What Happened At MF Global?

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- CME Group: How the World Advances www.cmegroup.com.

"I simply do not know where the money is, or why the accounts have not been reconciled to date. I do not know which accounts are unreconciled or whether the unreconciled accounts were or were not subject to the segregation rules. Moreover, there were an extraordinary number of transactions during MF Global\'s last few days, and I do not know, for example, whether there were operational errors at MF Global or elsewhere, or whether banks and counterparties have held onto funds that should rightfully have been returned to MF Global."

- Testimony of Jon Corzine before the House Agricultural Committee Dec. 8, 2011

In an age of heightened regulation that has witnessed rampant bank and market failure, outright fraud and more prosecutions of insider trading, one would think that the protection of customer funds would be a moot point. It wasn't. The story of MF Global, the recently failed commodity futures broker, is a telling example of a collapse with unfortunate ongoing consequences. For Jon Corzine, erstwhile Goldman Sachs chair and New Jersey politico, the undoing of MF Global marks the latest of series of undertakings with good intentions gone bad.

Spun out of Man Financial Group in 2007, in a less than remarkable initial public offering (IPO), at a time when upsets in the global financial markets were beginning to be felt, MF Global was a commodities brokerage house (futures commission merchant, FCM) offering clearing and executions services. It had ambitions to become a financial services firm on the order of a Goldman Sachs or J.P. Morgan. Blighted with a bent for aggressive, even excessive risk taking, it would seem only fitting that Jon Corzine would come to head the firm.

A substantial capital infusion from JC Flowers helped put the firm back on its feet, even if only for a short while. Himself given to risky trades while at Goldman Sachs, which he came to lead, Corzine put together a team that would share his ambitions for MF Global, yet with few naysayers on either the management team or the board. A fatal flaw in the management design and an apparent violation of the canons of enterprise risk management, was his assumption of the role of both CEO and head trader - two functions that should remain separate. The role and responsibilities of the chief risk officer (CRO) were insufficient.

The firm's undoing resulted from what many are calling a repurchase to maturity trade (RTM), whereby the firm finances its balance sheet by posting collateral to a counterparty that extends the firm credit, and then repaying the counterparty when the collateral - in this case, euro denominated sovereign debt - matures. Some, however, disagree with this interpretation of the strategy, calling the firm's transaction a total return swap, which is a form of credit risk management. In this scenario, MF Global sold protection to buyers long the underlying assets - eurozone sovereign credits - receiving both yield and capital gains from them. MF Global sold insurance and purchased price and credit default risk of what were increasingly shaky assets.

As the seller who received the total return on the reference asset, MF Global did not actually own the reference assets, but was subject to price and default risk in an off balance sheet transaction, being synthetically long the assets and their attendant risks. A drawback of the total return swap is that the underlying assets must be easily tradable, that is, liquid. Clearly, European sovereigns failed to meet this criterion. Who wanted to conduct business with a firm subject to increasing default and liquidity risk?

These circumstances ultimately scuppered the firm's salvation by Interactive Brokers in the 11th hour. The rash of credit downgrades would not exactly enhance the firm's standing. While no eurozone country has yet defaulted, the perception became the reality, as lenders to the firm issued margin calls, fearing for their own safety.

In an effort to meet its obligations, MF Global admitted to accessing what should have been separate client funds. This latter action would appear to constitute fraud, though no one has been charged, as yet, with any criminal wrongdoing.

The Bottom Line
MF Global's collapse affected not large financial institutions, but smaller clients, such as individual investors and small business clients (farmers, ranchers, financial advisors) who used commodities to diversify portfolios and hedge risk. James Giddens, the trustee, is seeking to recover all of the clients' misappropriated funds, approximately two thirds of which have been returned to date. Unlike bank deposits or brokerage accounts, futures accounts carry no backstop akin to FDIC insurance or SIPC coverage. For this reason, account segregation is deemed sacrosanct.

Finally, by the fact that there has appeared to be no systemic ripple effect, MF Global would not seem to have been too big to fail. The implications for other firms of a similar nature are not insignificant, though. There has been some talk of design of an insurance system for futures brokers along the lines of a SIPC or FDIC, as existing regulation appeared less than up to the task of protecting clients. The boondoggle visited upon MF Global casts yet another pall on the financial services profession and its trustworthiness.