Streetwise Professor

November 3, 2011

MFers Be Dipping* (Into the Customer Funds)

To put it in NavSlang: the MFers really screwed the pooch.  $600+ million in customer funds are missing.  That represents about 11 percent of the segregated customer funds.  It will be fun and games for customers to recover their money.  Matt Leising reports that customers may wait years to recover if MF Global is sued, as is almost inevitable.

New emerging details suggest that right after waving goodbye to CME auditors last week, MF started dipping into the customer kitty.  ICE states that there was no segregation breach.  Perhaps ICE was going to audit this week.

Not surprisingly, the CME and CFTC are coming under considerable criticism for the MF collapse.  One suggestion in this article by Greg Meyer is that the CME Group is lax in its oversight because MF was one of its biggest sources of order flow, thereby presenting the exchange with a conflict of interest.

I disagree with this interpretation.  I’ve written a lot about self-regulation over the years, and the theme of that research is that self-regulation is well-suited for some things because incentives are strong and well-aligned, and ill-suited in others for which incentives are weak or poorly-aligned.  Market manipulation is the main example of the latter.  (I have an article in the JLE from 1995 that examines this in detail.)  Especially for a for-profit investor owned exchange, incentives for broker oversight are stronger.  Having a broker go bust, especially as ugly as MF went bust, is not good for business because it casts doubt on the reliability of FCMs generally.   Lower confidence in the reliability of brokers and the safety of customer funds reduces the demand to trade.  Yes, MF accounted for a decent amount of order flow, but there is vigorous competition to serve that flow, and it is in CME Group’s interest that it be served by reliable and trustworthy FCMs.  There is no upside for CME from lax enforcement here, and a whole lot of downside–which it is experiencing now.

There is no such thing as perfect, error free, real time auditing.  Moreover, regulators had been pressuring MF Global for some time, so it’s not like the firm completely escaped scrutiny.  The issue is that when firms like this go down, it tends to happen very rapidly.  They are inherently fragile.  Once the run begins, it tends to end rather quickly.  In MF’s case, it lost funding when haircuts on its repo’d Eurodebt went up because of (a) the decline in market value of the debt, and (b) its rating downgrade–which was in fact in large part a response to regulatory action.  The end came in a matter of days.

Another theme is that there was a breakdown in controls at MF Global.  Uhm, controls are intended primarily to keep underlings–like the Delta One trader at UBS–in line: they aren’t designed to, and are unlikely to, stop a determined CEO from taking on excessive risk.  That’s especially true when the CEO is somebody like Corzine.  (Who is, by the way, a disgrace to my alma mater.)  It’s the board that has to keep the CEO in line, and all too often the board is like the CEO’s petting zoo.  That appears to be the case here.

One last thing.  I noted that the collapse of MF makes the CFTC look foolish not because of its failure to oversee the firm, but because of its adoption of a rule regarding clearinghouse membership that MF lobbied for very hard.   (The NY Fed also doesn’t look too swift for approving MF as a primary dealer.)  Another big supporter of the $50 million capital rule adopted by the CFTC was Jefferies Group.  Jefferies was downgraded by a non-big 3 rating agency (Egan-Jones).  The company’s stock fell about 15 percent on the news; it has since recovered on positive comments from Meredith Whitney on CNBC.  This bears watching, and again highlights the tension between the goal of making CCPs safe and allowing easy access to CCPs.

*Obscure Supersuckers reference.  A h/t to the first to decode it.

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  1. MF’ers be Trippin’. My fave from the Supersuckers.

    Comment by Blank Frank — November 3, 2011 @ 3:35 pm

  2. @streetwiseprofessor You’ll understand that there are many people outside the US with wry smiles right now. For some time, US regulators, US CCPs, FCMs et al have been preaching to those outside the US about how bullet proof the US segregation and portability provisions were and how quickly default situations could be dealt with. Likewise, Futures was held up to be the model to which OTC markets should aspire and qualms about client loss mutualisation provision were misplaced and would only result in higher costs if changed.

    Notably, CME & CFTC held out MFG as a prime example of a firm that should be an OTC clearing firm, notwithstanding its’ lack of experience in the products. MFG appeared at CFTC roundtables opining on how segregation should operate.

