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Opalesque Futures Intelligence

NFA Election Features Well Known Industry Participants

Thursday, December 13, 2012

George Crapple and John Roe provide insight into the upcoming NFA election issues. The first of a two part series.

The National Futures Association (NFA), the independent regulatory organization policing certain segments of the derivatives industry, is having election from mid-December until January, 2012. NFA elections are seldom contested. Last year, Ernest Jaffarian of Efficient Capital and Douglas Bry successfully challenged recommended candidates. This year the two Commodity Customer Coalition cofounders entered the fray. James Koutoulas, principal at Typhon Capital Management, and John Roe, Principal at BTR trading, petitioned to be on the ballot against George Crapple of the Millburn Ridgefield Corporation and Thomas Lloyd of Campbell & Company. In the first of a two part series, profiled in this issue are two candidates, George Crapple and John Roe.

George Crapple, co-Chairman of Millburn Ridgefield Corporation

Mark Melin (MM): Talk about your business background. Use this as an opportunity to paint a picture of how you would serve on the NFA board.

George Crapple (GC): The last election brought back Doug Bry, who had been on the NFA Board before, and Ernest Jaffarian, of Efficient Capital. Those are good Board members. (Bry and Jaffarian are known for their activist stance on MF Global). I'm sure that our CTA/CPO area will be well represented regardless of the election's outcome.

In terms of my background, I started off in 1969 as a lawyer with Sidley Austin in Chicago. And in the early 1970s, I started doing futures work as a lawyer. We had several clients that were in the futures brokerage business and we were very early in doing some of the futures funds, and that's how I met Malcolm Wiener, the founder of Millburn Ridgefield Corporation (a trend following CTA), and we were working together from 1976 on. Malcolm often said, why do you want to be a lawyer in Chicago? Come to New York and be a commodity speculator. This gave me some pause initially, but in 1983 I saw the light and joined Millburn full-time in Connecticut and New York.

Prior to that time, while I was still in the law business, we put together some of the early major publicly offered managed futures pools using, I think possibly for the first time, some of the major investment banks as underwriters.

I have been with Millburn Ridgefield since 1983. Malcolm retired around 1987, and Harvey Beker and I have been Co-Chairmen of Millburn pretty much since that time; Co-Chairman and Co-CEOs.

I have, as I guess you are aware, done a number of things in the industry over the years. I was Chairman of the Managed Funds Association, having been on the Board for a few years. I am not clear on exactly my dates, but it was around 1998-1999, because I specifically recall testifying for the House Banking Committee on the Hedge Fund Disclosure Act that had been then introduced in the House by Richard Baker, now the President of the Managed Funds Association. It's a small world. That was after the blowup of Long-Term Capital after the Russian default and devaluation in 1998.

MM: Amazing to be at that moment in history.

GC: Yes, isn't it? I have been on several CFTC Advisory Committees over the years, the Technology Advisory Committee, currently the Global Markets Advisory Committee. I have been on that for a number of years. I am in my second fairly lengthy stint on Board of the Futures Industry Association (FIA), which I think most people know is by and large the Trade Association of the FCMs, and I have been a representative of the customers on the FIA Board.

With respect to the NFA, I have been on the board since 1996, the Executive Committee since 1998, the Appeals Committee since 1996, as Chairman in 2000 and on the Business Conduct Committee from 1984 - 1994. The Appeals Committee of the NFA hears appeals from decisions of the Business Hearing Committee, either brought by the NFA if they don't like the outcome of a hearing, or more often by the parties in the industry who have been in effect prosecuted by the NFA for one sort of infraction or another.

MM: Well, why don't we transition to the next question? What do you view as the significant industry issues today and how is this relevant to your election to the NFA Board?

GC: I think the most prominent issue facing the industry and the NFA today is looking at the failures of MF Global and Peregrine, and doing what is humanly possible to see that those types of events don't occur in the future. There are many issues facing the industry, but I think many of us in the industry are quite surprised that those two failures could have occurred, without pointing the finger anywhere in particular, it was time for industry, a self-regulatory organization introspection to determine what can be done to make sure that sort of thing doesn't happen in the future.

