To say the MF Global situation is a mess may be the understatement of the century. What began as an excuse to extol the segregated account’s safeguards against an FCM stock slide as MF Global shares lost 70% of their value in a week rapidly morphed into a full-fledged industry disaster as bankruptcy papers were filed and executives acknowledged a shortfall in those previously sacrosanct accounts.

This admission, in conjunction with the bankruptcy, has caused over $5 Billion of customer funds held by MF Global to be frozen, unable to be accessed or transferred out.  Right on cue, the lawyers have begun to circle, with employees, bondholders, and the customers themselves filing claims for their piece of the $40 Billion in Assets MF Global reportedly had on hand.

What was a very small probability just two weeks ago now looks to be a near certainty – that over 150,000 futures industry customers who held accounts at MF Global will have their money locked up for anywhere between several months to several years. Before a single penny can be distributed, a legal team charging $1,000 an hour will have to go line by line through books that have been described by regulators as a “disaster,” making the potential (and incentive) for a speedy turnaround non-existent. Even then, once the books have been closed on the accounting side, the legal battle royale begins, and if the Sentinel case is any indication, we’ll be waiting for quite a while to run through all the cases,

My firm, Attain Capital, uncomfortable with the direction MF Global was taking, moved all of its accounts from MF Global 2.5 years ago. Even with that foresight, we have had clients close their accounts in the MF Global aftermath because they are worried about the safety of their segregated funds, while many others heatedly question what the industry is going to do to make sure this never happens again.

While the lawyers fight with JP Morgan over who should get what money (how would you feel about being a taxpayer who bailed out the big banks only to have them get priority over your money in bankruptcy?), the rest of the industry needs to be talking about how to salvage our collective business.

Many of you may be feeling lucky you didn’t have exposure to MF Global, or even enjoying an uptick in business because of the MF Global accounts being transferred to you, and that’s understandable. However, that joy becomes short-lived as one realizes that this mess threatens the continued growth of not only your firm, but our entire industry.  Brokers, CTAs, service providers, technology companies, and more will all go out of business because of this – some immediately because they won’t get their most recent payments due from MF Global, and others over the next several months as their business falls due to their client base’s inability to access the funds held at MF Global that they need to trade.

But the biggest threat is to the future. It’s that large investor who would have happily opened a futures account just a month ago, but now chooses not to because he is unsure what would happen to his funds should a bankruptcy occur at his broker of choice.

How do we make sure that such an investor regains confidence in the industry, and chooses to go ahead with that investment? The hollow emails by FCM presidents and owners to their clients saying they care is simply not enough; actual solutions and fixes to the problems which allowed the MF Global mess to happen need to be enacted.

The industry needs to change to protect that which was formerly held most dear – the segregated account. Here is what we propose:

Create a coalition to make all the MF Global customers whole, immediately.

There are billions of dollars of profits between the exchanges, brokerage firms which just received free business from the MF Global demise, and others in the industry.  Someone (ahem… CME)  needs to step up and create a coalition of these industry giants and pony up the money to make each and every one of the MF Global accounts whole, immediately.

If the government didn’t think that MF Global was too big to fail, the industry surely needs to. Do you think the CME put forth their $250 million guarantee or $50 million recovery fund out of the kindness of their hearts? No- they are worried about volumes, and rightfully so. With about $5 Billion worth of customers now unable to trade, the sooner those customers can pump those funds back into the markets, the better for the CME’s bottom line.

How is this supposed to work? We’re not saying this coalition needs to pony up the money and never get repaid. We’re saying they should step in and cover the money until the bankruptcy runs its course and the funds are released.  Why can’t the industry put together a fund which covers the customer segregated funds, and in exchange for making the customer whole, the customer signs over any claim they had to their money in bankruptcy court to the fund?

Think of it more as fronting the money. After all, nearly all agree that it is just 10% or so of the money which is missing.  At worst, the fund would be out the $600 million in missing segregated funds (and that’s only if the trustee is unable to get any of the $41 Billion in MF Global assets to cover that shortfall). The problem here is less about there being no money than it is about the money being frozen up.

