Insight: How Colombian drug traffickers used HSBC to launder money

By Carrick Mollenkamp and Brett Wolf

Tue Jan 1, 2013 1:06am EST

n">(Reuters) - When several Colombian men were indicted in January 2010 on money-laundering charges, the case in Brooklyn federal court drew little attention.

It looked like a bust of another nexus of drug traffickers and money launderers, with mainly small-time operatives paying the price for their crimes.

One of the men was Julio Chaparro, a 48-year-old father of four who owned three factories that made children's clothing in Colombia.

But to U.S. authorities the case was anything but ordinary. Chaparro, prosecutors alleged, helped run a money-laundering ring for drug traffickers that took advantage of lax controls at UK-based international banking group HSBC Holdings Plc. It was one of the most important leads for U.S. investigators pursuing a case against the bank that eventually led to a $1.9 billion settlement on December 11.

Chaparro was "basically putting the orchestra together" and investigators saw "him as a major player in terms of cleaning a lot of money," said James Hayes, special agent in charge of Homeland Security Investigations at U.S. Immigration and Customs Enforcement in New York. Known as ICE, the agency and its task force led the probe.

The Colombian's lawyer, Ephraim Savitt, said Chaparro was a middleman in the operation, but disputed the extent of his client's role, saying he was the "page turner of sheet music for the conductor."

Chaparro, who was arrested in Colombia in 2010 and extradited to the United States in 2011, pleaded guilty to a money-laundering conspiracy count in May and is awaiting sentencing in 2013.

An HSBC spokesman declined comment.

Much about the trail that drug traffickers used to move U.S. dollars - the proceeds from drug sales - through HSBC and other banks remains unclear. By design, the process is layered to evade detection.

But a review of confidential investigative records that originate from two U.S. Attorney office probes and federal court filings in New York and California, as well as interviews with senior law-enforcement officials, shows how investigators tracing the activities of people who allegedly worked with Chaparro were able to expose large-scale money laundering at one of the world's biggest banks.

The federal law-enforcement task force - named after El Dorado, the mythical city of gold in South America - used wire taps, email and computer searches, information from at least one inside source, and old-fashioned surveillance, to piece together the ring's operations.

SMUGGLED ACROSS BORDER

Drug cartels sold narcotics in the United States and routed the cash to Mexico, often using couriers to smuggle it across the border. That cash would then be put into bank accounts at HSBC's Mexico unit, where large deposits could be made without arousing suspicion, according to U.S. Department of Justice documents.

In one filing, U.S. prosecutors said, Chaparro and others allegedly utilized accounts at HSBC Mexico to deposit "drug dollars and then wire those funds to ... businesses located in the United States and elsewhere. The funds were then used to purchase consumer goods, which were exported to South America and resold to generate ‘clean' cash."

In a typical transaction, a middleman in a drug cartel would offer to deliver consumer goods, such as computers or washing machines, to Colombian businesses on favorable terms. Another person in the United States would buy the goods from firms using funds from drug trafficking, and fulfill those orders.

Money launderers exploited the laxness of HSBC in policing shadowy money flows, the Department of Justice said earlier this month. Failures included not conducting due diligence on customers, not adequately monitoring wire transfers or cash shipments and not having enough employees to run anti-money laundering systems. U.S. Assistant Attorney General Lanny Breuer called the lapses "stunning failures of oversight."

The situation was so bad, according to the Department of Justice, that in 2008, the head of HSBC's Mexican operations was told by Mexican regulators that a local drug lord described the bank as "the place to launder money."

The Chaparro probe, led by ICE and the Justice Department, converged over the past two years with two other investigations - led by federal prosecutors and investigators in West Virginia and by the Manhattan district attorney - resulting in this month's settlement with HSBC.

HSBC and its employees avoided criminal indictments, as the bank agreed instead to a deferred-prosecution deal that forces it to strengthen controls and accept a compliance monitor.

Today, Chaparro sits in a federal detention center in Brooklyn, reading the Bible and awaiting sentencing, said Savitt, a former U.S. prosecutor in Brooklyn, who submitted a list of questions to Chaparro for Reuters.

"He is contrite, regretful and ashamed about his crimes," Savitt said. "He wants to serve his time and rejoin his family. He understands that a prison term could prevent that from happening for many years."

Under federal guidelines, he could face 15 to 18 years in prison.

ON CHAPARRO'S TRAIL

The El Dorado federal task force, based in a building on the west side of Manhattan near Chelsea Piers, serves as an umbrella organization for some 250 law-enforcement officials from state, local and federal agencies.

One of the task-force supervisors is Lieutenant Frank DiGregorio, a former New York detective who spent years tracking the so-called Black Market Peso Exchange, which is used to convert dollars to Colombian pesos through trading in goods. DiGregorio along with two younger investigators - Graham Klein and Carmelo Lana - led the HSBC case.

