Commodity Futures Trading Commission Commissioner Jill Sommers (Image credit: Getty Images via... [+]
The Commodity Futures Trading Commission (CFTC) is exploring ways to better protect investors. One proposal on the table is to provide $250,000 per account insurance coverage. That would be similar to what federally insured bank customers receive from the Federal Deposit Insurance Corporation (FDIC).
While this proposal is still at the trial balloon phase -- at first blush it makes a lot of sense -- it won't work unless it has the teeth of an FDIC. Will it prevent major swindles such as the recent Peregrine Financial Group scam or MF Global? It's hard to say, but it would give auditors an opportunity to look at a company's books and take action before the firm goes belly up.
Under the FDIC's modus operandi, the agency keeps a close watch on a firm's balance sheet, reserves and liquidity. If a bank gets into trouble, the FDIC can force a merger with a stronger organization. If it's beyond repair or it can't find a well-heeled partner, the place is shut down over a weekend.
What happens to depositors' funds? If they have $250,000 per account or less, they are completely protected. They don't lose a dime.
Although there's myriad reasons to trash banking regulators, the FDIC is among the most efficient in recent times at spotting trouble and taking action to protect deposits. They have a great deal of power to walk in, go over books with a fine-tooth comb and pull the trigger on a failing institution. Will a similar agency overseeing commodities investors have the same power? It should.
One of the reasons Peregrine and MF Global got to the point of collapse without any watchdog action is that they were governed by relatively weak regulators. There were plenty of warning signs, but the CFTC and National Futures Association didn't step in until it was too late. Now they are mostly in the role of sleuths trying to track down and recover investors' money.
The CFTC investor protection fund, the brainchild of commissioner Bart Chilton, would fund itself by charging member insurance premiums the same way the FDIC derives its operating income. One of the models for the commodity insurance fund is the Securities Investor Protection Corp. (SIPC), which was set up to compensate investors if a brokerage firm goes bust.
If the commodity insurance agency gains traction -- and it's facing a stiff headwind from the industry -- SIPC would not be the best model. SIPC does not provide dollar-for-dollar deposit insurance. If you're swindled, you may not get your money back. It has a relatively small staff, doesn't necessarily perform rigorous inspections and is not seen as a tough regulator. Thousands of investors are still trying to get money back through the SIPC from various big-time frauds involving Bernie Madoff and Alan Stanford. The agency is reasonably clear in what it doesn't do on its website. It's no FDIC.
Note: Even though many think SIPC is a securities industry regulator and full insurance fund, it's not (clarification posted 8/13). The SEC and FINRA monitor that industry. And a court order excluded SIPC from the Stanford recovery, SIPC states. More on SIPC in a future post.
Those opposed to regulation in general cite the all-too-human gremlin called "moral hazard." This school of thought posits that if you have insurance in place, that provides an incentive for potential crooks to take more risks. I've always believed that scamsters will more likely perpetrate a fraud if no one is looking and they think they can get away with it. More sunlight is better than less.
Still, the insurance model has some merit. There's an institutional incentive to protect the interests of the insurer and the insured. Some of the toughest tests in the commercial world are conducted by the insurance industry. They test products, produce reams of research on risks of individuals, industries and companies and price them accordingly. Those firms at higher risk pay higher premiums.
If you play by the rules and your books are clean, you typically won't get any regulatory interference from an insurance-based regulator. You could even make an argument that if the FDIC had full purview over the banks before the housing crisis instead of the Federal Reserve maybe the meltdown could've been averted. The Fed, in hindsight, proved to be an awful regulator that essentially kept a risk-taking culture in place. But that's a New York-sized maybe and I digress.
It's well known how insurance has made modern life more survivable. If a breadwinner dies unexpectedly and has a life policy, survivors won't be destitute. Should your house burn down, it can be replaced without forcing you into bankruptcy. Cancer, heart disease, accidents -- all covered with decent insurance coverage. Own a bar or manufacturing firm? You're covered. If all of the major catastrophes can be covered by pricing risk and buying insurance, why not commodities investments?
