MF Global: The blame game

MF Global was a Broker-Dealer/ FCM that speculated in highly leveraged sovereign debt with their proprietary funds. At some point they used their customer segregated accounts to support their proprietary positions. The result was a bankruptcy filing on Oct. 31 that has caused massive hardship to their customers and wreaked havoc on the futures industry.

I've spent a great deal of time talking to and listening to people about what went wrong at MF Global and even more time talking to and listening to people about what is wrong with the futures industry. There is a lot of anger and finger-pointing. I recognize that much of the criticism is emanating from those who have lost money. While I sympathize with all those who haven’t yet recovered their funds, I feel it is important to set the record straight and point out some of the realities.

Who to blame

The initial object of criticism was the Commodities Futures Trading Commission (CFTC). As the primary regulator of the futures industry and of MF Global, the CFTC was criticized as having somehow failed in its responsibilities. This was probably unfair. The Commodity Futures Modernization Act shifted the role played by the CFTC from a frontline regulator to an oversight regulator. Further, the CFTC is not really structured to “regulate in real time.” Because of this, the CFTC usually acts after the fact. While the CFTC certainly has the ability to (and does) seek restraining orders in cases of on-going frauds, the CFTC generally relies on the severity of its penalties for deterrent effect, rather than on the immediacy of its enforcement actions.

More pointed criticism has been leveled at the CFTC regarding its role — or lack thereof — in the bankruptcy process. The CFTC's inability to direct the liquidation of MF Global, Inc. and its acquiescence in allowing the proceedings to be handled by the Securities Investor Protection Corporation (SIPC) as administered through the Securities Investor Protection Act (SIPA) has been questioned by many in the industry. As has been pointed out by Commissioner Jill Sommers, "Under SIPA, the Securities and Exchange Commission (SEC) has the authority to refer an entity registered as a broker-dealer (whether or not such entity is also registered as an FCM)." The CFTC has no authority to initiate a bankruptcy proceeding on behalf of an FCM and felt that it was essential that MF Global be placed in bankruptcy as soon as possible. The CFTC and the entire commodity industry have been frustrated because of this failure in both the commodities laws and the bankruptcy code.

The second object of criticism has been the CME. There is no evidence as of yet that CME Group failed in their duties as a designated self-regulatory organization (DSRO). We will have to await the inevitable inquiry to see if CME Group could or should have done anything differently. There is a feeling that CME Group, as the DSRO, should be in the position of an insurance company to all those who have lost their funds as a result of the MF Global bankruptcy. I think this reflects a misunderstanding of what a DSRO is and does.

SROs and DSROs

All exchanges are Self-Regulatory Organizations (SROs). The exchanges formulate and adopt rules consistent with the Commodity Exchange Act and CFTC regulations. They regulate the conduct of their members, enforce their rules and punish violators. As FCMs are frequently members of several exchanges, a single exchange (usually the exchange where the FCM conducts most of its business) is named as the DSRO. Those FCMs that are not members of exchanges (non-clearing FCMs) and introducing brokers have the National Futures Association as their DSRO.

In addition to enforcing exchange rules, DSROs audit FCMs for financial integrity and for matters involving customer protection. The DSROs have an organization known as the Joint Audit Committee, which sets uniform standards for the audit and supervision of FCMs and IBs.

Much like certified public accountants in the corporate world, DSROs sample, investigate and report. On an annual basis the DSROs audit segregated funds. They verify balances, examine segregation acknowledgement letters, review account captions and analyze the types of investments.

MF Global’s customer segregated account was apparently in compliance at their annual audit. CME was notified of a credit downgrade of MF Global on Oct. 24 and that brought on an interim review. CME stated that it believed MF Global’s segregated funds were intact on Oct. 26. MF Global provided a segregation statement showing excess segregated funds at Oct. 27. Exactly when the customer segregated funds were raided still is unknown.

The purpose of the DSRO is to act as the delegate of the CFTC. It investigates and reports, it doesn’t guarantee. A certified financial audit by outside auditors is still a requirement. It is not likely that an auditor will uncover a fraud except in the course of a long and thorough investigation. In the short term, a determined attempt to elude detection would likely succeed. In no event can the DSRO be considered an insurance company.

Some believe that there is an inherent conflict of interest in having an exchange acting as the DSRO for its member FCMs. As DSRO, CME has every incentive to be acutely concerned about the financial condition of the FCMs that it audits. CME is intensely interested in protecting all the member FCMs that make up the exchange as well as protecting themselves from the financial failure of any single FCM. The continued existence of the exchange depends on it.

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