An unintentional loss of connection to the CME Globex trading engine is called an "ungraceful disconnect." Your working orders are canceled and your position essentially is frozen. What happened on Monday, Oct. 31, 2011 had a similar result, but the cause was a total disgrace — the MF Global bankruptcy filing a "disgraceful disconnect."
The scene on CME Group's trading floor morning of Oct. 31 was utter chaos. Every employee and trader from MF Global who hadn't passed through the turnstiles by 7:30 a.m. found that their key cards were turned off. In addition, their electronic access to the CME's Globex trading engine had been severed. Every MF Global customer also had been cut off from the Exchange. Bryan Durkin, COO of CME Group, was present on the fourth floor talking to the scores of traders milling around who could not gain entrance to the exchange. The bankruptcy petition of MF Global, filed that morning, came as a shock to everyone and the consequences were devastating.
It is not unheard of for a futures commission merchant (FCM) to fail. It happened in 2008 with Lehman and before that it happened to Sentinel and to Refco. But in every case prior to MF Global, the CME was able to arrange an orderly transition of business to one or more FCMs. During those transitions, customers were not barred from the market, employees were not locked out of the building and the integrity of the futures industry was maintained. The entire business of MF Global was to be transferred intact to Interactive Brokers, but they backed out when a shortfall in customer segregated funds was discovered. That left the entire matter in the hands of the bankruptcy court and CME Group was powerless to step in.
Through its principals, MF Global has blazed a trail into new and uncharted territory. While there have been instances in the past where FCMs have entered bankruptcy with shortfalls in customer segregated funds, never before has the sanctity of customer segregated funds been violated so blatantly and in such unprecedented amounts. The first few days after the filing, we thought that we were looking at sloppy bookkeeping. But as days dragged into weeks and the shortfall continued to grow, it appeared that a concerted effort was made to loot the customer segregated funds to support the proprietary positions of MF global.
We in the futures industry are guilty in repeating the phrase that no one has ever lost money because of the failure of an FCM. Apparently that is no longer true. The Securities Investor Protection Corporation (SIPC) bankruptcy trustee still contends that there is $1.2 billion missing from customer segregated funds. This is extremely discouraging.
The failure of MF Global has devastated some 38,000 customers, thousands of employees and hundreds of creditors. It also is a black eye for the futures industry as a whole. Ours is an industry built on honesty and trust. Your FCM guarantees that your trades will be made good — win, lose or draw. CME Clearing guarantees that all the trades submitted by your FCM will be made good — win, lose or draw. MF Global has broken the faith and taken customer funds. I am not certain that the futures industry ever can recover fully.
Chronology
From the very outset of this debacle, Dorman Trading has been at the forefront of those firms trying to help make the transition as painless as possible for MF Global customers. At approximately 11:00 a.m. on Oct. 31, we were contacted by a non-clearing FCM. They cleared their trades through MF Global and their thousands of customers were now locked out of the market. I'm proud to say that by 4:00 p.m. we had them and their thousands of customers trading.
The following day we met with two employees of MF Global. They ran a division of MF Global that catered to "local traders" and operated at the CME under their own divisional clearing number. We quickly reached a verbal agreement to accept their traders and their traders' positions in what ultimately would be a bulk transfer from the bankruptcy trustee for MF Global. On Nov. 2, the Commodities Futures Trading Commission (CFTC) issued a letter permitting the transfer of the MF Global customer accounts and acknowledging that the transfer of the "local customers" would present some difficulty because of the unique risk profile that they can present. Dorman Trading was identified by the CFTC as one of five clearing firms in good standing that would participate in the bulk transfer. We immediately set out to repaper these customers and get them back on the floor or in front of their computers. The timing of the trustee's bulk transfer still was uncertain, but we got most of our new customers back onto the floor or in the market by Nov. 3.
We could not accept the MF Global customer positions without adequate cash to meet the required margins. The message coming from CME Clearing was unclear. Would the gross margin be transferred or would it be net? Insufficient cash could put us in the same position as MF Global.
On Thursday, Nov. 3, Durkin and CME President Phupinder Gill came to our office to explain the terms of the bulk transfer. For customers with open positions, we would receive the cash equivalent of the futures margin plus the value of short options, less a haircut of approximately 25%. The long options would transfer without cash, but we would have the value on our books. There was no discussion of the customers who were flat or even the true account balances of the customers with positions being transferred.
The assignment was signed by the trustee and on Nov. 4 we received the positions from MF Global. The cash to support the positions arrived with an allocation table from CME Clearing. We were allowed to aggregate accounts with identical ownership, which allowed for a more equitable allocation of the cash. A second cash distribution was provided to us before we allocated cash to customer accounts. None of our accounts was seriously under margined.