The overall probe began in 2007 when investigators analyzed how courier companies ferried cash through airports in Miami and Houston, a person familiar with the case said. They ultimately tracked that to HSBC's operations in Mexico and then connected it to funds moving through New York.

A tipping point in the investigation came in 2009 when El Dorado agents arrested a man named Fernando Sanclemente. Two sources familiar with the case say Sanclemente was an operative in Chaparro's network.

Sanclemente, who was charged with allegedly conducting financial transactions tied to narcotics trafficking, is free on bail with a $200,000 bond, according to the latest court docket entry, which dates to January 2012. His lawyer, James Neville, declined to discuss the status of the case.

According to a criminal complaint filed against him by Lana, the El Dorado agent, on June 30, 2009, task force agents followed Sanclemente for more than two hours as he drove around Queens in New York to ferry cash from drug sales.

Sanclemente first met with a person for about "30 seconds" on one street corner, and left with a yellow plastic bag. Later that night, he drove to a Dunkin' Donuts near LaGuardia Airport, where a black livery cab pulled up and the driver handed him a black bag.

The El Dorado team followed Sanclemente to Laurel Hollow, New York, some 40 minutes away, where the investigators stopped and searched him, finding about $153,000 in the two bags. At Sanclemente's apartment, investigators said they found ledgers and documents consistent with money laundering.

With the arrest, investigators gained insight into Chaparro's alleged transactions. At one point, investigators set up undercover bank accounts where they were able to get Chaparro's network to wire proceeds that could be traced back to HSBC's Mexico operations, according to people familiar with the situation and a Department of Justice filing in the HSBC case.

Federal agents would ultimately home in on $500 million that had moved from HSBC Mexico to HSBC's operations in the United States, according to the confidential investigative records.

Between October 6, 2008 and April 13, 2009, Chaparro and others conducted money laundering transactions totaling $1.1 million tied to narcotics trafficking, the indictment against Chaparro alleged.

(Reporting By Carrick Mollenkamp and Brett Wolf of the Compliance Complete service of Thomson Reuters Accelus; Additional reporting by Tomas Sarmiento Cordero in Mexico City and Aruna Viswanatha in Washington; Editing by Paritosh Bansal and Martin Howell)

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Insight: MF Global puts harsh light on self-regulation

Former MF Global CEO Jon Corzine testifies about the firm's bankruptcy during a hearing before the U.S. House Agriculture Committee on Capitol Hill in Washington, December 8, 2011.

Credit: Reuters/Jonathan Ernst

By Philip Shishkin

WASHINGTON | Wed Dec 14, 2011 2:35pm EST

WASHINGTON (Reuters) - 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."

THE FUTURES POLICE

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.

OVERSIGHT STAFF CUTS FLAGGED

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.

FINES A SLAP ON THE WRIST

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.

"DON'T FIX WHAT AIN'T BROKE"

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.

CME SIDING WITH BUSINESS

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.

UNDERFUNDING OVERSIGHT

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)

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Insight: MF Global puts harsh light on self-regulation

Former MF Global CEO Jon Corzine testifies about the firm's bankruptcy during a hearing before the U.S. House Agriculture Committee on Capitol Hill in Washington, December 8, 2011.

Credit: Reuters/Jonathan Ernst

By Philip Shishkin

WASHINGTON | Wed Dec 14, 2011 2:35pm EST

WASHINGTON (Reuters) - 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."

THE FUTURES POLICE

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.

OVERSIGHT STAFF CUTS FLAGGED

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.

FINES A SLAP ON THE WRIST

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.

"DON'T FIX WHAT AIN'T BROKE"

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.

CME SIDING WITH BUSINESS

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.

UNDERFUNDING OVERSIGHT

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)

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Insight: Fidelity's expensive debt raises eyebrows

By Tim McLaughlin

BOSTON | Wed Nov 23, 2011 4:07pm EST

BOSTON (Reuters) - Fidelity Investments gives a select group of employees an unusual perk. It lets them make unsecured loans to the company at annual interest rates that have paid them nearly 20 percent in recent years.

"It was the best investment I could have made," said Ani Chitaley, a former Fidelity senior vice president. "When I left (in 2007) to start my own company, I had to give them up. That was a sad day."

The promissory notes, officially called junior subordinated debentures, have become a key but expensive source of capital for the world's second-largest mutual fund over the past decade.

The interest on the debt is tax deductible and some of the debentures also double as an equity substitute for top performers and other insiders.

Several current and former Fidelity executives, who did not want to be identified for this story, said the debenture program is a relic of the past when Fidelity's profit margin was substantially higher. And they argue the expensive debt puts the company at a competitive disadvantage.

Analysts at Moody's Investors Service have singled out the employee-held debenture debt as an area of concern.

