When segregated funds become unsegregated: The MF Global debacle

Dec 30, 2011
by DTN

MF Global appears to have violated one of the major tenets of clearing house accounting: the company transferred money from segregated customer accounts to the firm’s proprietary accounts. And since the firm declared bankruptcy, those funds have become the center of a collapse that has shaken farm country nationwide.

Two months after MF Global’s collapse, customers’ accounts are, on average, 72 percent of what they were prior to bankruptcy filings, and the estimated $1.2 billion missing from customer accounts hadn’t been recovered as of this writing. Commodity Futures Trading Commission (CFTC) Commissioner Jill Sommers said in congressional testimony they now know where it went; a day later, CFTC Commissioner Bart Chilton said they didn’t know where it went.

Even CFTC’s leaders aren’t on the same page about what happened at MF Global. Like so many other bankruptcies, MF Global’s has spawned more questions than answers.

No one has yet tallied how much money was lost on liquidated positions because farmers and elevators couldn’t find enough extra cash to meet margin requirements at the new firms to which their accounts were transferred. There’s no way to quantify how much confidence was lost in brokerages, clearing houses or the futures markets. Only time will tell how big the legal bills will be.

Here are the results of a poll on MF Global as of the time of publication.

How has the potential loss of $1.2 billion in segregated customer MF Global accounts affected your attitude toward using futures and options?

40 percent - No change, I never use futures anyway; 14 percent - No change, I will continue to trade futures as normal; 23 percent - I will still trade, but keep less money in my margin account; 20 percent - I will be less likely to use futures markets; 3 percent - My cash contract choices are changing; 0 percent - Other. The eighth-largest bankruptcy in the nation’s history is by far the most widespread one to hit farm country, almost exactly a year after Eastern Livestock Company sent out $130 million worth of bad checks and was forced into bankruptcy. And like Eastern’s bankruptcy and so many others, it’s likely to be years before everything is resolved. As DTN’s vice president of editorial, Urban Lehner, wrote in a recent column: “Following the MF Global debacle is like reading one of those telephonebook-sized Russian novels.

So many characters, such intricate strands of plot and subplot, so much to think about. It’s easy to lose your way, to dwell on secondary issues while letting the main theme, the moral of the story, slip away.”

Those subplots have kept the DTN newsroom busy for the past two months and that likely will continue. And while those subplots, such as changing regulations, creating insurance for commodity accounts or the latest hearing on Capitol Hill, have real consequences, at the end of the day, it’s important to remember that someone who is determined to break the rules will always find a way.

“But stop people from making bad decisions that have colossal consequences?

That’s as difficult in financial entanglements as it is in Russian novels.”

“There are limits to our ability to impose virtue and obliterate vice,” Lehner wrote. “There are unintended consequences to every step we take in the name of reform. As the MF Global story unfolds, as the twists and turns of the plot become clearer, we may learn lessons that will help us do better in the future. Or we may find that the best we can do is to insure against future misuses of customer funds.

“But stop people from making bad decisions that have colossal consequences? That’s as difficult in financial entanglements as it is in Russian novels.”

The biggest issue now is restoring confidence in the futures market, perhaps with the exception of those still waiting for their money. The details of who knew what when will emerge over time. Bankruptcy courts will plod forward. But right now, elevators and farmers are skeptical of a system that once had their full faith. And in a time of relatively high prices and incredible volatility, it can be argued that proper hedging has never been more important.

At the DTN Ag Summit earlier this month, Jeffrey Hainline, chairman of Advance Trading Inc. in Bloomington, IL, said lack of protection of segregated funds has raised significant doubts about hedger risk.

“What do you do with this uncertainty? How do you manage your risks? Do you stop utilizing exchange products until the ‘seg’ funds have much improved safeguards?” Hainline said.

“That would be an unrealistic thing to consider, wouldn’t it? But now, who is your counterparty? You thought it was guaranteed. Maybe that was an unrealistic view, but that was the view that the industry promoted.”

CME Group has said it won’t cover customer losses if MF Global’s bankruptcy fails to make them whole. It will use nearly all of the capital in the CME trust, $50 million funded by contributions from clearing firms, to help cover losses resulting from forced liquidations of positions, according to CME Group Chief Operating Officer Bryan Durkin. Their action alone can hardly restore confidence in a system that has a

nebulous web of regulators and self-regulators enforcing accounting laws that were supposed to be made of steel.

The Department of Justice, CFTC and other departments are investigating the collapse; criminal and civil penalties appear likely. In the meantime, lawmakers will mull laws requiring segregated funds be held by a third party, creating a form of insurance such as exists in equities markets and other regulations reform. But for those in farm country, the funds tied up in bankruptcy court will long be a source of anguish. — Katie Micik, DTN