The industry simply can’t afford to wait for the bankruptcy to run its course. Every moment of inaction that passes is a moment without those funds coursing through the industry’s veins. Consider that MF Global reported in its Q2 financials that it cleared 575 million contracts over the three months that ended June 30^th, 2011.  If  the exchanges are getting $0.25 per contract, without taking action, that’s about $575 million in lost revenues per year. If the brokers who just received the accounts could get $0.25 per contract on the business moved to them, that’s $575 million in new revenue for them (assuming those accounts can get back trading).

There is plenty of money to go around, especially in the name of saving what has been the cornerstone of this industry since its inception- the sanctity of the segregated account. Hell, Attain will even pony up our share. Without taking this step, there is little any of us can do to help our clients feel secure. Industry participants will likely be worried about setting a precedent, but that is, in fact, the whole point. We need to be able to point to this time in our industry’s history and say, “Yes, it was ugly, but the industry stepped in and made the accounts whole.”

If you’re still not on board, why not backstop the coalition fund with a rule granting the ability to increase NFA fees from the current $0.02 per trade to $0.03 to cover any shortfall the fund has to cover? And as a final brushstroke, how about making the coalition member’s investments in the fund count 100% towards their net capital computations, treating it like cash in the bank?

The choice is a known cost in a temporary, defined and shared burden or an unknown cost in an inequitable and unquantifiable loss of business in the long run. How’s that for risk calculation?

Preventative Measures

While this may put out the fires in the short-term, at the end of the day, there’s still much more work to be done. It’s not enough to simply react; we need to be proactive about preventing this from ever occurring again. How? We’re glad you asked.

1. Extend SIPC protection to futures investors. When it came to light that the SIPC was rapidly moving to ensure that all claims to the assets of MF Global were resolved, the initial reaction of many industry participants was to breathe a sigh of relief. However, as many soon found out, SIPC protection is currently only offered to securities customers- meaning only those trading stocks and bonds would be covered, and not our beloved exchange traded futures investors. In our minds, there is zero reason why investors in traditional asset classes should be afforded such protection while investors in the alternative space are not.

As such, we propose that regulations governing the SIPC be amended to ensure protection of futures clients’ holdings as well, with guarantees on the individual account level (the sub-account of the customer segregated account on the FCM’s books) and not just the main overall account level containing all of the customer funds.

The CME and ICE should cut 10% off their marketing budget and put that to lobbying Congress for this protection. This isn’t 1970, when stocks and bonds were the only game in town. If the world turns to the CME to manage risk, the CME needs to turn to Congress to lower the risk of managing that risk.

2. Amend CFTC rule 1-25 to limit segregated funds investment to US Treasuries only. One of the issues that’s gotten a lot of press since the shortfall in funds at MF Global went public is the idea that Corzine might have used those funds to finance his European bets. There’s no proof of this yet, but the concept alone rattled many. The general belief was that FCMs could not, under any circumstances, touch segregated funds.

That’s not true. Under 1-25, FCMs are allowed to gain interest on excess segregated funds through specific investments under explicitly outlined circumstances. There are three limitations that really matter here: preservation of capital, preservation of liquidity, and adherence to risk standards.

Under the rule, FCMs can invest in 6 different vehicles (U.S. treasuries, state bonds, government agencies, commercial paper, corporate notes or bonds, sovereign debt, and money market mutual funds), but, with the exception of U.S. Treasuries or money markets, these vehicles have to have the highest rating possible from one of the NRSROs- or, official ratings agencies. This means that, technically speaking, the allegations flying around that FCMs may legally use segregated funds to invest in high-risk junk bonds are utterly incorrect. That being said, we’re still not satisfied with the requirements.