I don't know to what extent that people in the industry are now aware of it, but really quite a bit has been done. The most obvious failure was the real-time monitoring of customer segregated funds did not exist at that time. And the NFA and the CME, which are basically the auditors for a lot of the FCMs, the CME in fact for the bigger ones than the NFA, have engaged, and I am sure you know about this, AlphaMetrix 360, which is a program designed to in effect real-time get from the entities holding segregated funds the balances and to be able to monitor movements in and out of segregated funds.

When you look at Peregrine, there was a very longstanding fraud going on from I think almost the onset of when Peregrine became an FCM. So obviously the third-party monitoring on a real-time computerized basis didn't exist at all. And in the case of MF Global, in this flurry of transactions, to me you can't have a situation where a $1.6 billion disappears without any individual responsibility.

"...to me you can't have a situation where a $1.6 billion disappears without any individual responsibility."

So looking at those issues which left the customers holding the bag in both cases. I think the AlphaMetrix 360 program which will track all of the depositories will be a huge step in the right direction. And while it would be nice to think that, that kind of improvement in the regulatory scheme would have occurred anyway, I am not sure it would have if it hadn't been for these two dramatic and really unfortunate events. I think that will go a long way toward giving assurance to the customer base in the futures industry that the segregated funds are being carefully monitored and are safe.

"There has also been a misperception in the futures industry, and perhaps it's partly the fault of the futures industry itself. This has given people the impression that segregated funds are not subject to any vulnerabilities at all."

There has also been a misperception in the futures industry, and perhaps it's partly the fault of the futures industry itself. This has given people the impression that segregated funds are not subject to any vulnerabilities at all. Of course there are situations where a brokerage firm could fail, where segregated funds are not completely safe regardless of any type of reform.

But certainly we didn't expect in the industry the kind of movement of segregated funds that happened in both MF Global and in a different set of circumstances in Peregrine, we didn't think that was one of the vulnerabilities.

Of course the NFA has taken this very seriously and commissioned a major report looking into the circumstances around the Peregrine situation, and that report has not been delivered yet.

MM: Do you want to move into the positions you advocate and what your goals for the NFA?

GC: The situation with segregated funds and the protection of segregated funds is what I would consider probably the most important element. But one of the things that I think the NFA has done well over the years, and it's very important to continue it, is to try to weed out of the industry the types of firms that take advantage of the customers through shady sales practices, or not complying with capital rules, or not being truthful to the NFA with audits, and there have been many, many cases like that brought over the years. I see a lot of them personally because of the Appeals Committee work I have done over the years, and I think that the NFA has been quite efficient in this area.

Now, one of the points that I think is quite important, and Doug Bry has emphasized this point also. I think they have excellent people at the NFA, but there could be and should be further sensitivity to the types of red flags for fraudulent behavior that in hindsight were there in the Peregrine situation. And the NFA has embarked upon a program to further educate its auditors on red flags or fraud.

In that same vein, another initiative the NFA has been pursuing, which I think is very important, especially after looking at the Peregrine and Madoff cases, was greater scrutiny has to be given to the types of firms who are performing audits on FCMs. Certainly in the Madoff case, which was not a futures case, but is an illustration of a single person auditing firm. The Peregrine case featured a very questionable auditing firm, and the NFA is in the process of tightening up the types of firms who are qualified to give required audits for FCMs.

So I think it's in everyone's interest in the industry, particularly the CTAs and CPOs who are represented specifically by the four NFA Board members who are elected by the CPOs and CTAs that the integrity of the futures industry from the capital and segregated funds point to the sales practices and the capital requirement, compliance, is vigorously pursued by the NFA.

MM: Should the NFA be an active or passive organization?

