective finances stand behind every trade, has been the main backstop to all futures trading for many decades. It was widely understood by all market participants that if a clearing member failed, all the other clearing members and the exchange itself would step in to guarantee customer funds and prevent contract default. The CME boasts on its web site that anywhere from $8 billion to $100 billion in protection is available in the event of a clearing member failure. If it was telling the truth, it would seem $600 million should be no problem.

Instead, we all have a very big problem, thanks to the CME Group. ...  What the CME Group has done by not immediately guaranteeing all MF Global customers and positions is to undermine belief in the futures market clearing system. ...

Worst of all, even MF Global customers who held no open futures positions and only cash and unencumbered assets, like registered warehouse receipts for silver, gold and other commodities, have found those assets under the control of the bankruptcy trustee. If you do own warehouse receipts on silver or other commodities that are tied up in the MF Global bankruptcy, you must run, not walk, to a securities attorney to secure your legal rights to your property. ....

.... What needs to be done is that the CME Group must be stripped of any regulatory powers it has. As I have long contended, there is a clear conflict of interest in having a for-profit entity set its own rules and regulations, especially an entity that shows nothing but contempt for its own members at large and its customers. The CME Group spends all of its energies encouraging artificial trading schemes, like High Frequency Trading, designed to increase trading fee revenue and not on market integrity and customer protection. The CME Group has just demonstrated to the world its contempt with its failure to stand behind MF Global customers even though it promised to do so beforehand. Next time you watch the CME Group commercial that runs incessantly on financial TV that proclaims how farmers and airlines come to the exchange to hedge their price risks, please keep in mind that the CME just abandoned those farmers and airline customers who were MF Global clients.

One other small bonus that has emerged from this disaster is that the event has revealed as a lie all the nonsense that CME leaders have publicly proclaimed about the integrity of their markets. For the past few years, the smug and arrogant leaders of the CME have testified publicly before congress and the media about how the exchange’s clearinghouse system withstood and avoided the failures of the non-clearinghouse financial system as typified by AIG. CME officials trumpeted the advantages of it being a Self-Regulatory Organization (SRO), quite capable of handling regulatory matters without the need for further government regulation. Unfortunately, even high officials of the CFTC were apparently sucked in by the appearance of financial strength and integrity portrayed by the CME’s clearinghouse system of guarantees and the wisdom of letting it continue to regulate itself. That has now all been shown to be a lie. What good are guarantees if they are not honored when need be? What good is self-regulation if it leads to the wholesale abandonment of the customers’ financial interest?

There's a lot of talk these days about the terrible entitlement mentality of the American working class -- mainly that they think they are entitled to jobs or some minimal economic opportunity. Here's the thing: the ultimate entitlement mentality that is actually threatening the downfall of free-enterprise capitalism is the entitlement fantasy promoted by banksters, namely, that capital is entitled to accumulate upwards even when not invested in fundamental economic enterprises and although not subject to any risk whatsoever.

What investors should be entitled to -- although not as the result of some bogus law of invisible-hand economics -- is vigorous criminal prosecution of the perpetrators and profiteers who are systematically looting working people around the world. Not just 99% of the working people, but 100% of us! It's important to realize that investors and working people bear responsibility for the disaster. No one is entitled to regulatory control of destructive profiteering forces unless they are willing to exert the necessary due diligence, including unceasing attention to the fundamentals of democratic political process.

Quoting further from the SilverSeek.com article by Theodore Butler --

The disaster is that for the first time in modern financial history, the main guarantee of the clearinghouse system has completely failed its most important constituent – the customer base. The underlying promise to every participant in the futures market is that your money and open positions are safe from theft and default. This is the very glue that holds the future market together, namely, that all market participants can depend upon strict regulation and oversight to safeguard against fraud and theft. That’s what has made the US organized futures exchange system the envy of the world. Until now.

