Two weeks after MF Global's collapse, officials from the Commodity Futures Trading Commission briefed Senate staff on the brokerage firm's final days. When asked about reports that the brokerage firm had written checks that bounced when customers tried to cash them, the regulators had an admission that surprised the room: they didn't know about the bad checks.

This seemed like something they should be aware of, a Senate staffer present at the meeting recalled. A CFTC spokesman declined to comment.

Customers still have no explanation of what happened to MF Global and some $1 billion missing from its customer accounts more than a month after the firm's failure. And regulators struggling to solve the mystery are now forced to play catch-up.

That's in part because over the past decade, as trading volume soared, federal regulators eased direct oversight of the industry and handed more regulatory powers to the major exchanges. Now, this self-policing arrangement is prompting concerns about the regulators' and the exchanges' ability to detect and deter suspicious conduct in the rapidly expanding marketplace.

A look at the recent history of self-regulation shows the government repeatedly raised concerns about the resources the major exchanges dedicate to market oversight, while the federal agency also experienced staff cutbacks and retreated from hands-on policing.

Both the federal regulators and the exchange where MF Global operated, the CME Group, maintain they did all they could in the run-up to MF Global's collapse. But calls are growing for a better system of auditing and enforcement to prevent similar crises in the future.

I think we've gone too far in allowing the exchanges to be so self-regulatory that it's obfuscated the need for the cop to be on the beat all the time, says Bart Chilton, a Democratic commissioner on the CFTC.

Even the industry itself is acknowledging that there will need to be some changes. While defending the self-regulatory system, Dan Roth, president of the National Futures Association, said we should be able to identify certain frailties of the current structure that will need to be addressed.


Self-regulation is the hallmark of the U.S. futures industry. Proponents argue that by placing oversight in the hands of the people who really understand the industry, the system benefits everyone. Critics point to the recent transformation of the exchange business, away from a non-profit cooperative model, as a reason the exchanges' commercial interests are overshadowing their market-oversight role.

Though it dates back to the middle of the 19th century, the self-regulatory nature of trading futures got a boost in 2000 with the passage of the Commodity Futures Modernization Act. The main thrust of the bill, signed into law by Bill Clinton in the waning days of his presidency, was to exempt the rapidly growing market for certain types of financial and energy derivatives and swaps from federal futures regulation.

The law was lobbied heavily by the financial industry, which argued that too many rules were hindering financial innovation and economic growth. But it became an easy target after the 2008 financial crisis, in which these types of complex financial products played a role. So lawmakers passed the Dodd-Frank financial-reform law, which pulled the swaps back under the federal regulatory umbrella and instructed the CFTC to write new rules to govern them.

Another, less-discussed, purpose of the 2000 deregulation effort was to limit the prescriptive powers of the CFTC and to give more freedom to the exchanges to set their own rules. The goal was to provide regulatory relief to futures and options exchanges, James Newsome, who was the agency's chairman in 2001, said at the time. The overall U.S. futures and options industry grew nearly five-fold between 2000 and 2010 when 7.12 billion futures and options contracts were traded, according to Futures Industry Association.

Just as futures trading was exploding in volume, the federal agency was taking a step back from direct oversight of the markets both because of the 2000 deregulation and because of agency understaffing. For instance, when the CFTC in 2003 went after a futures trader allegedly operating a foreign currency boiler room, a court told the agency it had no jurisdiction.

Even in areas where the federal agency retained jurisdiction, direct oversight of the markets rested with the futures exchanges themselves. And those exchanges began ripping up their century-old business models and consolidating rapidly.

Ever since a group of brokers formed the Chicago Board of Trade in 1848, the exchange industry was organized into nonprofit cooperatives of brokers setting their own rules.

Technological and competitive pressures began building on the exchanges that forced more change. In 2000, the Chicago Mercantile Exchange shed its old cooperative structure and soon went public. It later bought the Chicago Board of Trade. And then the newly formed CME Group Inc. acquired the owner of New York's mercantile and commodities exchanges. That made CME Group a dominant U.S. exchange, and one of the largest in the world.


