The Striker Report

In 2009, McLean professor of business administration David Moss argued in Harvard Magazine for regulating financial institutions, in particular those "so big or so deeply interconnected with other financial actors that their failure could trigger cascading losses and even contagion across the financial system."

Moss made the case that federal guarantees for large institutions without concomitant regulatory reform would be a recipe for disaster. Certainly the financial crisis of 2007-2008 seemed to support this argument. But detractors of financial regulation often point out that such regulation already existed before the crisis, and failed to stop the contagion.

This is true, but largely misses the point. In the U.S., regulators were philosophically opposed to the detailed regulation of complex derivatives markets; many of these same regulators hailed from Wall Street themselves, and believed that too much government interference would chase markets away to friendlier locales. Had they been committed to consumer protection and willing to work with like minded counterparts in other countries, the cascade of leveraged debt might have been more easily mitigated or even prevented.

While the current controversy over MF Global's handling of client funds fails to meet Moss's standards for a systemic crisis, this is little consolation to the failed company's clients who no doubt wonder how such a large firm - the eighth largest bankruptcy in U.S. history - was allowed to go so long without someone checking under the hood.

Texas Republican congressman Randy Neugebauer also wants some answers, and recently pressed the Commodity Futures Trading Commission (CFTC) for an explanation. Of particular interest to lawmakers and investors is the question of segregated funds: did MF Global mix its clients' money with its own?

According to CFTC Enforcement Director David Meister, the regulator requires customer accounts to be "segregated every moment of every day", although this may not have been the case with MF Global. While the CFTC is responsible for enforcing commodity related laws, the day-to-day resolution of market disputes is often left to the National Futures Association (NFA), a voluntary industry group. Indeed, there are even more watchdogs on guard. The Chicago Mercantile Exchange had the primary responsibility for auditing MF Global's books. What's more, because MF Global did security business, the Securities Exchange Commission (SEC) had oversight, along with the Financial Industry Regulatory Authority (FINRA). With so many guards on duty, how could this happen?

The question remains an open one, and while the Chicago Mercantile Exchange is scrambling to defend itself from customers burned in the MF Global implosion, investors are not sitting on their hands, waiting for handouts - they are taking action on their own behalf. Investor advocate John Roe has formed a group, The Commodity Customer Coalition (CCC), to press regulators and congress on the issue.

At least there is some recent good news, according to CCC Attorney and Co-founder James Koutoulas who reports that "it appears that the [MF Global's SIPA liquidation] Trustee finally agrees with the CCC, the CME, the ICE and countless others who contend there is more than enough liquidity to get clients 75% of their funds immediately. We applaud this motion and support the Trustee's efforts to accelerate it through the court."

If true, this is welcome news for frustrated MF Global customers. Investors and other interested parties can follow the latest developments at the group's website http://commoditycustomercoalition.org.

Regulating financial markets is an immensely complex and thankless job. No regulator ever receives accolades for successfully auditing a reputable firm or for protecting clients from predators - they only get the blame when things go wrong.

While mistakes are inevitable in financial regulation, Striker believes that these represent aberrations, not the status quo. We feel that financial regulation is not only necessary, but essential to properly functioning markets. However, there are a number of steps that could be taken to improve the financial regulatory system.

To begin with, regulators can come up to speed in risk assessment. Global risk profiles are constantly changing, and regulators need to tighten metrics in assessing a firm's value at risk if the firm in question is large enough to represent a potentially damaging disruption to markets.

Next, regulator pay needs to become competitive with private sector equivalents. In the 1990s, the Chicago Federal Reserve reportedly attempted to hire financial regulators to look at the booming market in mortgage backed debt, but could not compete with Wall Street in terms of compensation. We know what happened next.

No human system is perfect, and trust is a vital part of doing business in the world. Still, investors must play an active role in sounding criticism or praise of developments in regulatory practices. Due diligence must extend to clearing firms and exchanges as policies evolve. Groups like the Commodity Customer Coalition are essential ingredients in helping clients perform due diligence, as well as providing valuable information about ongoing issues.

In the wake of the MF Global debacle, the NFA is rethinking some of its policies regarding the insuring of commodity accounts. According to Reuters, executives at the NFA and the CME are discussing the possibility of a government-sponsored insurance fund modeled after the Securities Investors Protection Corporation (SIPC), or an industry-sponsored bailout fund. While they are doing so, they would do well to remember David Moss's warning about offering safety nets without carefully enforcing regulation. The last thing taxpayers need at this point is to fund another bailout of a rogue financial company.

As Britain's financial services authority noted back in 2006, "any improvement in market outcomes for consumers and producers of financial services that result from regulation translate into direct benefits for the economy." The difficulty is getting regulators the tools and incentives they need to do the job well. While previous policy approaches have relied on a revolving door between regulators and regulated, a sounder approach would establish stronger firewalls between the two, and ensure that regulators receive adequate compensation for the task.