Numerian tells it like it is --

People from all political slants are seeing a corrupt and broken financial system, operating with impunity, stealing money outright from individual and now institutional investors, with the Obama administration doing absolutely nothing to prosecute the malefactors or fix the infrastructure problems. (Numerian)

It goes deeper than just the CME Group ownership structure

Once the Chicago Mercantile Exchange abandoned its brokerage-owned structure and went public, it introduced the pernicious influence of the profit motive to the functioning of a registered exchange, which should be looked at as a financial utility moreso than even a commercial bank. Moreover, in the 1990s, the profit motive as expressed as an expected annual ROE for a financial institution was at least 15%. When the CME went public it was instantly competing for shareholder/investor dollars in a market where Goldman Sachs was offering 30% returns on equity, albeit with greater risk and volatility in the earnings stream.

What's an exchange to do under such circumstances? Expand; shut down the competition; look for synergies and efficiencies of scale; seek out new markets abroad, and so on. The quarterly pressure to generate yet another 15% return on ever-higher amounts of equity produces distortions in the mission of the institution, and eventually in its ethics. Before privitization, when owners of the exchange got their profit out only on retirement by selling their seat, the prized committee to be on was the Risk Management Committee, which set the rules for sharing of losses in the event of a bankruptcy of a fellow member. Floor members had a vested interested in how losses were allocated, and were forced to do so fairly and quickly without damaging customers. After privitization, nobody cared about Risk Management or the rules very much, because traders on the floor were owners only in the very limited sense of being a shareholder in a massive public company. Any losses the exchange incurred would ultimately be born by the shareholders, so the "pass the hat" practice that is embedded in the rules could effectively be junked in a real crisis.

I think this is in part how the CME got to the stage where it doesn't care that it has harmed or even bankrupt thousands of small investors/customers. We've seen this phenomenon before. Goldman Sachs as a partnership forced every partner to pay attention to the firm's risk, because their wealth was tied up entirely in the firm and not obtainable until they retired. After Goldman Sachs went public, the problem of risk ultimately became someone else's concern - the amorphous "shareholders" who were now bankrolling the company anonymously. The employees of the firm could take excessive risks because they were no longer personally liable for the losses. Similarly, securitization gave Wall Street the excuse to peddle absolute trash in the mortgage backed securities market, because after 90 days the securities could not be returned to the broker. Credit risk on 30 year mortgages effectively got truncated to 90 days maximum. After that, no one cared what happened to the securities or the mortgages underlying them.

We could go on and on about the deleterious effects of the profit motive on institutions which serve some public good, like hospitals, health clinics owned by doctors, universities and colleges, and so on. Society needs to step back and take a very deep look at this philosophy that the profit motive always generates the best outcome for all parties concerned. That means we will have to reject Ayn Rand, Margaret Thatcher, Ronald Reagan and a few other apostles of free markets, which turn out to be mostly excuses for the exercise of rampant, unfettered greed.

I recall when Brooksley Born was making her pitch for oversight of the over-the-counter derivatives market, we viewed it in the banking industry as yet another power grab by the futures industry. It was also viewed as another political battle between the Chicago markets, which were futures dominated, and the New York markets, which were bank dominated. The futures industry had its pals in Congress, most of whom were on the Agriculture committees. The banking industry had its support in the Banking committees.

Brooksley Born has been made into some far-seeing hero who would have saved the nation had she won the day, while Alan Greenspan was a tool who could never see anything wrong with derivatives. The first assumption, at least, is wrong. The CFTC had no staff to oversee OTC derivatives, and no experience providing oversight, since the futures industry worked on self-regulation. Had the CFTC won the battle in Congress, the result could have been disaster. The CFTC could have done serious damage to that part of the OTC market which worked well then and is working well now: basic interest rate swaps and options, currency swaps and options, and some few related products in commodities.