The next week the CME embarked on a "true up" process whereby they clawed back cash from accounts that were allocated funds in excess of their balances at MF Global. The trustee was able to compare the funds transferred to an account with the account balance at MF Global as it existed on the day of the bankruptcy filing. No account was permitted to become an MF Global debtor. Some issues arose because of the failure of MF Global to properly relate accounts with identical ownership. The CME was very helpful in resolving discrepancies and ensuring that there were no grossly inequitable results.
On Nov. 23 the trustee assigned the "cash only" accounts from MF Global. We received approximately 60% of the account balances as they existed at MF Global on Oct. 31. At the time, we did not have an accounting for those accounts with T-Bills, other collateral or the accounts that received bad checks, but on Dec. 9 the bankruptcy judge approved a third bulk transfer meant to true-up all account to 72%.
The unfortunate
The CME has stepped up and volunteered to advance $550 million to help MF Global customers. This is an attempt to restore some faith in the system and based on the early estimate of the shortfall would have gone a long way toward that goal. At $1.2 billion and climbing, the CME funds may be too little, too late.
In their brochure "The Financial Integrity of CME Clearing" the CME lays out the entire regime for safeguarding the market. In addition to all the risk management controls that CME Clearing can employ, they have three layers of funds to be used in the event of a default by a clearing member such as MF Global. There is a $100 million surplus fund, a $2.3 billion guarantee fund and the ability to assess the remaining clearing members up to 275% of their guarantee fund requirement.
Unfortunately, these funds are only available in the event a clearing member defaults on its obligation to CME Clearing. The CME guarantee does not apply when an FCM appropriates customer segregated funds. Apparently MF Global was in good standing with CME Clearing in the sense that it did not default on its obligation to the CME, and as a consequence the guarantee fund is unavailable to MF Global customers. MF Global customers will be treated in accordance with the bankruptcy statutes as they apply to futures accounts.
The good
I have read a great deal of commentary about who is responsible. The question that I cannot answer is whether the CME, as the designated self-regulatory organization (DSRO) for MF Global, was somehow deficient in their oversight. I think we will have to wait for a complete post mortem to make that call. From what I have heard, the customer segregated accounts appeared to be intact on Oct. 25. The MF Global officers apparently depleted the customer account segregated funds in the few days between Oct. 25 and Oct. 31. It should be noted that auditors only sample and do not examine every transaction. Further, auditors have little ability to detect a well executed fraud in the short-term.
My experiences with the CME this past month have left me with nothing less than admiration and respect. They immediately recognized the seriousness of the event and they put everything aside to do the best they could for the MF Global customers. I recall talking to a CME clearing employee at 6:00 a.m. and then speaking to that employee at 10:00 p.m. that same day. He told me he hadn't gone home in five days. I saw that same dedication and professionalism from all the CME employees with whom I have worked on this matter.
The bad
I have had traders in my office crying. This was their livelihood and now it is gone. How will they pay their bills? I've had farmers tell me that the proceeds from the fall harvest were sitting at MF Global. How will they buy seed and fertilizer? I've known some MF Global employees for 25 years. Where will they find new jobs in this economy? And selfishly, will the customers alienated by this disgraceful event ever come back. Won't the entire industry suffer from the loss of their volume and liquidity?
The ugly
The bedrock of the futures industry is the segregation of customer funds. Segregated funds are secure from the creditors of your FCM. Your FCM may invest or deposit segregated funds with a bank or another broker, but it is done with the acknowledgement of the recipient that the funds remain customer segregated. That makes the funds secure from the creditors of that bank or other broker.
The flaw in the segregation regime is that there is nothing to prevent the unscrupulous from improperly removing customer funds from segregation, and that apparently is the case at MF Global. Section 4d(a)(2) of the Commodity Exchange Act (see 7 U.S.C. sec. 6d(a)) makes it unlawful for an FCM to fail to "treat and deal with all money, securities, and property received by such person to margin, guarantee, or secure the trades or contracts of any customer of such person, or accruing to such customer as the result of such trades or contracts, as belonging to such customer. Such money, securities, and property shall be separately accounted for and shall not be commingled with the funds of such commission merchant……"
There are not a great many segregation cases, but the Sentinel trustee is currently pursuing that avenue in a bankruptcy proceeding. In 2009 the CFTC charged JP Morgan with inadvertently violating segregation in the settlement of a Treasury auction. The result in that case was a fine.
The CFTC has made a point of stating that every violation of the Commodity Exchange Act is a potential criminal violation. It is my fervent hope that they will back their words with deeds. If faith in our financial institutions is ever to be restored, then an egregious breach of trust such as this must be punished and punished severely.
Marc Nagel is Chief Operating Officer of Dorman Trading, LLC. He can be reached at: mn@dormantrading.com.
