WASHINGTON – The demise of an Iowa brokerage where the founder tried to kill himself hurts investor confidence and could damage the markets for options and futures, investments that keep food and energy prices in check.
Without stronger oversight of those markets, investors will flee, leaving them too thin and brittle for companies to hedge against swinging commodity prices, experts and investors said Wednesday.
Peregrine Financial Group declared bankruptcy Tuesday and hasn't accounted for $215 million of customer money. Authorities said founder Russell Wasendorf Sr. tried to commit suicide by running a hose from the tailpipe of his car to the inside.
To be sure, Peregrine handles only a tiny slice of the market for futures and options. But
its implosion addles traders already worn down by months of scandals, missteps and revelations of fraud, said Michael Greenberger, a former senior official at the Commodity Futures Trading Commission, which regulates the industry.
"These markets have lost the confidence of their customers, from the small businesses that need to use them to hedge, to the large funds who use them to invest," said Greenberger, a professor at the University of Maryland School of Law.
If the markets don't receive a strong, immediate boost of confidence, he said, "everyone is going to be hurt, because hedging — if it's done properly — helps consumers by creating lower prices. If not, prices are going to go up."
Futures and options allow companies to lock in prices for commodities, so an airline buying fuel or a farmer buying fertilizer can predict what those things will cost. Knowing in advance saves businesses money and reduces prices for consumers.
When fewer investors participate in a market, it becomes more difficult to buy and sell investments quickly at the price that traders want. People end up paying more than they otherwise might, and small changes in demand jerk prices up and down.
Kevin Davey, an individual investor who used Peregrine to buy and sell futures, said price swings are inevitable "when there's just not enough orders at certain prices."
Futures and options were specialties of Peregrine, which filed for Chapter 7 bankruptcy liquidation in Chicago late Tuesday. The company bought and sold the investments for small retail investors and some larger clients.
Wasendorf left behind a note that led police to notify the FBI, which has launched a preliminary inquiry. Wasendorf was accused in civil fraud charges Tuesday of misusing money from a bank account at U.S. Bank, claiming it contained more than $220 milllion when the balance barely topped $5 million.
The money in that account belonged to customers, and was supposed to be kept separate from Peregrine's own money.
The separation of client money and company money, known as segregation, is the "industry's claim to fame" in projecting investor protection, said Davey, the Peregrine customer.
"A lot of retail people are going to start thinking twice about investing in futures," he said.
Peregrine's failure piles on the ruin of MF Global, which was run by former New Jersey Gov. Jon Corzine. It was the first case on that scale of a brokerage grabbing client money that was supposed to be walled off.
"What you're looking at is within nine months, two different brokerages basically commandeered customer segregated accounts, and people just can't have that," Davey said.
Everyone knows futures trading is complex and difficult to profit from, he said. "Now even the ones who win still might lose, if the brokerage ends up taking your money."
MF Global rattled the futures market, but it was not alone in shaking market confidence in recent months. Some other events that shook investor faith in the structure and oversight of markets:
— Facebook's high-profile stock offering in May was botched. Technical problems marred the open, the stock still hasn't returned to its offering price, and shareholders have said financial information was withheld from some investors.
— Electronic trading platform BATS attempted an initial public offering of its own in March but withdrew the deal after a series of technical glitches and a rapid price plunge.
— Despite a slowly recovering U.S. economy, stock trading has been unusually volatile during the past three summers because of Europe's debt crisis, uneven economic data and last year's downgrade of the U.S. credit rating.
— High-profile hedge fund employees have been charged and convicted in a broad criminal probe of insider trading by federal law enforcement agencies
Ordinary investors reading newspapers at home are growing skeptical that they can get a fair shake with so much inside information flying around Wall Street, investment advisors said.
"It's typical for an older person to bring in a clipping on one these subjects, and they're always asking, 'What does this mean?' and they don't have the complete story," said Mike Sullivan, a Charlotte, N.C., consultant to financial advisers.
He said it's getting tougher for advisers to reassure their clients, especially older Americans who would have less time to recover if their portfolios withered.
Several analysts and investors said that the only answer to this latest shock wave is bold action from the CFTC, which regulates the futures industry.
Right now, the CFTC relies on a network of industry-owned "self-regulators" that it designates to perform regular audits for companies like Peregrine and MF Global.
CFTC officials have discussed creating a deposit insurance fund, similar to the fund that compensates people when stock brokerages fail and the Federal Deposit Insurance Corp., which covers bank deposits.
But Greenberger said it would be difficult for such a fund to cover people's losses because the typical business buying futures to hedge has many millions of dollars tied up in the investments.
"This puts a big hole in the market, it requires a terrific boost of confidence and we're moving in exactly the wrong direction," he said.
He said the CFTC needs to do more of its own audits and rely less on the industry self-regulators, who gave Peregrine and MF Global passing audits in the months before they collapsed.
"If we don't do that, the market's going to heck in a handbasket and everybody is going to be hurt," he said.
The CFTC has argued that it lacks the resources to conduct more aggressive enforcement. President Barack Obama's budget proposed expanding the agency from about 700 employees to about 1,100, Greenberger said, but congressional Republicans have blocked efforts to increase its funding.
A CFTC spokesman did not respond to a request for comment.
Daniel Wagner can be reached at www.twitter.com/wagnerreports.