What has happened since 2000, however, is that the banking industry has sought new profit opportunities (surprise, surprise) in products like Credit Default Swaps and mortgage-backed securities, since the older derivatives mentioned above (like interest rate swaps) have become commoditized, much safer to trade, but also barely profitable for a trader. The industry obviously went crazy with these new instruments and has almost literally brought down the global financial system. Alan Greenspan stood by when this was developing rather than provide more intense and effective oversight.

This is a rather different and more accurate history of what happened than the meme in the internet that Brooksley Born would have saved the world if she had gotten her way. It is certainly true that putting derivatives into a clearing house structure would have helped, but she wasn't even arguing for this. She was arguing for CFTC oversight whether derivatives were traded on an exchange or not. Moreover, the CFTC did nothing to stop the exchanges from going public and changing the whole paradigm of their business. We've now seen the terrible consequences of that decision.

Thanks for going into more detailed analysis

You've taken us a level deeper into the history, enlarging our understanding from an inside point-of-view.

IMO, we keep returning to one key theme: that the entire world of finance capitalism, including regulators and legislators, put the entire world of global economics at risk. 'We' (the public) must also accept some measure of responsibility for the mess, because we let pass the basically suspect meme that capital always accumulates upwards automatically without any need to be invested in any fundamental economic activity -- and with those who stand to gain not obliged to assume any risk. It goes back to the money-grows-automatically myth, with that growth guaranteed by unregulated capitalism backed by governmental guarantees. You might as well believe that money grows on trees.

Looking at that meme from the outside, it should never have been accepted. It was, from the start, the essence of an obviously dangerous delusional system.

Even without understanding how to distinguish between positive or useful derivatives and destructive derivatives, common sense should have caused sirens to go off in everyone's minds, and I believe that was the case for a few members of Congress -- but no where near enough of them to slow down the momentum toward disaster. In the sense that a sufficient cause of any disaster lies with the last party to have declined a clear opportunity to avoid it, Bill Clinton deserves the lion's share of the blame. Of course, the deeper underlying problem is corruption of campaign financing and the concentration of mass media -- that and dumbing down of the American public.

I think the basic destructive and obviously faulty meme has been well-epressed here by BruceJudson in recent blog 'Why Atlas Shrugged' --

"Heads I win, tails you lose."

I call it the Enron error.

Brooksley Born did ask some right questions

Maybe Brooksley Born didn't have the right answers, but at least she was asking questions that needed to be considered. I don't claim to understand the complexities of the derivatives issue, but I have been aware of the dangers for 15 years now ... and so should have every member of Congress and, certainly, President Clinton. I am referring to the bankruptcy of Orange County, California.

See, short PBS' Frontline story, Two Early Derivative Blow-Ups

The entire program can be viewed online from a link at the above-linked webpage. (I'm sure that Numerian is very familiar with this popularized version of events, and it's probably been incuded in a round-up by Robert Oak, but there may be readers who are not aware of it.)

Whatever her shorcomings, it does appear that Born was asking a much-avoided question: "What about transparency?"


Here's a link to part 2 of the three-part series by Lynn Hume at the Bond Buyer website, 'Orange County versus Enron' (2004) --

link to BondBuyer.com (article and series)


Here's a quote of Brooksley Born asking the basic question about transparency (and admitting incomplete knowledge) from the webpage that plays the Frontline video --

We didn't truly know the dangers of the market, because it was a dark market," says Brooksley Born, the head of an obscure federal regulatory agency -- the Commodity Futures Trading Commission [CFTC] -- who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country's key economic powerbrokers to take actions that could have helped avert the crisis. "They were totally opposed to it," Born says. "That puzzled me. What was it that was in this market that had to be hidden?"

Price discovery is a great advantage of clearing houses

No doubt Ms. Born was on the right track when she talked about transparency. While that can imply that all derivatives should go through clearing houses, it was not completely what she was pushing. She was, nonetheless, on the side of the angels in terms of the basic argument. In fact, though she lost the battle, she won the war. The banking industry went ahead in the 00s and began building a clearing house for basic swaps. This is one reason why there have been no problems in this sector of the derivatives market despite all the turmoil in the industry.