As CME Group grew, federal regulators were relying on the exchange operator to be their eyes and ears on the ground. But in several recent assessments, the CFTC said that CME failed to adequately staff its oversight arm, while some of its fines lacked the necessary bite to scare repeat offenders. Combined with the rapid growth in trading volume and complexity of financial products, these staff cuts could impair the effectiveness of an exchange's compliance program and impede enforcement, federal regulators warned in a 2010 audit of the company.

The flurry of mergers that swept the world of commodity exchanges was partly to blame for the alleged shortfalls, the regulators said.

Prudence suggests that when exchanges merge, they should avoid substantial reductions in their combined compliance staff, federal regulators said in the 2010 audit, urging the company to add employees. In a follow-up audit a year later, the regulators criticized CME Group for the same alleged staffing shortfalls and noted the issue is of particular concern because of the substantial share of the entire U.S. futures and options marketplace accounted for by the CME Group exchanges.

A CME official said that merger synergies didn't reveal themselves quite as quickly but noted that CME's exchanges have always conducted effective internal oversight. Since those audits, CME says it increased its market oversight staff to about 150 employees and has been increasingly relying on technology to keep tabs on the market amid large growth in the trading volume.


In their recent audits, federal regulators also said that fine amounts for some types of trading-related violations may be low enough that traders could view them as merely a cost of doing business. The regulators urged the CME Group to have a fine schedule that would penalize repeat offenders with progressively higher fines. The issue has prompted federal regulators to step in with their own penalties in cases where they thought the CME was merely slapping traders on the wrist.

Consider the track record of Edward Sarvey and David Sklena, two longtime Chicago Board of Trade brokers who traded U.S. government debt. By 2004, Sarvey had already drawn five penalties for trading violations, with exchange fines ranging from $100 to $25,000 and short bans from the trading floor. Sklena had been sanctioned twice, according to records from the National Futures Association.

In 2004, the two traders engaged in what amounted to insider trading on futures pegged to five-year Treasury notes, according to court documents. The trades netted Sarvey $357,000, while Sklena earned $1.65 million in a single morning. Their customers lost about $2 million, court documents say.

In 2007, the Chicago exchange fined Sarvey and Sklena $125,000 and $175,000 respectively, and banned them from trading for about two months. But federal regulators deemed the penalties insufficient and brought their own civil case against the pair in 2008. That complaint morphed into a federal criminal indictment. Sklena was found guilty of fraud last year and sentenced to five years in prison. Sarvey died before the trial. His former lawyer, John Legutki, says he is surprised and saddened by the escalation of the case from relatively minor exchange penalties to a full-blown criminal prosecution. This all weighed on him very heavily, he says of Sarvey.

The case also weighed on federal futures regulators who say it is indicative of soft exchange penalties that fail to deter unscrupulous brokers. It is not an isolated case, a CFTC official told Reuters. The agency declined to provide numbers on how many times it intervened to correct what it thought were insufficient exchange sanctions.

A CME official said that it was the exchange that first caught Sarvey and Sklena, and that the subsequent federal case was built on all the good work that the exchange did. He said that maybe with some exceptions, (federal regulators) find the fines and the penalties that we issue are appropriate. CME also says that the number of enforcement actions brought by its subsidiary exchanges grew from 83 in 2000 to 132 so far in 2011.

During his congressional testimony on MF Global's collapse on December 8, CME Group's executive chairman Terrence Duffy said one way to deter future abuses would be to have stricter penalties. Duffy said the exchange had conducted its audits and spot checks of MF Global at the highest professional level and that the alleged misappropriation of customer funds by the firm was disguised from all regulators.

In a common refrain, many market participants have accused CME Group of not doing enough to supervise large brokerages whose business and trading volume are key to the company's bottom line. I've had more than one person say to me that all CME wants is volume, volume, volume, and they don't necessarily care about the integrity of the marketplace, says Jerod Leman, an account executive at Wellington Commodities, a Carmel, Ind.-based broker that works with farmers who lost money in the MF Global collapse. In 2010, CME reported that its average daily trading volume grew to 12.2 million contracts, up 19 percent from the year before.


This is not new territory for commodity exchanges. A prominent farmer advocate in 1932 complained that the members of the Chicago Board of Trade have set up a little government of their own, in which trials are held like a secret lodge, according to Jerry Markham's 2001 book The Financial History of The United States.