If we learned anything from 2008, it is that ratings agencies were doling out the highest ratings possible on toxic mortgage-backed securities right up to the point that things blew up. In fact, the rating agencies even downgraded MF Global…wait for it…. after they went bankrupt.  Our trust in their ability to assess risk adequately enough to ensure the preservation of segregated client funds is nil. As such, our recommendation is that 1-25 be amended to prohibit investment of segregated account funds in anything but U.S. Treasuries. While a statement issued today by CFTC Commissioner Scott O’Malia pointed out that we do not know the root cause of the missing funds, and that it’s possible the missing funds have nothing to do with investments permitted under 1-25, in our minds, this changes nothing; this rule needs to be altered regardless of the MF Global investigation’s conclusions.

3.  Establish regulation under which language must be added to all creditor agreements for any registered FCM in which those creditors agree to the assignment of the customer segregated accounts as the primary lien holder on all assets of the company. Under current provisions, segregated accounts are given what is, in our minds, inadequate protection during the bankruptcy process. True, their accounts cannot be tapped to meet outstanding financial obligations of the bankrupted FCM, but there’s also no guarantee of those funds being made whole in the event of a shortfall, nor protection from a too big to fail bank like JP Morgan sending in armies of attorneys arguing that their claim should take precedence over the customers.  While clients may, after a pro-rata distribution, file a claim with the Trustee in an attempt to get their missing money back, it appears that there are back door methods for big creditors like JP Morgan Chase and those who held MF Global bonds to get in front of the customers in the claims process. As TheStreet summarized:

“The group of customers, led by James Koutalas, chief executive of a Chicago-based commodities trading firm, are taking issue with a lien and other protections offered to JPMorgan in exchange for a $8 million loan the bank extended to MF on the first day of its bankruptcy, according to the report. That would allow JPMorgan the right to some assets over other creditors.”

In our minds, segregated account holders should absolutely come first in the claims process. Unlike the creditors and bold holders, who knowingly accepted the risk of default when they handed over their money, MF Global clients were paying MF Global to hold their funds- not lose them. With this in mind, we believe that the law must designate segregated accounts as the primary creditor if an FCM goes belly up, ensuring that, should there be a shortfall in client segregated funds, available assets of the bankrupt FCM will be tapped to make those accounts whole before any other creditor gets their day in court.

You can be sure that the big creditors would take an immediate and very big interest in insuring that any FCM they lend money to has the adequate procedures and safeguards in place to protect customer funds knowing that they are second in line behind said customer funds. If you can’t rely on morality to protect the funds, rely on greed and the invisible hand of those who would stand to lose money should the customer segregated funds be breached.

4. Establish regulation outlining standard operating procedures in the wake of an FCM bankruptcy. Part of the reason that the MF Global situation has been so chaotic was the result of poor planning. Positions were stuck in limbo. There was no infrastructure for facilitating an orderly transfer of accounts, which led to an ad-hoc distribution among arbitrarily selected FCMs without the transfer of legal documents- including those necessary for a CTA to trade on behalf of a client. Without any stipulations regarding timeframe, the process was drawn out to the detriment of all parties involved. Add to that a failure to effectively communicate what was going on to the clients involved, and it’s no wonder the situation turned into the nightmare it did.

In the wake of both the Refco and Sentinel scandals, one would think that remedies would already have been put into place for such administrative Bermuda Triangles, but unfortunately, that did not occur. In order to prevent such a disorderly dissemination from occurring again, we suggest that new regulations be developed; outlining exactly what is to happen in the event of an FCM going bankrupt. The old plan seemed to be, wait for a suitor to step up and take on all of the accounts. That clearly worked out wonderfully this time around. Coming up with standard operating procedures outlining the immediate impact on open positions, where the client funds are to be transferred to and within what timeframe, and so forth would help avoid the confusion we’ve seen to date.

A Call to Action

We are not about to claim that we have all the answers. Have we researched these subjects? Yes. Have we consulted with others in the industry? Absolutely. Does that mean that the solutions proposed here are perfect? NO.

