"Bulls make money, bears make money, pigs get slaughtered."
That trading axiom has come up in numerous conversations following the MF Global bankruptcy and has meaning beyond the fact that MF Global’s Chairman and CEO Jon Corzine was building a huge leveraged position in the sovereign debt of many of the so called "PIIGS" (Portugal, Italy, Ireland, Greece and Spain).
It has to do with greed and the simple fact that those positions were over-leveraged. But as we go to press two weeks after MF Global filed for bankruptcy, the details of the failed trades and legacy of MF Global and its predecessors are a minor sidebar in a scandal that goes to the heart of the futures industry — customer protection through segregation of customer funds.
The futures industry has held itself out as a beacon during the recent credit crisis based on the fact that futures customers did not lose a single dollar outside of market risk, and no regulated futures firm needed government bailout money. But MF Global Holdings declared bankruptcy on Oct. 31 because an acquisition by Interactive Brokers Group fell through when an apparent shortfall in the futures industry’s holy of holies was discovered: A shortfall of $633 million, 11.6%, of MF Global segregated funds.
It is the fact that seg funds were missing that turned what in the past had been relatively orderly bankruptcy transitions to a drawn out process with customers left in the lurch. Dan Driscoll says that any shortage in seg funds complicates the matter because it can entail more risk to the firms taking on the accounts. He says the segregated funds can be three places: a clearinghouse, FCM or a bank.
"What happened to the sanctity of customer segregated funds? Was it always a mirage? Were we just fooling ourselves all these years?" asks David Matteson, partner and member of the Investment Management Practice Group for Drinker Biddle.
His sentiments have been repeated dozens of times over by various segments of the industry.
Our timeline of the MF Global debacle (below) lists facts but cannot convey the confusion, dismay and ultimately anger that followed. Accounts were frozen, traders were blocked from the floor and liquidation-only policies were confused, with customers facing on-again/off-again access to their accounts.
"I lived through Refco and a couple of smaller bankruptcies in the industry, but this one is the most disorganized. This is not an orderly transition of business," said Dorman Trading COO Marc Nagel shortly after the bankruptcy.
The first order of business was assigning control. Because MF Global Inc. was registered as both a FCM and broker/dealer, the Securities Investor Protection Corporation (SIPC) was granted control of the liquidation by the U.S. District Court for the Southern District of New York, and James W. Giddens was named trustee.
This appears to be mandated by the Securities Investors Protection Act (SIPA) but has raised the ire of futures customers. According to the trustee, MF had 50,000 futures accounts and only 400 securities accounts.
"Where was the leadership from the CFTC (Commodity Futures Trading Commission) to argue that we don’t want the futures side to go through SIPC, we want it to be a Chapter 7, because we need to get our clients’ money in their hands ASAP, and we want to be in control of that?" Matteson asks.
That the liquidation of a futures firm was put under the control of securities regulators has frustrated customers waiting for their money. And even if it was stipulated by law, many industry veterans felt the CFTC and CME Group should have fought for greater control. "Make the argument, even if you lose the argument tell the judge why it is important to keep [futures seg funds] separate," Matteson adds.
What followed was the task of moving all of the accounts, and some of the customer funds, to other firms. CME Group identified the accounts that could be moved and the firms willing to take them, working with the trustee who needed to get approval from the bankruptcy judge. A total of 17,000 accounts were moved along with $1.55 billion in capital that represented approximately 60% of the margin capital held at CME Clearing.
But this process was not without controversy. James L. Koutoulas, CEO of Typhon Capital Management, says customers were not allowed to keep open trade equity. "Our livestock clients had big winning trades on with a lot of positive open trade equity, but when they closed that out at MF Global all those profits stayed on the MF Global books."
Many customers needed to place additional margin at their new brokers despite having profitable trades. Several other traders complained about this process that stripped equity from winning trades.