GC: There is no doubt in my mind that in a sophisticated and rapidly evolving business, like the futures business, which now also is to include the swaps business, that activism is absolutely necessary.

Activism is from a point of view of making certain to the extent possible that any regulatory structure meets the industry as it evolves, but it doesn't mean that every proposal to be active would necessarily be appropriate -- that the NFA would necessarily be the appropriate venue for it.

A proposal made after MF Global was that the NFA lead a collection campaign to see if money could be raised to make the customers whole, and that really was considered to be outside the responsibilities of the NFA, as basically authorized by the CFTC. But the NFA has I think stepped up as new challenges have arisen.

For example, the retail foreign exchange business has really grown tremendously over the last five or six years and the NFA has put in place a regulatory structure and evolved it many times since it was first put in place, including raising the capital requirements and looking into the appropriate representation of that segment of the industry and the governance of the NFA.

And a big challenge from that point of view now is all the responsibilities under the new swaps regime, where there will be many new registrants with the NFA from the swaps part of the business world. Plus, a number of the CPO exemptions have been removed and there will be a lot more CPOs registering.

So the NFA is in the process of undergoing a substantial expansion in responsibilities and personnel, and it's going to be a very important challenge to see that the swaps area is properly regulated and audited.

And again, part of the industry which is being regulated is represented also in the governance of the NFA, because that's basically been I think one of the great strengths of the NFA that the participants in the industry have served on the Board with a large contingent of non-industry public directors.

So I believe that going forward the NFA should continue to be extremely diligent in looking into the ways it can improve its execution of its regulatory mandate, and basically, as in any area, learn from experience.

"...the NFA really has excellent people, and is making a very strong effort to discharge properly its role in regulating the futures and now swaps and retail foreign exchange industries. I don't think there is anything more important to the group of four Directors of the NFA who are elected by the CPO/CTA community than to keep the FCMs under good scrutiny to protect the customer segregated funds and to continue the effort to in effect drive out any bad performers."

I said earlier the NFA really has excellent people, and is making a very strong effort to discharge properly its role in regulating the futures and now swaps and retail foreign exchange industries. I don't think there is anything more important to the group of four Directors of the NFA who are elected by the CPO/CTA community than to keep the FCMs under good scrutiny to protect the customer segregated funds and to continue the effort to in effect drive out any bad performers who are engaging in bad sales practices and giving the industry a black eye.

You think back -- well, my history in the futures industry goes way back and there were many, many examples of basically fraudulent schemes going on.

MM: Exactly. NFA cleaned up what was at one point the Wild West.

GC: And this is an area that the NFA has been very effective in, through the auditing process and auditing sales practices and cleaning up the industry. I mean, there will always be a new scamster who pops up, but this is an area where, for example, looking at customer complaints, they are way, way, way down over the years.

So although one would certainly wish that MF Global, which was primarily an auditing project of the CME, and Peregrine, which was an auditing object of the NFA, had never happened, we have to use hindsight to learn the lessons that a crisis will teach. And I think the NFA does has definitely risen to the occasion and the protection of segregated funds are going to be vastly improved with the measures that have been undertaken and that are being implemented currently.

John Roe, Co-Founder of the Commodity Customer Collation and principal of BTR Trading

Mark Melin (MM): First, address your business background relative to your election of the NFA Board, what's relevant about your past experience?

John Roe (JR): Let me give you a little of my background. I have been in the industry now, in one way or another, since 2003. I am currently a principal of BTR Trading Group, an IIB (Independent Introducing Brokerage) firm. We execute algorithmic systems and we do managed futures execution for private clients and institutions.

I have a commodity trading advisory firm, Roe Capital Management, which has a couple of programs that we trade for private clients. Prior to founding these two companies, our IB was a division of MF Global. BTR is now a GIB (Guaranteed Introducing Broker) of Rosenthal Collins, and we are in the process of transiting to an IIB.