But someone needs to start the dialog. The CME has made a nice first step with its $250 million guarantee to the trustee. The efforts of Koutoulas and Roe to provide a voice for the clients in the bankruptcy proceedings are certainly admirable. But at the end of the day, we all know that there is a long road ahead of us. Laws need to be changed and rules rewritten.  The industry needs to step up and reclaim its image. At the end of the day, perception is all that matters. If this situation is not resolved effectively, every CTA, FCM, CPO, Commodity Broker, Introducing Broker and Exchange will lose a sizable amount of business. There’s no getting around it. People aren’t going to invest in something where they don’t feel secure.

Make no mistake- these are extraordinary times we face, and they require an extraordinary communal effort to be survived. Despite the challenges on the horizon, we have no doubt that, in one way or another, this industry will rise to the occasion.  Because as important as it may be to understand what’s transpired and what’s at risk here, what comes next matters even more.

Sincerely,

JEFF MALEC
CAIA  |  CEO, FOUNDING PARTNER
ATTAIN CAPITAL MANAGEMENT, LLC.

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Reuters Breakingviews columnists break down how the Dodd-Frank financial regulatory reform legislation still wouldn’t have caught problems at a smaller firm like MF Global.

“Clearly MF Global is not going to be considered a systemically important institution, so those rules … even those rules are very sketchy in terms of what they do that’s new,” said columnist Reynolds Holding. (more…)

Traditionally staid and conservative firm seeks buyers as concentrated bets in European Sovereign debt markets go badly wrong

Opinion:

In an episode of art imitating life, the movie Margin Call depicts a financial services firm that concentrated all its risk in one sweeping bet that went badly wrong. In the case of the movie, the trade that exploded in the debt markets of 2008 forced a financial services firm to liquidate assets in an attempt at survival. Fast forward to October 2011, and MF Global, one of the industry’s leading Futures Commission Merchants (FCM), is struggling for survival as it receives a real life margin call. As of this writing the New York Fed suspended conducting business with the firm and more significantly the CME Group has cut off trading access to the firm.

The eighth ranked FCM in 2010 with $8.6 billion under management, MF Global was, like many futures brokerage firms, following staid and conservative management principles that generally didn’t gamble company assets through proprietary trading. (In 2008 when a rogue Wheat trader made headlines by racking up $145 million in losses, such unauthorized trading wasn’t part of the firm’s management plan.)

Things changed rather dramatically during spring of 2010. This is when a gambler took the reins of power. As a result, the company is currently scrambling for liquidity to raise cash while its leader, former Goldman Sachs superstar Jon Corzine, might be looking at the numbers to figure out what went so very wrong. This might be similar to 1994 when Mr. Corzine was co-lead of Goldman’s fixed income group when it posted losses that almost took down the investment bank. But upon reflection, it looks more like the 2008 car wreck then NJ Governor Corzne was in while speeding down the expressway without a seat belt.

What Went Wrong?

With a University of Chicago background, a school known for producing strong quantitative minds, Mr. Corzine really needs to look no further than another U of C alumnus, Nobel Prize winner Harry Markowitz, to figure out why things went so bad so quickly.

As MF Global, one of the leading brand names in the futures and options industry, fights for oxygen and liquidity, Mr. Corzine’s significant concentration of risk towards a single market move in Sovereign debt highlights what is known as investment concentration. This means all risk in a portfolio might be influenced by one significant macro global force. In this case, when the credit markets in Spain, Portugal and Ireland logically fell apart without significant austerity measures in place, the bond investments and the fortunes of MF Global all lost value at the same time. This investment concept stands in contrast to Markowitz, whose Modern Portfolio Theory promoted the concept of asset diversification of returns streams, a cornerstone of proper derivatives risk management. Mr. Corzine might have missed that diversification memo.

There are several points of derivatives risk management Mr. Corzine and his well connected crew have ignored. Perhaps the most significant also was related to a debt issue. While at Goldman Sachs, Mr. Corzine and those designing non-transparent derivative products were witness to a warning from a demure female with a powerfully strong will: Brooksley Born.

