MF Global Exposes the “Dark Side” of Futures Clearing
Nov 11, 2011
Everyone wants the best deal. It’s the American way. Doesn’t matter if it’s buying a new truck or selling crops. It also holds true for financial products like insurance, bank loans, and yes, the commissions we pay for futures clearing.
Futures clearing and execution commissions have been under pressure for a long time. The $40.00 round turn is now the $3 or $4 round turn, plus fees of course. It’s the way of the world; as things get more efficient the competitive landscape forces the cost of doing business to go down or risk losing market share.
In a low commission environment, the FCM really doesn’t make that much on commissions, they make it on "the float", using your money to invest in all sorts of supposedly liquid vehicles to gain a few cents of interest for their benefit. With interest rates near zero, aggressive firms such as MF began to look outside the safety of overnight Money Market repurchase agreements (REPO’s), which paid nothing, to instruments with "more bite".
If you use an Introducing Broker, most of their revenue comes from a share of the commissions. That said a typical IB-FCM relationship does include "interest sharing" so your IB also benefits from "the float". The Media has reported that some MF IB’s have said they will make up their client shortfalls as a result of the MF bankruptcy.
In 2004, the CFTC began to allow the use of customer segregated funds for something called an "internal REPO" basically allowing an FCM to borrow money from their clients to invest in instruments with a better rate of return. Even though the client may not know about it, it’s all perfectly legal (CFTC 1.29). The problem is that many of these higher interest-bearing instruments are not as liquid as Money Markets or Commercial Paper and are usually longer in duration. Since longer-term instruments can cause a liquidity crunch, MF and other FCM’s have credit lines to draw from should clients have money requests that can’t be met.
Credit rating firms such as Moody’s monitor the use of credit lines and when MF exhausted the $1.6 billion in credit they had on October 25th, their credit was dropped to "junk" which precluded them from borrowing any more. Rather than doing the right thing and declare bankruptcy at that time, MF played Russian Roulette with customer cash for the next 5 days. MF had invested heavily in European Sovereign debt with client funds and hoped that the European debt crisis would be solved over a weekend. Even a first year economics student understands the complexity of global economies but someone at MF obviously didn’t.
The CME’s claim that MF was in compliance with seg funds requirements just days before the collapse is not in dispute. However when you add the exhausted credit line with the amount of internal repos linked to sovereign debt, alarms should have sounded. It’s interesting to note that MF’s segregated requirements dropped a little more than $1.6 billion, the exact size of their credit line, between their August 31st CFTC filing and the CME’s estimated requirement on November 1. Coincidence?
In late October 2010, the CFTC held a series of meetings "to consider the issuance of proposed rulemakings under the Dodd-Frank Act", or as some in the financial community lovingly refer to it, the Franken Dodd Act. During these meetings discussions specifically cited the need to alter these so-called internal REPO’s used by FCM’s "to exclude foreign sovereign debt, clarify the liquidity requirement, and expand concentration limits for GSE’s CD’s and Commercial Paper". Those discussions, which most likely could have saved MF’s clients, took place a year ago yet were never acted upon. Why? MF and a whole litany of other FCM’s and Banks balked and demanded the CFTC re-open their comment period. The CFTC acquiesced and the rest is history.
So what can you do at this point? The obvious answer is to keep as little excess margin as possible in your futures trading accounts. The other option is to deposit Treasury Bills in your account. The problem there is that T-Bills pay nothing and if you have a margin call, you must come up with cash. If you do leave a financial instrument at your FCM, purchase them "away’ from your FCM, make sure they are in your name, and transfer them into your account. Otherwise the FCM can purchase the Bills in their name and just put them in your account. How about a Letter of Credit (LOC) from your bank? CME does accept LOC’s for some instruments, not all, so it’s best to check with the exchanges.
You must not be fooled into a false sense of security since your account has been transferred. The excess in your account is entirely at risk. The clearing corporations, CME or otherwise, will not, and cannot, guarantee funds that are not under their roof. It’s impossible. Margins on deposit and Open Trade Equity will be guaranteed; the rest stays at your clearer and is not guaranteed.
With banks seemingly charging us for when we sneeze, constantly transferring money back and forth to your futures accounts will be pricey but it may prove less costly than losing 11.6% of your money on deposit with your clearer, which MF clients are finding out the hard way.