Prior to that I worked with my partners at Refco, that's how we ended up in MF Global, and prior to that I was a Globex broker on the floor of the Eurodollar pit at the CME.

Most of my work has been in the private client space. I have spent most of my career working either as a CTA or with CTAs, so I know that market segment very well and so I think I can represent them well.

I have also had experience with the institutional side of business, coming from the floor. So I think I have got a pretty well-rounded background in terms of my ability to represent the interests of CTAs.

I am also the co-founder of the Commodity Customer Coalition. When MF Global went down, we got together with just a very few people and decided that we weren't going to stand by while the MF Global disaster unfolded, and as a result I think we have positively impacted that process and I think we have actually developed a new organization which can act as the activist organization to which you alluded in the final question.

We are very proud of the work that we have done, we are very proud of what we are -- other work that is ongoing. We are really focusing on shaping industry's response to PFG and MFG. I think this time next year we will be see the futures industry doing business in a very different way.

MM: What are the significant industry issues you see and how is this relevant to the election?

JR: Well, the chief issue facing the industry clearly is customer confidence and that goes directly to the customer protections that are afforded to commodity customers. We have to look at ways the NFA can impact that.

The NFA has taken some positive steps. Obviously the decision to utilize Confirmation.com and look at various balances and have a direct electronic access to bank accounts shook out PFG. It was an embarrassment that the PFG fraud went on for 20 years, but nonetheless, electronic access to FCM bank accounts makes that kind of fraud more difficult and obviously that's a positive development.

There have been a few other positive changes but the NFA needs to do quite a bit more. NFA has a unique opportunity to change the way the futures industry does business for the better and they ought to take that opportunity.

"...Look at the heart of the problem... ban Jon Corzine for life..."

The first thing that the NFA needs to look right at the heart of the problem, that is to ban Jon Corzine from doing business as an NFA associate member for life. It's completely within the NFA's purview to do that. They have the ability to bring an action on their own ,quickly and easily. There are a number of violations of NFA Rules which Mr. Corzine committed that support the case for a lifetime ban.

"Since it appears that we are going to have a difficult time getting a criminal case against Jon Corzine prosecuted, we want to make sure that one of the consequences for violating the sanctity of segregated funds is that you don't get to touch customer money again."

To begin, Mr. Crozine is responsible for record keeping violations, supervision violations, and violation of ethics rules. All the NFA has to do is get the business conduct committee to consider the case and to issue a decision. Since it appears that we are going to have a difficult time getting a criminal case against Jon Corzine prosecuted, we want to make sure that one of the consequences for violating the sanctity of segregated funds is that you don't get to touch customer money again. It's one thing for the NFA not to bring a case against Russ Wassendorf. Russ will find it difficult to manage customer money from a federal prison cell. Corzine on the other hand has been cited in two of the most respected national newspapers in the country, 'The New York Times' and 'Wall Street Journal', as wanting to manage money again. If he does so as a hedge fund manager, it could be under the rubric of an NFA registrant. No matter what you think of Mr. Corzine's criminal culpability, he certainly doesn't need to be anywhere n ear customer money again and the NFA can make sure that never happens. Very easily it's one of the first things that they can do. I think it will help show that there is a price to pay for violating the sanctity of customer funds. If there is no criminal case pursued against MF Global, then there definitely needs to be a consequence for such a serious breach of the segregation system and that consequence is you are out of the business forever.

"If there is no criminal case pursued against MF Global, then there definitely needs to be a consequence for such a serious breach of the segregation system and that consequence is you are out of the business forever."

Beyond that I think that we have to, and I know the NFA is currently conducting a review of its procedures, but I think that the NFA has to look at its audit culture. If you talk to any CTA they will tell you a horror story about something that happened in an NFA audit that was just an absolutely arbitrary, capricious, and ridiculous. I can remember like during mine, which concluded last October, I literally got into a debate with one of the auditors over whether or not the past performance disclaimer on my website needed to be in all capital letters or not. We went back and forth on it, we spent time citing what we felt were relevant rules and I asked them to point out where in the rules that was stated. After they couldn't find that regulation they wanted me to change it anyway. Meanwhile -- while that conversation was going on-- Russ Wassendorf was stealing money from PFG customers. So the focus is clearly on the wrong thing.

