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.