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Option Trading Rules Faulted in CFTC Report

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Times Staff Writer

Federal commodity regulators said Monday that New York’s Commodity Exchange and its financial clearinghouse may have violated government commodity regulations last March in their handling of the multimillion-dollar failure of Volume Investors Corp., a New York futures and options brokerage.

The staff of the Commodity Futures Trading Commission also said in a report to the five-member commission that the Volume collapse exposed several shortcomings in the commission’s own regulations.

Among other things, the staff proposed that an industry group study the institution of some sort of insurance coverage for commodity investors--perhaps similar to that afforded securities investors by the Securities Investor Protection Corp.

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The collapse of Volume and its aftermath raise questions about the future of options trading on all of the nation’s futures exchanges, the regulators said at a special meeting of the commission called to review the Volume failure. The long-outlawed trading in options on futures was allowed on a limited basis on the commodity markets in 1983 in a CFTC pilot program that comes up for review in October.

“This is a very ominous warning for the future of the options program,” CFTC Commissioner Fowler West said. “We’re under the urging from the exchanges to take the lid off the program altogether, but there are great doubts in my mind as to the wisdom of this course of action.”

Segregation Questioned

The incident calls into question the reliability of the CFTC’s entire regulatory policy, the CFTC staff told the commission. That policy is designed around the cornerstone of a process known as “segregation”--the assurance that customer funds are kept separate from those of a firm itself. Segregation ensures that a failing firm is not inclined to steal from its customers, but it evidently does not protect each customer from the default of other customers.

“The Volume case raises serious questions of regulatory policy and of whether existing commission rules have, in effect, been oversold,” the CFTC staff’s report states.

The Volume collapse, which came on the heels of an unexpected $44-per-ounce increase in the price of gold on March 18-19, was the first failure by such a commodities firm to cost innocent customers money since the CFTC’s creation in 1975.

It occurred after three Volume customers, acting together, were permitted to sell large amounts of gold options at minimal prices. When the price of gold rose, the three customers were so financially strained that they missed about $26 million in margin calls--demands for cash to cover their investments--from brokers.

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Although legally required to make good on those customers’ obligations, Volume itself did not have the money to do so. As a result, it too defaulted, and assets belonging to 100 innocent customers were seized by the Comex Clearing Assn., an independent institution that functions as the financial intermediary in all trades executed on the Commodity Exchange, or Comex.

A statement issued by Comex shortly after the CFTC report was released argued that the exchange “strictly followed its own rules in dealing with the consequences of the failure of Volume Investors Corp.”

The CFTC’s staff report Monday said that both Comex and the Comex Clearing Assn. delayed suspending Volume from trading for more than a day after the firm’s actual default March 20. The delay was critically costly to the innocent customers, the report states, in part because it allowed customers who had an early inkling of the firm’s problems to transfer their assets, taking unfair advantage of customers who remained exposed.

Furthermore, in the intervening day, Volume’s financial situation deteriorated dramatically. This ultimately prevented customers from gaining access to their accounts after the suspension was declared March 21.

On the morning of March 20, the report states, the transfer of all Volume customer accounts to other brokers would have required $18.5 million in cash deposits, an amount covered by the $17.9 million credited to those customers by Volume and an additional $570,000 of the firm’s own capital.

A day later, however, Volume’s customer accounts, drained by the defaults of the three gold-option customers, had declined to a deficit of $2.3 million. At that point, it was impossible to transfer the accounts of innocent customers.

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