From the December 01, 2011 issue of Futures Magazine • Subscribe!

A foundation at risk

Editor's Note

"If this can happen to a highly regulated company like [MF Global], who can we trust in the future? Now speculators have three concerns: 1. The market, 2. Our own poor judgement and 3. To hope the clearing [firm] will not steal the accounts." Futures reader

It’s time to wipe that smug smile off our face, the "our" meaning the futures industry. The bankruptcy of MF Global revealed a breakdown of an industry that has thrived knowing that customer margin was "safe" because of segregated fund protections. The sacrosanct institution of protecting margin at the exchange clearinghouse level while enforcing a strict segregation at the clearing firm has been tested throughout the years: Refco, Stotler, Lehman, et al. Sometimes it wasn’t as it should be: Volume Investors, Sentinel. But typically the funds were moved over with accounts and positions so clients would not have to worry about where their money was in addition to market risk.

Having covered many of these firm failures — my first was in the 1980s when Volume Investors went down in flames because of the overtrading of three of its customers — I’ve learned moving funds is never flawless, but typically gets done quickly. Some events have had major snags, like the Baring default when overseas exchanges froze all Baring margin accounts. And of course Volume Investors was a disaster, largely because commodity options were so new and basically no margin was required on far out-of-the money positions. Although other clearinghouse members were fine, customers who had margin money at Volume had their funds frozen. The reality is that an exchange clearinghouse is obligated to its members, not to the customers of the clearing firm.

Enter MF Global, which adds some new wrinkles (see Trendlines overview, and "Top 50 Brokers: This one is on us" by Managing Editor Dan Collins):

  1. Securities Investor Protection Corp. (SIPC) immediately took control of the bankruptcy after a request by the CFTC and Securities and Exchange Commission. Although SIPC took over the Lehman failure, Lehman’s futures commission merchant (FCM) and broker/dealer were able to send funds/accounts to Barclays before going into bankruptcy and before SIPC took control. MF Global didn’t have that luxury. Why?
  2. Missing segregated funds at MF Global complicated the moving of seg funds. Required margin held by the exchange was fine, but roughly $633 million in excess margin held by the firm somehow disappeared between the time the CME Group — MF’s designated self-regulatory organization (DSRO) — audited MF Global the week of Oct. 24, and the following Monday, Oct. 31, when the firm declared bankruptcy. The funds — still publicly missing as I write this, 14 days after the firm went down — have been blamed on sloppy bookkeeping by MF Global. Of course it could be something more sinister, but if sloppy bookkeeping is a possibility, wasn’t this ever seen during audits? And does it really take more than a week to find $633 million, especially when the CME just had done an audit? And what about the outside auditor? Further, on July 31, 2011, the CFTC FCM Financial Data report showed MF Global already undercapitalized, so why wasn’t an auditor or regulator camping out at the firm?

Perhaps most blame should go to the trustee, who didn’t seem to understand the rules of the game. But the CFTC deserves as much blame, abdicating its responsibility when a huge majority of the MF Global accounts were futures based. Then of course blame the DSRO, which apparently dropped the ball on monitoring MF Global when things heated up.

So trading just got riskier, and the futures industry has been humbled. But worse, its bedrock — segregated funds — is now under fire while thousands of MF Global customers get burned.

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