A few other things to note. Particularly when it comes to options, many derivatives are difficult to price. The basic Black-Scholes options formula has gone through many iterations, applied to all sorts of products and circumstances, and with each new application, the market has gotten further and further away from an options pricing formula that works or makes any sense. The assumptions that go into the formula for many products are almost absurd. This was decidedly the case with Credit Default Swaps and Options. Robert did a post on this about a year ago with some technical detail; it should still be in the archives. The point is, the industry abused the Black-Scholes formula by going out into products, circumstances, and risks that could never really be modeled according to bell curve assumptions, Brownian motion statistics, and so on. This is not only why so many of these products blew up, it is why the industry could never really channel these products into a clearing house. No clearing house worth its risk management reputation would accept such products. I think by 2000 this divergence in approach between the exchanges and the OTC market was becoming pronounced and noticeable. Ms. Born's effort was in that sense doomed from the start. Had she gotten her way, the stable products might have been made worse with incompetent CFTC oversight, and the newer and riskier products given a veneer of undeserved respectability if the CFTC had forced them into a clearing house. They would have blown up the clearing house itself eventually.

Secondly, having talked to many senators and representatives in Congress about derivatives in the 1990s, I never met any who had even an adequate understanding of derivatives. Rep. Leach of Iowa came closest, and he worked very hard to figure them out. Mostly everyone else in Congress ran away when the word derivatives came up in the discussion. With that background, the fight between the CFTC and the OTC market boiled down to trusting either Brooksley Born, or The Maestro, Alan Greenspan. It was no contest, considering how much in awe people held Greenspan. I suppose that is an unfortunate lesson on how politics works, but it suggests Ms. Born was 5 or 7 years before her time.

Problem with applying the Medusa allegory

There's a problem with my using the Medusa allegory as a prognostic -- if the head is removed, the entire body of the monstrous financial system of the current world-system, not just the writhing multi-snake head, would presumably have to die.

However, I doubt that such is the case. I don't believe that the Japanese Yen, the Swiss franc or the Australian dollar (maybe also the Canadian dollar or even the Sterling) would disappear in a day, in a week or in a year -- nor would the renminbi. IMO, it's likely that even the Euro will somehow survive.

Certainly it's becoming possible, not to say probable, that there will have to be freeze-ups of the banking system -- perhaps including non-functioning ATMs for some period of time.

It may become necessary to once again outlaw private ownership of gold bullion, as was done by FDR back in the 1930s. As goldbugs frequently remind us, it won't be pretty when likely cures for the systemic ills of the global financial system are implemented locally.

The problems are global, but the solutions must be undertaken locally, at any rate, on the national level. Nation-states must stand up to trump the authority of the corrupt global system, by force majeure if necessary (and it probably will be necessary). If not USA, then who?

Greaaaat article

WOW! "Who is that masked man?" Is it the Lone Ranger? No it's Numerian!

I've read volumes about the financial markets and just keep getting less informed. This is the first time I feel like I actually learned something.

Thank you

"Keep those cards and letters coming"


Thank you, Tom

There is many another lucid and informative article to be found on the Economic Populist, starting of course with the contributions of our editor, Robert Oak. You can also find some of my previous articles on the archives in my Workspace file.

CME comes up with money and hangs Corzine

Today (12/13) in the Senate Agriculture Comm. a Mr. Duffy of CME testified that CME had allocated 550 million dollars to the Global MF trustee to cover loses to "Farmers and Ranchers" only.
Also, he contradicted Corzine and said CME auditors have been told that, contrary to Corzine's testimony, that Corzine knew about the transfer of customer funds into company accounts.
Senator Roberts told Duffy "you just dropped a bomb."


that is a major bomb

I'll try to do an update post with some video. Question is, if they can verify this, will charges be brought? I doubt it! Bloggo gets 14 years but anyone connected with Wall Street at best gets a tisk, tisk. Thanks for letting us know.