Since those days, the futures business has grown to include hedge funds and other investors, large and small, trading at high volume and using increasingly esoteric financial products, which makes oversight more challenging.

For its part, CME argues it has an obvious self-interest in policing its trading floors because if traders lose faith in the integrity of the exchange, CME Group will lose business. In a 2006 hearing on the matter, CME's chief executive Craig Donohue dismissed assertions of a conflict between the company's profit-making and regulatory missions as conjecture and said don't fix what ain't broke.

Ted Butler, a veteran silver trader, has been pushing Comex, the New York metals exchange owned by CME Group, to investigate allegations of price manipulation on the silver futures market by a handful of large brokerages. But, he says, the exchange hasn't shown much interest. It is a continuing mystery how the conflicted CME could be responsible for any regulatory oversight given their inherent clear conflict of interest, Butler, who himself had drawn a CFTC sanction in the 1980s, wrote in a recent newsletter.

The federal agency is conducting its own investigation into the silver market, having found no evidence of wrongdoing in an earlier probe. A CME official declined to comment, citing the ongoing federal inquiry, with which the exchange is cooperating.


In a rapidly growing futures industry, CME Group often has to wade into policy debates between federal regulators and the businesses they oversee. In several of those debates, CME sided with the firms in opposing disclosure rules and trading curbs that could cut into those firms', and the CME's, bottom line.

The CME, for instance, opposed registration requirements for high-frequency traders. CFTC officials hoped the registration would force the traders, some based overseas, to disclose more about themselves and their trading software, and allow regulators to step in quickly in case of trouble that was seen in the so-called flash crash of 2010.

Because of the sheer volume and the number of transactions, high-frequency traders provide an attractive business to the exchange. CME Group balked at efforts to saddle them with additional requirements. A CME official says there's no uniform definition of what constitutes high-frequency trading, and that CME's internal systems already provide the exchange with incredibly granular information that allows us to look at trading activity.

Last year, for instance, CME Group fined a high-frequency trader called Infinium Capital Management $850,000 for glitches in its algorithm that unleashed rapid-fire trading orders and caused a brief spike in oil prices.


Over the past decade, the federal agency has tried to address potential conflicts of interest within the exchanges by insisting they appoint independent directors to their boards and increase the funding and independence of their regulatory oversight committees.

There was a concern about underfunding the regulatory function of the exchange, recalls Sharon Brown-Hruska who served as a CFTC commissioner between 2002 and 2006. Major exchanges going public only heightened concerns about self-regulation, she says.

CME Group, and other exchange operators, resisted what they saw as the federal agency's unwarranted meddling. But the CFTC prevailed and decreed the exchange boards should be more than one-third independent and that regulatory oversight committees should be properly funded.

Ever since the passage of the Dodd-Frank law, the CFTC has been consumed with writing new rules to prevent future abuses in the derivatives industry. As a result, the resources the agency can devote to enforcing the existing rules may have suffered.

Unfortunately, in response to the financial crisis, the CFTC has been off on a series of tangents, proposing one regulation after another, Senator Pat Roberts, a Republican, said at a recent hearing. Meanwhile, back at the ranch for the first time ever, we have a major problem.

The agency says it is being asked to effectively walk and chew gum at the same time, in an era when Congress is in no mood to increase the size of the federal government. CFTC now has about 700 employees, a 10% increase since the 1990s. In the same time period, the futures market has grown five-fold, CFTC Chairman Gary Gensler said in recent congressional testimony.

Two weeks after MF Global's bankruptcy, Congress denied the Obama administration's request for a CFTC budget increase despite the agency's insistence that it needs more money to do its job. The CFTC just doesn't have the staffing and the resources to audit the brokerages, says a former senior agency official.

That means the CFTC will likely continue to rely on the exchanges to police themselves, although the agency may choose to take a closer look at the markets in some cases. Shortly after the MF Global bankruptcy, for instance, federal regulators said they would conduct a review of the major futures brokerages to make sure their customer accounts are intact.

(Reporting by Philip Shishkin; Editing by Tim Dobbyn)