The MF Global debacle rocked the futures industry and its full impact is yet to be felt. We talked to some industry veterans regarding the fallout of MF Global in the industry and its regulatory processes. Here is what they had to say.
Futures Magazine: How has the MF Global failure and the bankruptcy process impacted the futures industry?
Chris Hehmeyer: The biggest impact is that these problems have been like a baseball bat across the side of the head to the entire industry as to the risks of a [futures commission merchant (FCM)] bankruptcy. People understand these rules better [now] than anybody did in the industry previously. Unfortunately we had to learn all this the hard way. Many people in the industry didn’t understand the laws around bankruptcies of FCMs. Because of our fantastic history with so few problems, the risks were underestimated. The risk of FCMs is greater than what had been understood previously. The biggest impact is that people now understand the risk better than before. The salesmen downplayed the risks because there had been so few instances of problems.
Fred Grede: It is difficult to quantitatively measure the impact on the futures industry from the MF Global fallout. How can you measure a loss of confidence in your business? Certainly industry volume is down over last year, but much of that decrease also can be attributable to market conditions. One of the measures I look at is funds held in segregation. According to [Commodity Futures Trading Commission (CFTC)] data, customer funds held in segregation are down about 10% over last year.
Subjectively, I believe the MF Global bankruptcy has had a huge impact on the industry. I have had countless calls from former traders and customers who want to understand the bankruptcy process, and of course, when they will get their money back.
More often than not, they don’t like what I have to tell them. But I also have had calls from all over the world. As an example, I had a call from a Ukrainian agricultural cooperative that got stuck in the MF Global bankruptcy. They can’t understand what happened and why they can’t get their money back quickly.
As a result, they are looking for other venues in which to do business.
Customers can understand market volatility, and are willing to accept gains as well as losses from market movement. But they can’t accept losses when someone else breaks the rules.
As far as the bankruptcy process is concerned, all of us in the futures industry have received a very rude awakening; that is, customer funds don’t have the priority we all thought they did in the bankruptcy process.
Philip McBride Johnson: Unlike the later PFGBest episode, MF Global’s loss of an estimated $1.6 billion in “segregated” customer funds may turn out to be an internal management goof. But that is hardly consoling because we fragile human beings are more likely to make mistakes than to deliberately raid other peoples’ money. If a mature FCM like MF Global can mess up under stress, it could happen at any broker regardless of past successes. This is the message that futures customers have received and that the industry must somehow address.
We do not have the luxury of knowing that large futures customers like hedgers on the Fortune 500 list have nowhere else to go. Even under the Dodd-Frank Act, they are free to hedge using private swap agreements instead of exchange-traded and cleared futures contracts. Will they do so?
FM: What has been/will be the impact to the regulatory structure?
Hehmeyer: People have come to a realization as to how all this stuff works. There is good and bad to that. In some ways [the regulatory impact] remains to be seen. The things that need the most attention are the bankruptcy laws, particularly with regard to joint FCM/broker-dealers. It will take huge efforts to change something like bankruptcy laws surrounding a failed FCM. I can only hope that the impact on decision makers is great enough to cause action, because there are things that need to be changed.
The vast majority of seg funds are very, very safe. People are more focused on what the risks really are than in the past and that is a small silver lining. The issue of the customer money being unequivocally in front of any other creditors obviously needs to be clarified. The situation of two trustees arguing over whether the creditors are in front of the customers or not speaks for itself — it needs to be clarified. The whole idea is that the customer money goes to the customers first and then the creditors argue over what is left. That needs to be one of the issues addressed.
Grede: I doubt that we will see any impact on the regulatory structure, perhaps some new rules or some changes in procedures. But all of our regulators, the CFTC, [Securities and Exchange Commission], [National Futures Association] and designated self-regulatory organizations do a very good job.
I don’t see a better system out there.
Johnson: On these pages within a few days after the MF Global revelation, I suggested a structural “fix” that would place all customer funds with a separate, CFTC-regulated central repository that conducts no other lines of business. Understandably, the industry looked for less dramatic changes such as heightened surveillance and enhanced auditing. The question is whether such measures — which leave customer funds at risk of future losses because of broker error (remember, MF Global collapsed over a long weekend and shortly after an audit by the CME Group) — will restore customer confidence and avoid a flight to other venues.
FM: What does the industry need to do to return customer trust to the process of segregated funds?
Hehmeyer: It needs to clarify the sanctity of customer segregated funds in the rules and regulations of the Commodity Exchange Act and (CEA) the bankruptcy laws. That is not easy but it really needs to happen.
Grede: I’ve been a big believer in the system of customer fund segregation throughout my career. But, I have unfortunately found that once we are beyond the parameters of CFTC jurisdiction, other rules and laws seem to interfere with the traditions of the futures industry. Customers are not as well protected in the bankruptcy process as they thought they were.
The time has come for the futures industry in the United States to create a customer protection fund. I know all the arguments against it as far as imposing additional costs on an already struggling industry. But the costs of not doing anything are far greater than the cost of restoring confidence in the futures business.
Johnson: The ultimate fallout from MF Global is yet to be seen. Maybe it will fade into a distant memory, an aberration that rarely occurs. Or, it could loom large, especially with corporations and pension funds where “fiduciary duty” will not allow the danger to be ignored. Absent a change in the custodianship of customer funds, we only can wait and worry.
Ron Filler: The recent MF Global bankruptcy has raised a number of regulatory issues that the industry as a whole, both domestically and globally, must address and resolve. One of the most fundamental protections underlying the CEA and related CFTC regulations involves customer assets. It is of critical importance that the global regulatory framework provide the greatest customer asset protections.
Chris Hehmeyer is a 35-year industry veteran who currently is serving as the non-executive chairman of the board of the National Futures Association.
Fred Grede currently is serving as bankruptcy trustee to Sentinel Management Group. Formerly, he was chief executive at the Hong Kong Exchange (HKEx) and executive vice president at the Chicago Board of Trade.
Philip McBride Johnson is a former chairman of the Commodity Futures Trading Commission (1981-1983) whose name is part of the 1981 Shad-Johnson Accord. After serving in government, Johnson practiced law with Skadden Arps, retiring in 2010.
Ron Filler is director, Center on Financial Services Law at New York Law School. Filler previously was the managing director in the Capital Markets Prime Services Division at Lehman Brothers. He has spoken at hundreds of industry conferences and seminars during his more than 30 years in the futures and derivatives legal fields and has taught several different courses as an adjunct professor of law.