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.
What to blame
FCM/BD
Some criticism has been directed toward the MF Global corporate structure. MF Global was both a broker-dealer and an FCM in a single corporate entity. It is clear that in the bankruptcy process this has been a point of confusion. MF Global was 90% an FCM and yet we have the bankruptcy process being directed by SIPA, a securities act. Not only is there a lack of experience and understanding of the futures industry, but there is also a delay in expediting the bankruptcy proceeding. The separation of the FCM and the broker-dealer into separate entities would not have prevented the transfer of funds between the entities, but it may have made the bankruptcy filing into a cleaner, quicker proceeding.
There is a separate Trustee for the MF Global Holdings, Ltd. bankruptcy, the parent of MF Global, the FCM. That Trustee has taken the position that the CFTC regulations on bankruptcy, Part 190, are not applicable to the SIPA bankruptcy proceedings. The CFTC has filed a brief in opposition to the Trustee and is arguing for the commodity customer protections that are included in Part 190.The court has yet to rule.
Proprietary trading
There has been a great deal of concern about the fact that MF Global was involved in proprietary trading. It is believed that the losses incurred on the proprietary side resulted in the improper use of customer segregated funds. That is the issue that is currently being investigated, and it is thought that forbidding FCMs from engaging in proprietary trading might be a solution. Currently this is being discussed under the so-called Volcker rule, which is being applied to banking entities (and their affiliates). The Volcker rule would prohibit short-term proprietary trading except to U.S. Government and government agency obligations, as well as state and municipal obligations. Market making, underwriting and hedging would still be permitted under the Volcker rule.
Insurance
It has been suggested that the creation of an insurance fund similar to SIPC would help restore faith in the futures industry. There are many problems with this approach. I could envision a situation where FCMs compete for customers by offering ever higher returns on an insured account balance. FCM’s might feel compelled to take greater risks with segregated funds to generate the competitive returns. Presumably the development of an insurance fund would be funded by a transaction assessment. Currently the NFA assesses two cents per side and generates revenue of approximately $40 million a year. At that rate, a similar insurance assessment, would take 30 years to build up a fund large enough to cover the losses anticipated from MF Global. In addition futures accounts often are of very large size and while $250,000 (the SIPC limit) may be adequate for most retail securities customers, it would not be sufficient with regard to most institutional futures customers.
Segregation-fellow customer risk
All customer segregated funds are commingled with other customer segregated funds at the firm level. In theory, the funds of one customer are at risk to the losses of another customer. Recently the CFTC ruled on protection for the collateral for “cleared swaps.” The rules that have been proposed would insulate customer collateral from the losses of other customers. While this may become the rule for cleared swaps, it is not the rule for futures customer funds. There is some support, however, for extending this type of protection to futures customers’ segregated funds.
Segregation-types of investment
A great deal of concern has been expressed over the fact that MF Global invested proprietary funds in foreign sovereign debt. Pursuant to CFTC Reg. 1.25, even sovereign debt was an acceptable investment for customer segregated funds. Recently the CFTC moved to revise the eligible investments for segregated funds. The new rules allow investments only in U.S. Government or municipal paper, CDs, money market funds and certain corporate paper that is government guaranteed. Foreign sovereign debt is no longer acceptable for customer segregated funds.
Generally, money market funds are considered among the safest of investments. It should be noted, however, that in 2008 the Reserve Fund, a money market fund, “broke the buck” meaning that the net asset value declined to less than $1. At that point, the Reserve Fund was no longer considered good collateral. That caused a daisy chain effect of failures throughout the financial system. There was also the failure of the Sentinel Fund, which operated various funds under the auspices of CME’s IEF program. The funds in CME’s IEF program are considered safe investments and eligible for exchange collateral. The Sentinel investors and creditors are still in bankruptcy litigation and considerable losses were suffered by the FCM's who were involved. It is thought that some of the segregation and bankruptcy case law resulting from the Sentinel case may be applicable to the MF Global bankruptcy.
Segregation/commingling
17 CFR 1.20 - Customer funds to be segregated and separately accounted for…
c) Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person, or be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held.
Although the regulations specifically outlaw the commingling of customer property with that of the futures commission merchant, the reality is somewhat different. It is industry practice to comingle FCM property with customer segregated funds. The FCM's proprietary funds that are included in the customer segregated account are known as “excess segregated funds” and the process of adding them to the customer segregated account is known as “topping off.” In theory, customer segregated funds should never be permitted to be in deficit and the proprietary excess segregated funds added by the FCM are intended to prevent a deficit from ever occurring
When a transferee, be it a bank or a broker, receives funds from a customer segregated account, he has no way of telling whether or not these funds represent excess segregated funds belonging to the FCM, or customer segregated funds belonging to the customers. This issue arose in the MF Global situation, where JP Morgan apparently received a wire transfer from an MF Global customer segregated account and asked for confirmation that the funds involved were not customer segregated funds. JP Morgan was apparently concerned that customer segregated funds were being applied to a proprietary MF Global debt.
Possible solution
The Commodity Customer Coalition (CCC), founded by James Koutoulas and John Roe, intervened in the MF Global bankruptcy on behalf of the 8,000 customers who have joined the CCC. A legal theory proposed by the CCC is that customer segregated funds retain their special character in the hands of any transferee such as JP Morgan.
“The CCC is asking the court to order what the law requires: That the segregation protection of commodity customer funds travels with those funds as the FCM moves them throughout its organization. The Trustee has an obligation to trace customer funds wherever they travelled and claw them back to the estate of MF Global, or sue the entity who accepted them to recover them, so he may distribute those funds to customers.”
If this is not the current state of the law, it should be, and the Commodity Exchange Act and the Bankruptcy laws should be amended to make this an absolute protection for customer segregated funds. Anyone accepting customer segregated funds should be on notice that there is an obligation attached to these funds. I would take the matter one step further and require that any transfer of proprietary “excess segregated funds” must be made to a proprietary account first before any subsequent transfer. Proprietary funds should only be transferred to a third party proprietary account from a proprietary account. That way, if customer funds were ever wrongfully depleted, it would be easy to trace them. Further, any transferee of customer segregated funds would be on notice of the special character accorded segregated funds and act appropriately.
Conclusion
The Enron bankruptcy was not the result of a failed energy industry; it was the result of a criminal conspiracy. The Madoff bankruptcy was not the result of a failed hedge fund industry; it was the result of a criminal conspiracy. The MF Global bankruptcy is not the result of a failed futures industry; it is the result of criminal activity on the part of senior staff at MF Global. It is misguided to place the blame on anyone but the officers of MF Global. Someone at some point in time decided to raid the customer segregated account. Everything that has happened since is a result of that decision.
It is inevitable that there will be more legislation as a result of MF Global. My hope is that the treatment of customer segregated funds mentioned above, will be included among the laws that are adopted. It also is my hope that the laws that are proposed will not be so severe as to drive the non-bank FCMs from the futures industry. Over the past four years we have witnessed the failure of Bear Stearns, Lehman Brothers and now MF Global. The problems always seem to lie with the “big” firms. Now that there is an industry in crisis, the remaining big firms are nowhere to be found. You won’t find Goldman Sachs or JP Morgan among those firms that assisted the MF Global customers. No, it was the smaller FCMs such as RJ O’Brien, Dorman, Penson and Rosenthal Collins Group that stepped up to the plate and accepted a bulk transfer from the Bankruptcy Trustee. I hope that our regulators think long and hard about who stood up for our industry when it is time to adopt additional regulations.
Marc Nagel is Chief Operating Officer of Dorman Trading, LLC. He can be reached at: mn@dormantrading.com.
