MF Global: The blame game

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.

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