PFGBest debacle riles commodity futures industry
SAN FRANCISCO (MarketWatch) -- Commodity traders have seen their fair share of action this year from Iranian oil threats and a global economic slowdown, but now must also face growing concern over the integrity of futures trading in the wake of the latest regulatory investigation.
Questions over the safety and integrity of trading in commodity futures are "driving vast amounts of traders away from commodities forever," said Kevin Kerr, president of Kerr Trading International.
"The latest incident with the CEO of PFGBest boggles the mind, quite frankly," he said. "Investors should be confused and worried."
Peregrine Financial Group Inc.'s Chief Executive Officer Russell Wasendorf Sr. attempted suicide Monday. On Tuesday, the Commodity Futures Trading Commission filed a lawsuit against the firm, alleging it committed fraud by misappropriating customer funds. Later that day, the firm, also known as PFGBest, filed for bankruptcy in Chicago. Read more on PFG.
PFGBest couldn't be immediately reached for comment.
"There are enough reasons for investors to choose not to participate in [the commodities futures trading] environment with the awful fundamental news that we hear about every single day," said Steve Ayer, managing director and partner at HighTower in Harrison, N.Y. "So these potential frauds have the capability to push that already established cautious sentiment over the hump."
"Our entire system is built upon confidence, so when people lose that confidence in the regulators, brokerage firms and/or governments, then people can say enough is enough and pull their investments," he said. "Unfortunately, all across the globe this is happening, and PFG is just the latest example."
The CFTC complaint against PFG follows a similar situation with New York-based MF Global Holdings Ltd., which filed for bankruptcy last year after disclosing exposure to derivatives and other investments related to billions of dollars in European sovereign debt and leading to $1.6 billion in missing customer funds. Read about MF Global.
"The lessons learned from Refco, MF Global and [Ponzi scheme operator Bernard] Madoff seemed to have had little impact with regulators," Kerr said. Futures broker Refco collapsed in 2005.
The CFTC, National Futures Association, Chicago Mercantile Exchange and Securities and Exchange Commission have "helped to erode investor confidence rapidly," he said, along with the Madoff debacle, Refco, MF Global disaster and now PFG.
Alarm, hurt and mistrust
Indeed, the PFG scandal has already added to growing mistrust in the industry.
"To say that the collapse of PFGBest may lead to uncertainty is quite an understatement," said Andrew Schrage, co-owner of Money Crashers Personal Finance.
"As I follow the scandal, I hear alarming phrases such as 'reeling industry,' 'shattered confidence,' and that PFGBest, in tune with MF Global, had 'violated sacrosanct client funds,'" he said. "What's even more shocking is that the corruption in this case had allegedly been going on for several years."
Considering that it apparently took regulators so long to uncover the alleged fraud, "it's likely that you'll see significant suspicion going forward from investors," he said.
Following MF Global's collapse, the
The steps included the launch of the CME Group Family Farmer and Rancher Protection Fund to protect family farmers, family ranchers and their cooperatives against losses in the event of shortfalls in segregated funds, Terrence Duffy, executive chairman of the CME, said in testimony to Congress in April. Read about CME's moves to limit MF Global fallout.
"Following PFG, the farmer fund will be available to family farmers and ranchers who qualify," a CME spokesman said on Thursday.
But efforts by the industry to promote a boost to confidence in the trading market haven't had a lasting effect, and fraud investigations in the industry have already hurt traders several times over.
"Investors and farmers and end users have been hurt, and in some cases, those traders holding accounts at Refco were liquidated and transferred to MF Global," Kerr said. "Ironically, then those same people got their accounts moved to PFGBest when MF Global dissolved."
"The integrity of the industry is certainly at a crossroads with two large [Futures Commission Merchants] going under within nine months," said Dale F. Doelling, chief market technician at Trends In Commodities.
"These cases of fraud are going to impact trading and the futures industry because the retail customer is going to simply stop trading futures altogether," he said. "Fool me once (MF Global), shame on you; fool me twice (PFGBest), shame on me!"
Jeffrey Kennedy, chief commodities analyst at Elliott Wave International, said he sees "decreased participation in commodity futures trading because of a lack of trust and confidence in the system."
A fall in investor interest may have already been the case after the MF Global collapse, with data showing that market activity declined.
A CFTC report of open interest for the period of November 2011, during the MF global scandal, shows that there was a "striking drop in the amount of open interest -- and that this drop is concentrated in the physical commodities, particularly the agricultural and soft commodities," said Robert Ready, finance professor at the University of Rochester's Simon School of Business, whose research covers energy markets.
The CFTC report showed that open interest in November for wheat futures fell nearly 14%, cocoa's fell more than 19% and oil's fell more than 6%.
"There was a direct effect from people having to close out positions (or being unable to open new ones) due to the MF Global collapse," said Ready. That scandal was "an order of magnitude large than Peregrine, and the fallout may have physically prevented those affected from trading in their usual manner."
The data are not out yet in terms of the effect of PFG, "but it will be interesting to see these reports at the end of the month," he said. "The direct effect will be much smaller since the Peregrine fraud is tiny compared to the MF Global one, so it's unlikely you'll see the same big drop as a large fraction of investors are forced out of the market."
"The biggest question is whether people now think that this is a systematic problem, and therefore it will cause a longer-lasting drop in market participation," he said.
And that view will largely depend on what actions are taken to safe guard traders from another debacle.
PFG's Wasendorf Sr. was on the National Futures Association's Futures Commission Merchant Advisory Committee, with a term set to expire in February 2015, according to John Person, president of NationalFutures.com. The NFA is the futures industry's self-regulatory body.
"I see a major conflict of interest," Person said. "Because Russ was on the committee that set the rules, he knew how to get around them."
Person sent a screen shot of a list of FCM committee members, which has since been updated to exclude Wasendorf.
"Regulation for the commodities markets has always been a joke, a pretense to assure investors that the ... gamblers who populate the futures's exchanges are upstanding citizens," said Steven Evanson, chief executive officer at Evanson Asset Management, who traded futures around two decades ago.
The mistrust in the futures markets that's sure to follow PFG's debacle will also raise questions on how traders can avoid being the victim of such a mess.
"Investors must be extremely cautious when investing in the commodities market in light of some of the potential high levels of fraud," said Jeffrey Sica, president and chief investment officer of Sica Wealth Management.
"I would do a thorough due diligence on choosing a quality regulated firm to deal with," he said. And "to those who don't want to deal directly with commodity firms, you can participate in the prices of commodities through exchange-traded funds."
For now, while there are several precautionary measures commodity futures traders can take, though none are completely effective.
In terms of ensuring that "misappropriation of funds doesn't occur, it seems that the best bet is to make sure your broker is offering satisfactory proof that these accounts are indeed being managed correctly," said Ready of the University of Rochester.
Steve Gillette, president of Cirrus Commodities Exchange, said he's ceased trading and now he is only engaged in sales of bullion products for physical delivery.
"I no longer view the commodities market, specifically the precious metals market, as trustworthy," he said. "There is virtually no way to guard against fraud because those who would sink so low as to perpetrate fraud have lost their virtue."
Trends In Commodities' Doelling, who was a client of PFG's, said he currently has just one active trading account in the wake of the PFG fiasco, and "won't be opening any other accounts with any other brokers until the industry tightens up its compliance and oversight."
To be sure, "a collaboration between futures industry leaders, heads of the exchanges and even the retail customers is necessary to protect the consumer and the industry in general," he said.
But "if a guy like Russ Wasendorf can just raid the till without so much as someone batting an eye, then the industry is doomed," he said.