"In our view, the debentures carry substantial coupon rates that have driven FMR's interest expense to very high levels," Moody's analyst Dagmar Silva wrote in an October 27 research note. "...Fidelity's net income margins have consistently been more in line with our expectations for lower rated firms, in part due to its corporate structure."

Fidelity spokeswoman Anne Crowley said the company uses the internal debt to make investments to grow its businesses and better serve its customers. Fidelity declined to make executives available for comment.

ADVANTAGES OF PRIVATE OWNERSHIP

"We believe our private ownership and capital structure gives us many strategic and competitive advantages that make us very comfortable with our approach," Crowley said.

Analysts at Moody's said that, as a private company, Fidelity can focus on long-term objectives without the distraction of quarterly profit expectations.

"Being private, however, limited the financial flexibility of the company to some extent, by preventing it from accessing the public markets for fresh equity capital," Moody's said.

Closely held Fidelity is secretive about its financial statements, but documents obtained by Reuters show that $5.1 billion in subordinated debentures was outstanding in early 2010. More than half of that amount was in junior subordinated debentures. In all, subordinated debentures accounted for 41 percent of the $12.6 billion in debt on the balance sheet of Fidelity's parent, FMR LLC.

In 2007, some of Fidelity's junior debentures generated interest rates between 18.5 percent and 19.5 percent for employees and shareholders. In 2008, the range was 13 percent to 16 percent. And in 2009, it was 8.5 percent to 13.7 percent, according to financial disclosures reviewed by Reuters.

The returns are in stark contrast to investors scrounging for a few basis points of yield from money-market funds amid historically low interest rates. The yield on the 10-year treasury, for example, is about 1.94 percent.

Some participants have been known to borrow money to take full advantage of Fidelity's debentures. Some series of these debentures allow employees to put them back to the company at five- to seven-year intervals.

They are held by a select group of employees, including Fidelity Chairman Edward Johnson III and his family. The program is kept hush-hush. Participants have to sign confidentiality agreements, and availability is usually limited to several hundred employees for each issue. Fidelity employs about 39,000.

SLIMMER CASH COW

But Fidelity isn't the cash cow it once was. Over the past decade, index funds and exchange-traded funds have eroded the market share of the Boston-based company. To make matters worse, investors have lost their appetite for Fidelity's bread-and-butter product: stock mutual funds.

In a recent speech heard by only a small gathering of mutual fund industry executives, Fidelity Asset Management President Ronald O'Hanley warned there could be low stock market participation in the next decade, much like the 1950s.

That leaves Fidelity with a large amount of expensive debt while its higher-margin stock funds suffer from an industry-wide trend of redemptions. There is a direct correlation between Fidelity's management fees and the S&P 500, which is down about 7 percent in 2011.

In 2002, Fidelity generated operating income that was 7.3 times its interest expense. In recent years, that figure has been only 2.3 times to 4.3 times interest expense, financial statements show.

Standard & Poor's analyst Charles Rauch said in a May research report that FMR's overall capitalization was "on the low side" because the company needs substantial tangible equity to support other financial services businesses, such as insurance and brokerage, and its noncore strategic investments.

During the three-year period that ended December 31, 2009, FMR generated, on average, $20 in total revenue for every dollar in interest expense. During the three-year period that ended in 2002, that ratio was much higher, 38-to-1.

CONCERN MITIGATED SOMEWHAT

Most of Fidelity's competitors are publicly-traded companies, which incur their own compensation costs when they issue stock options and restricted stock to key executives and employees.

Moody's, which has a negative outlook and an "A2" rating on the company, said its concern is mitigated to some extent by FMR's high level of cash and liquid investments on its balance sheet.

FMR deducts debenture interest payments to reduce the taxable income that flows to its shareholders, which include top executives and the Johnson family.

Organized as an S-Corporation in 2007, FMR pays little if any federal income tax. This allows taxable income deductions and credits for federal income tax purposes to flow directly to shareholders. To keep its S-corporation status, FMR cannot have more than 100 shareholders.

In early 2010, FMR sold $63.6 million in debentures to about 600 participants, according to U.S. regulatory filings. The interest rate is typically two times the prime lending rate (currently 3.25 percent), plus what insiders call a 2 percent to 3 percent kicker.

Some of FMR's senior debt is much cheaper, though. Yen-denominated debt, for example, has had annual interest rates below 2 percent, according to financial statements.

In any given year, though, Fidelity's operations can generate between $2 billion and $3 billion in cash flow. And the company's investment portfolio, which has topped $10 billion in recent years, includes a large amount of low-risk, liquid assets, credit-rating analysts have said.

Fidelity can lower annual payouts on junior debentures because one component of the interest rate is pegged to meeting profit targets, financial records show. Fidelity typically asks employees to redeem the debt when they leave the company.

(Reporting by Tim McLaughlin in Boston; Editing by Tim Dobbyn)

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