Ms. Born was CFTC Chairwomen when, in 1998, she sounded alarm bells regarding non-transparent and toxic derivative products that were not managed in accordance with open, transparent and regulated rules that existed in the exchange traded derivatives markets. While she and her prophetic call for transparency into toxic assets were generally ignored – and she was effectively muzzled by a “Working Group” in Washington D.C. that existed of the likes of Alan Greenspan, Larry Summers and former Goldman alumni Robert Rubin and Timothy Geithner – Ms. Born eventually resigned office on June 1, 1999. The toxic assets to which Ms. Born’s warnings were targeted famously exploded in fall of 2008. Ms. Born, her ignored warnings now vindicated, nonetheless keeps professionally quiet on the topic, letting facts speak for themselves.

The History of a Debt Crisis

After losing re-election as Governor of New Jersey in 2009, Mr. Corzine set his sights on making his mark in the derivatives world again when he replaced former Chicago Board of Trade president Bernard Dan as CEO of MF Global on March 23, 2010. While his results at MF Global were similar to his re-election attempt, Mr. Corzine made a different choice in the derivatives markets this time around. Instead of non-transparent off-exchange mortgage derivatives, Mr. Corzine chose the regulated derivatives industry when he took the reins at an FCM that had deep historic roots tracing its roots dating back to 1783 when English commodity trader James Man founded the firm. Little did anyone know at the time MF Global, long considered an industry icon of sorts, was now on a path to being sold off in bits and pieces in a fire sale to the highest bidder.

Upon taking control at MF Global, Mr. Corzine had two choices: he could gamble, rolling the dice on a heavy concentration to Sovereign debt, or he could have chosen the path of popularizing a defensive investment portfolio that includes a diversity of returns streams – a concept championed by a host of academic thinkers and investment practitioners. Mr. Corzine’s choice speaks to a lost opportunity at this moment in economic history.

In choosing to gamble with Sovereign debt assets over focus on integrating uncorrelated investments into traditional stock and bond portfolios, Mr. Corzine wasn’t looking to the future, which is unfortunate. Upon taking over MF Global, he quickly stated his long term vision was one of logical asset management, transforming the FCM into the next big thing on Wall Street. This gave those in the managed futures industry reason to cheer. In the end, however, he couldn’t overcome his past where significant risks were taken – some that worked, some that didn’t. The difference between Goldman Sachs and Corzine’s MF Global is that Goldman often takes the both sides of trades – as they did in the mortgage derivatives crisis. At least they embrace the concept of diversification of risk and returns streams. Mr. Corzine’s concentration concept just didn’t work out.

“You shouldn’t risk more than you can lose,” noted veteran industry observer John Lothian. “This goes for traders as well as brokerage firms.”

What’s interesting here, the overlooked component is that Mr. Corzine gambled from within the futures industry which is known for “gambling.” However, the opportunity Mr. Corzine missed is the industry is really based on risk management and hedging, not raw speculation. The growing futures industry movement is away from raw gun-slinging speculation, to embracing logical asset management with an investment generally uncorrelated to the stock market through managed futures. It is an industry increasingly looking like an insurance company with probability tables and less like that represented by the Wild West and a gun slinger attitude of investment concentration. Unfortunately Mr. Corzine chose making his highly concentrated leveraged bets in Sovereign debt markets rather than expanding the concept of uncorrelated investments.

It’s in the uncorrelated investing concept that many on Wall Street seem to have problems. Perhaps it was the message about an investment that operates independent of economic strength that just didn’t jive with Mr. Corzine? Or it could have been the industry concept of account segregation and transparency where he might have missed the derivatives management memo? Clearly the defensive concept of true diversification didn’t resonate.

There is a movement in the futures and options industry away from the cowboy speculator and towards a logical and risk-focused investment. This is the direction many had hoped Mr. Corzine would take MF Global, the brokerage firm once considered industry legend. But that, apparently, isn’t going to happen.

As Mr. Corzine and Company are managing their margin call, liquidity drying up all around them, the opportunity to expand the concept of diversification with investments uncorrelated to the performance of the stock market might have received a temporary set-back. However, as a looming US government debt crisis that won’t go away easily becomes better understood by those including Mr. Corzine, the concept of true asset diversification is something that should not be ignored at this moment in economic history.