If I have four kids from the NFA sitting in my office, a one-man shop, arguing over whether to have capital letters or not on a disclaimer when that disclaimer is repeated ad nauseam in the 30 page disclosure document all of my clients must read, which cites every conceivable risk, how can the NFA have the time and resources to devote any serious audit effort to the guys holding customer money? There are thousands of CTA registrants, but only 70 or so FCMs holding customer funds.

We really have to look at the NFA's audit procedures and think about what's really important. The NFA spends a lot of these audits focused on sales practice fraud and that's certainly a noble thing and we want to make sure there aren't people out there who are engaging in the business of purpose of defrauding the customers by soliciting accounts and through false and misleading sales practices. But obviously the segregation model itself, it has to be rock solid before we can worry about whether or not someone is using misleading sales practices or high pressure sales practices. If the FCM is stealing customer funds, the sales practices used to solicit those funds by a broker or CTA are irrelevant. To some degree, customers are responsible for doing their own due diligence. Caveat emptor.

"Far and away the most important thing for customers is that they can be assured that their funds held by their broker are safe."

Far and away the most important thing for customers is that they can be assured that their funds held by their broker are safe. So I think the NFA has to take a good long hard look, top to bottom, at what it's really auditing and change a lot of the subjective criteria. I think that there is too much subjectivity in these audits and NFA is too focused on things that don't really matter. We have to focus less on a checklist. ON a lot of these audits, the auditors come in and as long as you give them everything on their check list, they're fine--it doesn't matter whether or not you created them using Photoshop, you gave them what they were looking for.

They need to focus less on ticking off the checklist of items that they need and more on making sure that the audit is well-served, and that the purpose of the audit is completed.

The NFA also has to be careful that it does not create a culture where it severely punishes honest mistakes. Whenever there is a crackdown on a given industry by regulators, there is a tendency to severely punish everyone who violates the rules, regardless of the severity or the intention behind the action. The NFA has to be mindful that some firms are trying their best to comply, but mistakes do happen. Humans make mistakes.

The NFA needs to look at the IB/GIB model. Now, this is a little bit outside the purview of the CTA rep on the NFA board, but there are a lot of CTAs that have dual registration as an IB, as I do.

The NFA right now is putting Guaranteed Introducing Broker at a tremendous disadvantage to Independent Introducing Brokers. Obviously in the post MF Global world, it's much more difficult to operate as a GIB, and I think we need to really examine if the GIB model is something that doesn't need to just completely go away, and if we could just lessen the restrictions on an IIB, or create a new type of GIB model which provides for multiple clearing relationships.

A lot of the GIBs who are small, only have a few accounts, they really can't operate as cost effectively as an independent, they are forced to be GIBs, but of course their customers want multiple clearing agreements and their customers are going away from them. So we have a whole segment of the market that's going to lose business as the result of this regulatory distinction that is forced upon the IB industry.

So I don't know what the solution is there, but the NFA needs to study that and need to think, are we serving the market well with the IB/GIB model?

I think that the NFA also needs to examine its arbitration process. When we first started looking at how we can restitution for MF Global customers, one of the first things we thought about as the CCC was let's go after Corzine in an NFA arbitration.

And we have plenty of NFA members and customers harmed here, they have got rock solid evidence that they were harmed, they have got their customer statements and they have got what -- they have got a distribution from the trustee, and those two things don't match up. And they can absolutely prove that money wasn't there when it was supposed to be.

That process will take about a year to get through the completion. If you are talking about a SIPA liquidation, it a minimum of two to three years to go all the way through it.

