The regulators that allowed bankruptcies: reasons and consequences

Brokers’ bankruptcies allowed by regulators: reasons and consequences. How and why regulators make mistakes and what they may lead to

If a market participant has a regulator’s license, it should mean that a broker is watched closely and any kind of fraud or liquidity problems are excluded. That is, there is a supervising authority that audits regularly a broker, monitors all its activities and, in case of any argument, there interferes the special commission for the interaction management between the financial markets participants. A license proves that a financial company is a broker, not a dealing centre.

Does it really guarantee that a regulator and a license, received by a broker, will protect you from any kind of problem? In practice, there have been many cases when regulators allow bankruptcies and traders lose millions of USD. I’ll describe the most infamous ones in the review:

1. How  SEC and CFTC underestimated risks and allowed the bankruptcy of MF Global.

2. How Ernst&Young and FCA overlooked WorldSpreads’ fraud.

3. How CySEC is standing up for IronFX’s interests while the traders are hoping to get their money back. 4. Why IFSC allowed the bankruptcy of Panteon Finance so easily

A license granted by a regulator is a kind of a marker for a trader which says that the broker is under control. Theoretically, the regulator shall watch over financial statements, check the level of capital, check if segregation rules are observed (separation of client accounts from the broker’s accounts), exclude insider transactions, and transactions connected with ungrounded risks. Theoretically...

On the internet, there are a lot of links to the famous bankruptcy of the British subdivision of Alpari that took place in spring 2015 right after the Swiss franc soared. At that time, FCA was able to save the clients’ money, and that story is always mentioned as an example of the regulator’s work efficiency. However, the cases when regulators (including FCA) allowed some big brokers’ bankruptcy due to glaring negligence are often kept secret. In vain! They are a brilliant example of the fact that a regulator’s licence is far from being a panacea for eventual problems. Read on to learn more about those cases.

1. SEC and CFTC: how an underestimate of risks blemished regulators’ reputation

SEC (U.S. Securities and Exchange Commission) and CFTC (Commodity Futures Trading Commission) are considered as ones of the most competent not only in the USA, but also worldwide. But the example of MF Global’s bankruptcy shows that not only cannot the regulators estimate the risks of the brokers in charge, but also they don’t know how many toxic assets their clients have.

By the moment of bankruptcy, the MF Global broker had had the 7th volume of assets in its segment. The company belonged to the segment of multilevel investment agents that conducted operations in derivatives. Just one week was enough for the broker to collapse. The financial audit revealed a deficit of $700 million in the segregated client accounts: the money was used by the company for financing its own operations. Also, it turned out that besides the loss registered in third quarter 2011, the total debt amounted to $39.7 billion, with the assets worth $41 billion.  SEC and CFTC committed an act of bankruptcy immediately, but the reasons and the guilty were still to be found.

MF Global’s mistake was unwarranted confidence in government bonds dealt in under a repurchase agreement (repo). MF Global sold the investors (pension and investment funds) securities, agreeing to buy them back later at a predetermined price. In other words, the broker recorded the selling of securities on its balance sheet without mentioning the buyback agreement. The stress tests conducted by the regulators didn’t reveal any problems of the broker while repo agreements were conducted off their balance sheet.

This was a sort of a financial pyramid. MF Global would buy European bonds, resell them with an agreement to buy them back, spend the money received on buying bonds again, and sell them again. But, the higher transaction volumes are, the more free money in needed for a buyback whereas investors tend to withdraw money in time of crises. There was a moment the broker didn’t have enough liquidity to increase collateral.

The principle of earning money through debt securities was the following: the reliability of securities was unshakable and the price grew. The buyer (a fund) earned the difference between the redemption price and the buying price (which is lower than nominal price), MF Global got a coupon paid out at the moment of redemption of bonds.   The European countries were supposed to continue servicing their debts and the European investors - to be more lenient with European troubles.

