The failure of Peregrine Financial Group highlighted weaknesses in regulatory oversight of the commodities market. Instead of getting stronger, however, the current system is about to be stretched a lot thinner.

At the same time that the Commodity Futures Trading Commission points its finger at the National Futures Association — the industry self-regulatory body that was Peregrine's front-line regulator — the federal agency is expanding the NFA's mandate to include the supervision of major swaps dealers.

"I don't think people are putting two and two together about what this means for a $300 trillion swaps market that's going to have [fund] segregation and products that are much more complex than what Peregrine was trading," says Michael Greenberger, a former director of the CFTC's division of trading and markets who now teaches at the University of Maryland School of Law.

Even before the successive custody failures of MF Global and Peregrine, handing responsibility for regulating major swaps dealers to the NFA was a great deal to ask. Market observers noted that the NFA had little experience overseeing the trading desks of giant banks, and Brooksley Born, the former CFTC chairwoman, argued before Congress that a self-regulatory organization was no substitute for a well-staffed federal agency.

Officials from both the CFTC and the NFA agreed. In interviews about a year ago, both regulatory bodies said increased funding for the CFTC was needed to properly regulate the major banks' swaps activities. If the commission didn't get enough money, it would have no choice but to delegate the bulk of its swaps regulation to the NFA.

"The less [the CFTC] gets in its allocations, the more responsibility it may try to shift toward the self-regulatory sphere," NFA President Dan Roth said on a conference call organized by the CFA Institute around the same time. A spokesman for the NFA subsequently told American Banker that "we will accept any responsibilities they give us."

The NFA did not return calls left on Wednesday and Thursday, and the CFTC did not respond to a request for comment.

The weaknesses exposed first by MF Global and then Peregrine have led some commodity market participants to question whether their regulators have the resources to tackle the new mandates of Dodd-Frank.

Ironically, the perceived strength of the commodities industry was the inspiration for significant portions of Dodd-Frank's reforms. The push to move swaps onto exchanges explicitly mimicked the futures markets, which survived the worst of the financial crisis without any major blowups.

There's nothing wrong with that structure, says John Lothian, who publishes a stable of newsletters on futures markets. But transposing it to a massive new market "has left some major holes in how these regulatory bodies conduct their primary missions," he says. "We've got the regulation we've ordered, which is cheap."

Both Greenberger and Lothian say they believe the problems at Peregrine could go back several years. This would belie the assurances that the CFTC and NFA gave commodities traders after MF Global collapsed that other participants were properly segregating customer accounts from their own funds.

Peregrine's alleged deceptions — which apparently included the submission of doctored bank statements and a fake mailing address to regulators — have raised doubts about the regulators' ability to control their principal markets.

"If people are just looking at balance sheets and not piercing through to test the reality of them, God knows how many entities are misreporting," Greenberger says, citing widespread fear of further deceptions. "I know so many people in these markets saying that everywhere they turn there's disappointment," he says.

Volume data from the Chicago Mercantile Exchange — whose parent, CME Group, is the self-regulatory organization that was in charge of overseeing MF Global — suggests just such a loss of confidence. After the Oct. 31 failure of MF Global, average daily trading volume fell from more than 12.4 million contracts a day to 9.6 million in December. Volumes still lag last year's tallies, though they were recovering before Peregrine's failure.

There are already anecdotal indications that confidence has again faltered. Earlier this week, Citigroup took the unprecedented step of providing commodities customers with access to data showing how their funds are being held. "It was spurred on by client demand following recent events," a Citigroup executive told Bloomberg News of the bank's decision. "It was a no-brainer."

Markets can't sustain such a general lack of confidence, Greenberger says. For that reason, the prospect of burdening regulators more heavily may be reason to worry. Yet that's exactly what's happening.

On Thursday the NFA said it had reached a deal to provide regulatory services to Phoenix Partners Group, a New York derivatives broker that runs a swap execution facility or clearing house. "This is a significant step forward as we engage in new regulatory activity on behalf of" swap execution facilities, the NFA's Roth is quoted saying in a press release.

Greenberger isn't so sure that the market's headed in the right direction, however. He pins the blame not on the NFA or the CFTC so much as Congress' refusal to give regulators sufficient resources for the tasks at hand.

"The CFTC was trying to respond to budget shortfalls by giving the NFA authority not only over the market they had but the new swaps market," Greenberger says. "And it just appears not to be working."

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