If you are talking about recovery from a class action lawsuit, it could be as long as six to seven years. The average NFA arbitration process takes a year. So that arbitration process can get people their money much more quickly than through the normal channels available to customers, either through a bankruptcy process or through a class action lawsuit. The problem is the cost to initiate an arbitration is ridiculous and unnecessary.

Without the attorney's fees, the cost per client that NFA charges for the hearing and all the expenses, is about $5,000. Well, if you are doing a 100 arbitrations, that's $500,000 in expenses. Even though as a single arbitration that's not any more expensive to do than a one client arbitration. You would be just working from one panel, you just have 100 customers who are sharing in legal expenses.

The NFA seems to be almost operating as a profit center or as a deterrent to filing multiple arbitrations or a class action arbitration. We have to look at that process and we need to streamline and open it up to classes of customers who have been harmed by FCM defaults.

We have tried to work this out in such a way that it would make sense cost effectively to do that, and we just couldn't, and it's because the NFA rose and the NFA can change those rules. If we tweak the rules to allow customers and registrants to file class action or group arbitrations when an FCM goes down, we could greatly increase the speed at which customers get restitution.

I think that's a good start for the first year.

MM: Are there any other positions you are going to advocate?

JR: In terms of other positions, those are the most important that come to mind. We have some things we are working on which we may tie in with the NFA, with respect to insurance or customer protection fund and with respect to an alternative form of segregation, but those are going to be changes which are coming to the NFA from other organizations; through CFTC or from the industry itself.

While there are other changes to law and regulation for which we need to be pushing, and we will certainly push the NFA in a direction to be for commodity customer account insurance, and to allow alternative forms of asset segregation, where we are involving custody banks instead of FCMs as the holder of record of assets that are margining positions in contract markets. But the NFA itself I don't think will have -- that will be necessary for them to do anything.

MM: Should the NFA be an activist or passive organization?

In terms of whether or not NFA should be an activist organization, I would say a little bit, yes. I think the NFA certainly considers itself an organization which is designed to protect customers. And I don't think you can really look at, the way they reacted either to MF Global or PFG and say that they were doing that filling that role. I mean, we wouldn't have formed the CCC if we thought they were. And I think since it's a membership organization, its Board of Directors are composed of members and representative of each different classification of membership, that the NFA could very easily be the organization that is out there pushing for those reforms.

Now, obviously as a regulator it needs to be careful about what it advocates. It can't necessarily take on a position that is adversarial to its own membership. It represents a very wide swath of the industry, many of whom have competing interests. You may have an investment bank that has the same registrations as a one-man firm. So that's a pretty big tent in which to have an activist organization.

It may not be possible. I think they do have to be careful who it's serving and what it's advocating. I think perhaps it's not the best organization to advocate for some types of reforms. It's hard for the police to police their own and then to advocate for a position on an activist basis, because if you have a role as a cop, you have an obligation to be impartial and dispassionate. And that's very tough to do.

Well, I think they could be a much more forceful advocate for customer; that doesn't mean I don't think they can't advocate for customers, because they absolutely can, and they do. I mean, if you look at the work that they do in terms of NFA actions, regulatory actions, they are definitely punitive on the little guy, to try to dissuade fraud.

Dan Roth has stated that the best way to deter fraud is through active prosecution of fraud, and the NFA certainly has taken that role, but they need to expand that role to include policing segregated assets and those who violate those rules. They need to not just look at the little guy who is running a shop and saying, we are going to make sure that -- we are going to really make sure you comply, but we are going to completely ignore whether or not your guarantor is compliant.

So I think that the activist question will fall on the Board, they have to be careful, they have got walk a very fine line, and try to represent the entire industry.

The next issue will feature interviews with NFA candidates James Koutoulas and John Vassallo. Mr. Koutoulas is co-founder of the Commodity Customer Collation, an attorney and fund manager running in the CTA/CPO category. Mr. Vassallo is president of Coquest Structured Products and is a current NFA board member in the IB category.



 
This article was published in Opalesque Futures Intelligence.
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