The problem started with Greece and then spread over to other countries (Cyprus, Spain, Italy, Portugal, Belgium, and Ireland). The European bonds started falling in price, the contractors (bond purchasers), asked for more collateral understanding that MF Global didn’t have enough money for buying the bonds back at the predetermined price. The liquidity crisis led to a rating downgrade, which in its turn provokes another rise in liquidity requirements. The saddest thing was that the broker used both its own and the clients’ funds.

MF Global’s bankruptcy showed that

  • regulators don’t know how many unrecorded repo positions brokerage companies have;
  • regulators and auditors (PwC) didn’t think investing in European bonds could cause any troubles.

2. FSA (FCA) and WorldSpreads: fiasco of the British regulator

The WorldSpreads company was founded in 2007 right on the threshold of the US mortgage crisis that partly affected the UK as well. The fact the company could acquire a large clientele and a solid reputation helped it go through the hardest year of 2008. Gradually increasing its turnovers, the broker reached a 40 million pounds capitalisation, which made of it one of the biggest companies in the sector. According to the law, the company had segregated accounts, but it didn’t help the clients at all.

Note: segregated accounts are traders’ accounts separated from the broker’s ones. Theoretically, in case of bankruptcy, segregated client accounts are transferred to another company.  In practice, a broker doesn’t have a segregated account for every particular client and the totality of positions is transmitted to the market or to a liquidity provider that cannot be checked by FSA.

In mid-March 2012, WorldSpreads had to acknowledge that £13 million out of £30 million was missing on the company’s balance sheet. There was a moment the broker’s management understood they were approaching a point of no return and tried to make an agreement to cover the deficit with London Capital Group and IG Group. However, the agreement failed and the broker had to publish a deficiency balance sheet. Such situation seemed a priori impossible in the UK, that’s why the fraud shocked the whole sector and the broker’s operation stopped immediately.

A later probe would show that the missing  £13 mln. had been withdrawn by WorldSpreads on the pretext of the clients’ permission to buy the company’s shares. If the  MF Global case was a risk underestimate, the WorldSpreads case was an outright fraud.

WorldSpreads’ bankruptcy was a precedent that revealed the weakness of the financial  Supervisory Authorities:

  • The “Big Four” auditor Ernst&Young didn’t see a hole on the broker’s balance sheet in the 5-year period of annual checks. There was no shadow of doubt regarding WorldSpreads, and no one knows how much money would have been withdrawn if the failed agreement hadn’t become public.

  • FSA relied on the auditor’s reports without controlling the broker by themselves. What is remarkable is that there’s no information on traders’ complaints. So we can conclude that the WorldSpreads broker manipulated the clients’ money while FSA’s supervision was a pure formality.

Later, another Big Four auditor KPMG, appointed to investigate the case, took legal action against Ernst&Young. Two years later, a settlement was reached. This was quite a successful outcome for the auditor at fault that was even able to restore its reputation (let me remind you about the bankruptcy of  the energy giant Enron in the USA in 2001 after which the Arthur Andersen auditor closed down and the Big Five turned into the Big Four).

The aftermath of  WorldSpreads’ bankruptcy was quite serious for FSA as well. The regulator was restructured in less than 1 year. Some of its functions were transferred to the Bank of England while the newly created organization FCA (founded on 1st April 2013) changed the approach to financial supervision, increasing the audit frequency from 1 year to 1 quarter.

The situation turned out the saddest for the clients of WorldSpreads. Neither segregated accounts nor compensation funds could save their money. Only 15%-40% of deposits were reimbursed.