    Chairman Gensler was also the author of the provision in S724 of Dodd Frank that mandated that access to US CCPs or for US customers to any CCP worldwide could only be via FCMs, rather than dealers and banks, notwithstanding that few FCMs are highly rated, generally have relatively little capital and rarely have secure financing arrangement in place. Moreover, the “agency” model was supposidely far superior to the “European” model and ensured clients avoided counterparty risk with their clearing firm.

    Lastly, Chairman Gensler was both quick and keen to mock London in relation to client money issues around Lehman and blame failings by UK regulators in relation to AIG Financial products.

    At this point, once the wisecracks have subsided, non-US [and perhaps US] parties are going to have significant reservations about US arrangements
    – segregation arrangements with US CCPs appear materially flawed compared to European CCPs like Swapclear where collateral is held by the CCP to support cleared positions
    – portability is clearly not guaranteed nor is it “immediate”. Clients are struggling to find alternate clearing firms, notwithstanding that CFTC & CME were insisting that pre-determined back-up brokers were completely unnecessary under the US model. Crucially CME’s lofty claims about its portability facilities have been found wanting
    – CFTC has experienced a big default on Chairman Gensler’s watch [and by a firm run by a fellow senior Democrat]
    – The scope of permitted FCM activity is evidently not as safe/dull as may have been portrayed to non-US parties, who were repeatedly assured they were safer than banks
    – It also throws into question the model whereby US CCPs such as CME provide intra-day credit lines to FCM to allow continuous clearing, unlike LCH who insist on collateral prior to clearing, since such lines by their very nature must deplete the assets that would have otherwise been available in the risk waterfall
    – Initial margin models that operate with close out periods on Futures at one-day don’t resemble reality given positions have remained open much longer than this following a default of a member [accounts in profit don’t pose an immediate risk, but as Kim Taylor of CME pointed out at a CFTC roundtable this year any failure to pay VM constitute a default and there must be accounts in this situation]

    For avoidance of doubt, I have enormous sympathy for all the firms that have been affected by the MFG collapse, as well as for MFG staff [many of whom were former colleagues of mine] and greatly hope that matters are indeed resolved quickly without any financial loss to any of the parties.

    My other hope is that US regulators & US CCPs will be a little more humble in their dealings with the rest of the world, and be more open to exploring ideas/solutions regardless of their geographic origin. At the very least, Chairman Gensler may have to rewrite large sections of his speech templates that extol the virtues of the US Futures markets and the safety of CFTC arrangements, which he insisted was the model the rest of the world should follow. Then again, perhaps he will find some angle to claim that this proves why implementing Dodd-Frank quickly is more important than ever!

    Finally, as you highlight, in approving the capital provisions about OTC CCP membership, Chairman Gensler gushed about how may FCMs would now qualify for membership of CCPs under this important “open access” provision, ignoring the representations of international regulators such as the UK FSA about the risk such arrangements may pose for CCPs. Perhaps this episode will cause many end-users to reflect on the importance of their clearing firms having liquidity and capital, thereby steering away from smaller firms regardless of the CFTC provisions.

    Comment by John Wilson — November 3, 2011 @ 4:26 pm

  3. To echo Mr. Wilson, all the above is certainly true – a little (?) humility is in order. thisis also going to be a tremendous boost to firms like State Street, BNY Mellon and others entering the field – at least they (or the Fed) have deep pockets. Size will matter.

    Comment by Sotos — November 3, 2011 @ 6:22 pm

  4. Make Corzine spend $12,000,000 defending himself. CME and locals should go after rest of MFer board IMHO.

    Comment by Reyray — November 3, 2011 @ 6:38 pm

  5. @Blank Frank–good call, good taste.

    @John–meaty comment. More later. Suffice it to say, that there is plenty of schadenfreud to go around.

    @Reyray–it probably is going to happen.

    The ProfessorComment by The Professor — November 3, 2011 @ 8:37 pm

  6. SP, any thoughts as to how clients of MF London, with claims on London seg (and non seg for that matter) funds, stand? Especially given the FSA’s insistance that the ‘SAR’ regime should mean rapid access to funds?

    Comment by TJ — November 4, 2011 @ 8:37 am

  7. I actually think it is quite good for a man who reaches retirement age, as Corzine has, to find a brand new activity or hobby with which to occupy his twilight years.

    Getting your ass royally sued off and avoiding jail for the rest of your life aren’t choices many people would choose, however.

    Is Skilling out yet?

    Comment by Green as Grass — November 4, 2011 @ 11:01 am

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