The Bright Side of the MF Global Fiasco

Posted by Virginia France on Nov 28, 2011

Filed Under (Finance, U.S. Fiscal Policy)

Two institutions come out looking good from the MF Global fiasco, the Chicago Mercantile Exchange and the Commodity Futures Trading Commission. 

MF Global, one of the biggest of the futures clearing firms, failed.  As a clearing firm, not only are its direct clients affected, but also the firms that clear their trades through MF Global, and those firms’ clients.  MF Global was unable to fulfill its obligations as a clearing member.  As a clearing firm, it deals with the central clearinghouses at the CME and other futures exchanges for itself and its clients, but also acts for other firms as their channel to the clearinghouse.  It is responsible for collecting and paying margin from its own clients and from the firms who clear through it.

The central clearinghouse is the apex of a pyramid of collateral protection.  Whether a position is long or short, each client posts margin as a guarantee against default.  The margin account is marked to market daily, forcing any losses (or gains) to be realized immediately, and deficiencies in the balance must be made good right away.  A client may trade through a smaller firm, which in turn trades through a clearing firm.  The margin deposited by the client with the small firm is passed to the clearing firm, which passes it to the central clearinghouse of the exchange.    

Clearing firms do not fail all that often.  Perhaps the most famous recent case was that of Barings Bank in 1993. When a clearing firm fails, the accounts of the clients and firms who clear through it are transferred to another clearing firm.  Their open positions and the corresponding margin balances are simply moved from the failed firm’s account to another clearing firm.  Because the positions have been marked to market on a daily basis, there are no accumulated losses or gains to be paid when the transfer is made.

In MF Global’s case, however, this transfer of accounts has run into problems.  Some of the money is missing. 

And this is where the U.S. regulatory system looks good.  Under U.S. law, client margin accounts are supposed to be kept separate from a firm’s own proprietary trading accounts; they are “segregated.”  The intent is to keep a financially troubled firm from raiding client’s margin accounts, which seems to be exactly what happened in this case.  You can see why this is desirable: if client accounts are segregated, they can be transferred immediately to other clearing firms, and trading can continue with a minimum of contagion.   The violation of customer account segregation in this case prevented the clearinghouses from immediately transferring the client accounts to surviving clearing firms.

Bad as it was, it could have been worse.  This is where the CME looks good.  All client positions are collateralized, and the collateral is passed to the clearing firm.  The clearing firm may forward all margin to the central clearinghouse, or it may be allowed to forward only enough margin to cover the net position of its various clients, retaining the rest for its own protection. 

Different clearinghouses allow different amounts of netting.  The CME is very conservative, requiring all margin to be forwarded to the clearinghouse.  This more conservative policy meant that the CME had more margin on deposit, and was thus able to transfer more accounts more quickly than clearinghouses which allowed more netting of margin deposits.

MF Global is in the news.  But it is not threatening the world economy with collapse.   When a major financial intermediary fails, the ramifications for other major market players can be huge.  When Lehman went down, the world shook.  When AIG failed, the systemic effects were thought to be so severe as to warrant government intervention, even though the firm was not a bank.  The system of collecting margin and prompt marking to market of gains and losses does not prevent a collapse, nor does it keep a firm from raiding client funds.  But it certainly minimizes the damage when bad things happen.

4 Responses to “The Bright Side of the MF Global Fiasco”

  • Robert London says:

    Is this article a satire or are you a paid shill for the CME?

    The CME was the designated self-regulatory organization (DSRO) for MF Global and thus had the obligation to certify the accounting of the books and records of the firm. The CME performed an audit of MF Global two days before funds first went missing and declared that all was well. If 100% of the client funds are not returned, it is a certainty that the CME will face a civil lawsuit for the return of said funds. The CFTC is responsible for regulating futures brokers so that funds REMAIN segregated. They failed miserably to do this. Gensler will soon have the oportunity to explain himself before a House committee.

  • Virginia France says:

    Nah, I’m just an economist, and Murphy’s Law is deep in our bones. I’m more interested in the deep structures that allow us to continue on when disaster happens. I’ve been teaching derivatives since 1984, and I’ve seen just about everything happen except the failure of the clearing system itself…which I pray I never see and you’d better join me!

    Yes, MF Global shouldn’t have got their hand in the customer accounts, and yes, somebody should have stopped them, though I don’t see how, given the speed at which money travels these days. But that just shows how vital customer account segregation is. And customer account segregation is built into U.S. commodities law, which governs futures trading in these parts.

    There have been clearing firm failures in the past, but you probably don’t even remember them. That’s because normally, there’s one big gulp and the waters flow on undisturbed. And that’s what the clearing system should do. You cannot prevent failure when you’re dealing with futures, because you don’t find futures in quiet waters.
    When Nick Leeson brought down Barings Bank in 1993, there was a similar nightmare trying to transfer customer accounts in Singapore. Barings accounts in the U.S. were transferred quickly, because the CME could identify which funds belonged to which customers. I don’t know if MF Global’s overseas positions are moving slower this time; after Barings, many overseas clearinghouses adopted U.S. margining and segregation practices. But customer segregation is vital to allow the rest of the market to pick up and go on.

    I’m not sure what you think the CME and the CFTC could have done. Most of the problem is usually internal to the firm, and neither the CME nor the CFTC can arbitrarily take over a firm they suspect of misconduct. Of course, it would have been nice if even more margin had been resident with the clearinghouse when the firm went under. When the Hunt brothers tried to corner the silver market in 1981, the New York Mercantile Exchange tried to rein them in by upping their margin requirements. But “super margin” is a dicey tool: too little, and you just make them mad, especially if they’re Texans; too high, and you precipitate the crisis you’re trying to avoid.

  • I produced a video based on my discussion with the COO of the CME.. my video is the other side of the slanted editorial


  • Dan DeRose says:

    An economist indeed and only a paid shill as far as any economist is by nature. You got me with the air tight legal logic but when will economists and legislators wake up to the dynamic times we now live in. The CME and the US Regulatory structure may look good from the luxury executive suites and the steps of Congress (and apparently academia) but they sure look like accomplices from the trading floor. The trading community believed their funds were safe in segregated funds and acted as such with disastrous results. The CME is now not much better than any bucket shop and the implications for the clearing business could be huge. With FY2011 earnings estimated at $1.3billion, you’d think CME would have the foresight to protect their brand (ad hoc guarantees notwithstanding).

    But more seriously, when will executives, regulators and academics get off their chariots and look at the battlefield! A dynamic environment requires a robust regulatory structure. CME/Regulators might have acted as they were supposed to but that doesn’t clear them of fault when the expectations were vastly different. An apropos example of such is Mr. Corzine’s own behavior. The paper he bet on with repos might be redeemed at par in only 14 months or so. Does that make his trade a good one? Most certainly not as the market called his bluff and made him puke. Expectations of a rational outcome were diverted by market forces which were themselves rational. Lets hope the same consequences don’t play out at the CME.