3. CySEC and IronFX: the regulator that doesn’t acknowledge its fault

IronFX is a classic global broker, providing trading in the foreign exchange and stock markets. It has been operating in the jurisdiction of Cyprus since 2010. The project has been founded and managed by a Cypriot, and the head office is also located there. The company gradually developed into more than 60 offices worldwide. The first complaints against the broker started in March 2015, but CySEC ignored them. The investigation by the regulator’s representatives started only in August-September 2015. In April 2016, they voiced a decision which astonished the traders. CySEC’s official position was as follows:

  • The regulator had no authority to make compensatory payments to the affected persons from the compensation fund until IronFX announced bankruptcy. However, the broker didn’t plan to announce bankruptcy, it simply ignored its traders’ demands;

  • The regulator obliged the broker to pay off its debts to the traders and pay a penalty of 335 thousand euro.

We still don’t know whether or not the requirements were fulfilled (they weren’t, according to unverified information). However, IronFX kept its Cyprus license. Besides, the company opened an office in China. As early as in October 2014, IronFX had problems in China (charge of fraud), but its subdivisions continue conquering the Chinese market after rebranding.

Another escalation of conflict took place in 2017. A group of investors with a Hungarian trader at the head made a collective complaint with the  Financial Ombudsman Service and the ESMA (European Securities and Markets Authority). It took them 5 months for examining the complaint. The answer was formal: there were no violations in the regulator’s activities. But the traders didn’t stop and their complaint to the European Commission turned out productive: the European Parliament interfered with the case. The examination of the complaint started in July 2017, the results are still awaited. Do carefully select the company to trade with; study its working history; if it has been operating for over 10 years and it hasn’t been engaged in serious judicious proceedings and official regulator’s complaints, then the company is likely to be reliable. And the “family ties” of Cypriot citizens seem to be quite significant in the present situation.

4. IFSC and Panteon-Finance: better late than never

Panteon-Finance was founded in 2010. Operating in CIS countries, the company positioned itself as a PAMM broker but also provided regular Forex services. Active marketing campaigns were quite efficient. Regular publications of reviews in investment blogs and forums turned this brand into one of the most recognizable ones in 2012. Panteon-Finance was licensed by regulator of Belize IFSC, though offshore but still popular with brokers. What could go wrong?

In 2013, there appeared a rumour in the traders’ community that Panteon-Finance is a mere pyramid. There was even a parallel to another famous broker Forex Trend. As early as in mid-2014, multiple complaints about the failure to fulfil obligations were filed against both companies.  In September 2014, the International Forex Traders Union announced an end to cooperation with these investment companies. The was no reaction from the regulator.

A record number of complaints against Forex Trend and Panteon-Finance was fixed in the period from autumn 2014 to spring 2015. In February 2015, the Center for regulation of over-the-counter financial instruments revoked its license. In May 2015, New Zealand’s regulator FMA warned about Forex Trend’s eventual bankruptcy, considering the company to be unreliable, but it didn’t take any other measures. Forex Trend continued drawing money while the FMA confined itself to suggesting that the traders refer to a dispute resolution organization (another example of “productive” assistance provided by an offshore regulator).

The situation with Panteon-Finance was even more interesting. The fact that the broker wasn’t fulfilling its obligations became public in October 2014-February 2015. IFCS published a warning on its site as late as October 2015, but it was hardly useful at that time.

After a few years of investigation, we would know that the pyramid Panteon-Finance, Forex Trend, and Private FX was governed by a group of people with Pavel Krymov at the head, who alone appropriated nearly 30 million USD. All those brokers turned out to be financial pyramids. The questions are:

●        How did they get a license when the regulators were supposed to check the origin and sufficiency of money?

●        How the 2 regulators allowed such breaches when their main objective is to counteract money laundering and financial pyramids?

●        Why despite that enormous number of complaints did the regulators react so late, to put it mildly?

Conclusion

The efficiency of regulators is sometimes questionable. It some cases, there was nothing more than carelessness or absence of an efficient control mechanism. In some cases, the licenses were just a formality, and in some cases a regulator took a broker’s side. So, everyone decides for themselves if regulators can be trusted.

 

When forex regulators are at fault: the anatomy of brokers’ bankruptcies

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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