Mark H. Melin is currently writing his fourth book on uncorrelated investing.  He is previous author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and an adjunct instructor in managed futures at Northwestern University.  He can be reached at markhmelin@yahoo.com

Contents of this article Copyright (C) 2011 Mark H. Melin.

Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors.  Past performance is not indicative of future results.

The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.

Keefe, Bruyette and Woods’ analyst Brian Gardner says complying with the new Volcker rule will be a bigger headache for banks than lost revenue from banning proprietary trading.

“Banks have never really disclosed with great specificity exactly what prop trading is and what percentage of their business is involved,” Gardner says. “The GAO did a study that came out several months ago, and they looked at the losses and profits over, I think it was a four-year period, and for the major banks, if you look at the numbers, they were not that large. I mean, they were, you know, we’re talking about billions of dollars in profits over a multi-quarter period spread over several banks. So my guess is, and I’m not a fundamental analyst, but sitting from a policy chair my guess is that the impact on the business models is not going to be as great as people have feared.” (more…)

Bernard Madoff whistle-blower Harry Markopolos says the Securities and Exchange Commission has come a long way in the past 2 1/2 years, but still needs to improve regulating industries such as munis, derivatives and fixed income.

“The SEC has sent its staff away to become trained fraud investigators,” Markopolos says. “I believe they have almost 800 certified fraud examiners on staff. They’re making rapid progress in training their staff on how to conduct proper investigations, where before that was totally missing within the agency.” (more…)

The United Kingdom’s ÂŁ3.9 trillion asset management industry faces a wave of regulation that could have a far-reaching effect on investor returns, says Richard Saunders, chief executive of the Investment Management Association.

“The regulators, the G20, the European regulators are currently re-making the world after the credit crisis,” Saunders says. “And we are facing … for example, the industry is gonna have to deal with, in the next eight months, 17 different European directives which will impact its work directly.” (more…)

Elected members of the United States Congress managed to beat the stock market. Reuters Breakingviews columnists Reynolds Holding and Richard Beales weigh on reasons for the outperformance, including a lack of regulation of their trading activities.

“Well, it is just like insider trading,” Holding says. “It is inside information. But that’s the interesting thing. The government has been hands-off on this, and this is because they claim, look, these senators … and representatives, they don’t have a duty to anyone not to trade, to disclose this information. So it’s not illegal for them to have this information about a bill that’s coming up….” (more…)

Richard Ketchum, the chief executive of the Financial Industry Regulatory Authority, or FINRA, tells Reuters’ Joseph Giannone that he sees “no higher priority” than ensuring market integrity by working against insider trading and says safeguards against another “flash crash” will limit extreme volatility. We have a story about it at HedgeWorld.com.

“I think the steps that have been taken, with the help of the SEC and CFTC, provide a better environment with the existence of single stock circuit breakers, with identifying restrictions and a variety of things that really created too much risk before,” Ketchum says. “We’re not in a perfect place from a market standpoint. Electronic markets are different. We’re all going to have to learn how to regulate with them. But I think investors should feel much better about the risk of extreme volatility than they did a year ago.” (more…)

Reuters Breakingviews’ U.S. Assistant Editor Richard Beales tells Insider’s Rhonda Schaffler that hedge funds should not be deemed “systemically important” by regulators.

“I think hedge funds do have a case there because, individually – well as an industry – they’re not huge. It’s $2 trillion of assets under management. It sounds like a lot, but the banking system in the U.S. alone has $13 trillion. Even if you add leverage, hedge funds have maybe $4 trillion…. So overall they’re small, they’re not that levered.” (more…)

European policymaker Kay Swinburne tells Reuters Insider that European Union legislators should make so-called dark pool broker crossing networks subject to regulation and introduce other structural changes to encourage traders back into the “lit space,” or trading venues with more transparency.
(more…)