Meanwhile, the trustee is conducting a forensic audit to determine what happened to the missing seg funds. At one point an MF Global attorney claimed there were no missing funds. There were reports that the funds were found at JP Morgan, who operated as both a custodial bank to MF seg funds and one of its proprietary trading creditors.
JP Morgan has filed a lien on some of MF Global assets that has some customers afraid they could be pushed aside. SIPC trustee spokesman Kent Jarrell says, "We are looking into the accounts of JP Morgan," adding, "[the forensic accounting] will be an independent, deliberative and thorough investigation."
But many people don’t understand why it is taking so long. Pauline Modjeski, president of Horizon Cash Management, says that it shouldn’t be so difficult to find out what happened. "This is customer segregated money. They should know where the money is. It shouldn’t take this long."
Koutoulas is informally representing MF Global customers and brokers and is attempting to be put on the Bankruptcy Creditors’ Committee. His charge that customers are not being represented has been echoed throughout the industry. After the transfer, futures customers still have roughly $3.8 billion in funds frozen.
The claims process is another bone of contention as it illustrates the industry’s frustration with the SIPC trustee. After the bulk transfer was completed the trustee indicated that no other client money would be released until the completion of a claims process. "All the account holders will get a mailing and be notified of the claims process, and after that we will certify the claims. At the same time we have to certify the assets and at that point a distribution should be made," Jarrell says. One day and many angry letters later the trustee indicated that he would file a motion for an "expedited claims process" which could provide distributions in increments.
One attendee on a conference call with Koutoulas’ group voiced customer frustration with the claims process. "We are not claimants," she bellowed, "we are customers and this is our money."
On Nov. 11, CME Clearing announced it "is willing to provide a $250 million financial guarantee to the trustee to give the trustee greater latitude to make an interim distribution of cash to customers... Additionally, CME Trust will provide $50 million to CME Group market participants in the event there is a shortfall at the conclusion of the Trustee’s distribution process."
The CME proposal does not cover the reported shortfall but it is a move many industry vets say CME should have made at the outset. It appears to be a reaction to an angry client base, one that feels abandoned by all the leaders of this industry.
"We have a complete financial disaster. We needed leadership among the financial institutions and regulators, that is what we needed, creative leadership. We didn’t see any of that creative leadership that could have made this a smoother transition for the customers," Matteson says.
It is hard to say what the lasting damage to the industry will be, but if customers are not made whole soon, that damage will be substantial.
European exchanges said they were completing transfers of MF Global client positions to other companies in mid-November even as the administrator overseeing the process in the United Kingdom said that more than half of the 1.6 million positions in place when MF Global Holdings filed for bankruptcy protection were still open.
European customers of MF Global — particularly those with positions on the London Metal Exchange (LME) —struggled to close or transfer positions to other brokers. The LME gave clients until Nov. 8 to submit requests for transfer to LCH.Clearnet, the clearinghouse for the exchange, and KPMG, the special administrator appointed to wind down MF Global’s European arm.
Intercontinental Exchange said ICE Clear Europe had completed the transfer or termination of contracts or the closure of all MF Global UK Ltd. client and proprietary positions by Nov. 9, acting on the requests of customers, and that contracts that had not been transferred to alternative clearing members would be liquidated.
Diarmuid O’Hegarty, deputy chief executive of the LME, said in a notice to LME members that the unsettled contracts that had not been transferred to other LME members would be subject to a 59-page, written default regulation that the LME had last updated in 1991. The default regulations will provide settlements based on metal prices published by the exchange on Nov. 1, O’Hegarty said.
Counterparties to unsettled contracts with MF Global were asked to submit to both the exchange and KPMG by Feb. 1, 2012, details of the contracts and supporting evidence. The LME and KPMG had not yet agreed on procedures for processing unsettled contracts but O’Hegarty said those procedures eventually would be made public.
"Counterparties would be aware that the reconciliation of unsettled contracts and the processing of such unsettled contract under the default regulations may take some time," he added.