Blythe Masters, the fox who belonged in the CFTC hen house. Photographer: Joshua Roberts/Bloomberg
Blythe Masters, the fox who belonged in the CFTC hen house. Photographer: Joshua Roberts/Bloomberg

Should the fox guard the henhouse? The U.S. has a history of regulating that way. The most prominent case was Franklin Roosevelt's 1934 appointment of Joseph Kennedy, a notorious stock-market manipulator, to lead a brand new Securities and Exchange Commission. Why Kennedy? "Takes one to catch one," Roosevelt said at the time.

The same reasoning should apply to Blythe Masters, the knowledgeable (some would say too knowledgeable) head of JPMorgan Chase & Co.'s commodities unit, which settled an enforcement case with U.S. energy regulators last year. Yesterday, the Commodity Futures Trading Commission said she would soon join an advisory committee. The outrage exploded on the blogs and social media. Today, Masters withdrew.

Too bad. She is exactly what the CFTC needs as it finishes writing derivatives rules. With the departure of Gary Gensler, the chairman for the last five years and a former Goldman Sachs Group Inc. bond trader, the agency lacks someone with a deep understanding of derivatives markets. Without that, regulators risk having the wool pulled over their eyes.

Admittedly, Masters was a controversial choice. She is credited with inventing the modern-day credit-default swap. It happened in 1994, when JPMorgan opened a $5 billion credit line for Exxon Corp. At the time, the oil major faced a huge punitive-damages bill from the Exxon Valdez oil spill. Masters came up with the idea of selling to investors the risk that Exxon might not repay the debt. This allowed JPMorgan to hold a lower amount of reserves against a possible Exxon default.

Masters saw credit swaps as risk-management tools, not the weapons of mass destruction they became. She surely didn't envision that American International Group Inc. would sell large quantities of swaps without having the collateral that would come due if the underlying credits deteriorated.

Then there is the Federal Energy Regulatory Commission matter. JPMorgan agreed to pay $410 million to settle a commission claim that the firm manipulated power markets. The case grew out of the 2008 acquisition of Bear Stearns, which owned the right to sell electric power to Michigan and California.

But the power business was unprofitable, so JPMorgan's Houston energy traders devised trading strategies that, the FERC concluded, caused the two states to overpay by $83 million.

Masters, whose division includes the unit involved, wasn’t named as a defendant. Still, she was very much on the hot seat, according to a document obtained by the New York Times. The newspaper's May 2013 article says:

While Ms. Masters was “less involved in the day-to-day decisions,” investigators nonetheless noted that she received PowerPoint presentations and e-mails outlining the energy trading strategies.
The bank, investigators said, then “planned and executed a systematic cover-up” of documents that exposed the strategy, including profit and loss statements.

Yeah, it looks pretty bad. But it's important to repeat: Masters was not named as a defendant. Is this because the FERC lacked spine? Or did it lack the evidence to charge her personally? We don't know the answer.

Masters may still be subject to prosecution since the settlement doesn't preclude a criminal case, and the Manhattan U.S. attorney appears to be conducting a probe, Bloomberg News has reported. Most prosecutors will tell you, however, that regulatory agencies often believe they have the goods, but what documents or statements they have often wouldn't hold water in court.

There are two other important points here. First, Masters was only joining an advisory committee. She wouldn't have had a vote on any rules or enforcement cases. Second, and perhaps most important, one piece of the regulatory framework -- making sure CFTC-equivalent rules are applied overseas so that banks can't bypass the agency by moving risky trades offshore -- has yet to be finalized. Masters could have offered invaluable advice on how to avoid regulatory arbitrage.

Kennedy, by the way, turned out to be a darned good SEC chairman. He was responsible for rules requiring publicly traded companies to file quarterly reports so that all investors have the same information at the same time. This reform grew out of his own market machinations, in which he traded on his insider knowledge of companies that other owners of the stock didn't have. Like with Kennedy, it would have been better to have Masters inside the tent.

(Paula Dwyer is a member of the Bloomberg View editorial board. Follow her on Twitter @paulaEdwyer.)

To contact the writer of this article: Paula Dwyer at pdwyer11@bloomberg.net

To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.