If nothing else, the collapse of MF GLOBAL has made one thing clear: The notion that customer assets were safe was a sham.
MF Global’s customers, who discovered that the firm had plundered $1.6 billion of their property, learned that the hard way. But they aren’t the only potential victims. The loophole that allowed MF Global to convert more than $1 billion in customer property to its own reckless bet on European debt is still in effect — although the Commodity Futures Trading Commission, which regulates futures and commodities brokers, said it had since pressured other firms to stop using it.
The CME Group, which is both the largest commodities and futures exchange and also regulates many brokers, told me this week that when MF Global collapsed last year, four of the 40 firms it oversees were still using an “alternative” calculation of customer assets that vastly understates what firms actually owe. A spokeswoman declined to name them, saying such information was confidential. In my view, they should all be identified publicly so their customers can demand reassurances that the practice has stopped — and that their assets are safe.
Since the Depression, when thousands of customers were wiped out by failing brokerage firms, the idea that customer assets are protected has been sacrosanct, embodied in laws and regulations that require the assets to be safely segregated. Violating these requirements is a crime.
The rules require a firm to put aside the amount it would owe if its customers’ accounts were liquidated. This would seem simple common sense: if a brokerage firm closed or failed, customers should expect to get the full value of their assets.
But the rules apply only to accounts in the United States. In 1987, the commodity commission approved a series of rules governing foreign futures and options transactions, one of which provided an alternative calculation of how much firms needed to put aside for accounts that traded on foreign exchanges.
The alternative calculation almost always resulted in a lower amount — sometimes much lower — that needed to be segregated in foreign accounts, because it covered only options and futures. Cash and securities held in customer accounts didn’t count. So if a customer held only cash and securities, the firm had no segregation requirement at all.
This may not have seemed such a big deal at the time, although even then, futures and options trading by American customers on foreign exchanges was growing rapidly. How and why this provision got into the federal register remains something of a mystery, and in the wake of MF Global’s collapse, no one seems to want to take credit (or blame) for it.
The commodity commission’s chairman at the time, Kalo Hineman, a cattle rancher and former Republican state lawmaker in Kansas who was appointed by President Ronald Reagan, died in 2003. Some regulators said that a tougher segregation requirement for foreign accounts would have been too costly and complicated to maintain given the technology at the time. Others point out that it was better than nothing, which was the prevailing standard for foreign accounts before the rule. A spokesman for the National Futures Association offered that “U.S. participation in foreign markets was small and generally limited to commercial users.”
None of this withstands much scrutiny if the commodity commission really wanted to protect customers. The answer may well be, as one regulator told me, “it’s what the industry wanted,” and that’s pretty much what it got.
Why the futures and options brokers lobbied for such a loophole is obvious: it allowed firms to do whatever they wanted with customer money, including using it to speculate for their own accounts. And by last year, that was no small sum. In his recent report, James Giddens, the MF Global liquidation trustee, showed the difference between the amount the firm had to segregate using the net liquidating method and the more lenient alternative method. On many days, it was more than $1 billion, reaching a peak of $1.25 billion last Oct. 13.
Apart from people working at the firms themselves and their regulators, few seem to have known about such an alternative calculation, even as trading on foreign exchanges has exploded. “I didn’t know it existed,” James Koutoulas, chief executive of Typhon Capital Management, a commodity trading adviser in Chicago, told me this week. “And we’re pretty sophisticated traders. I had no idea they were allowed to make a report that was so different from reality. No one ever told us a thing about this.” Mr. Koutoulas is also president and co-founder of the Commodity Customer Coalition, which is advocating for the return of MF Global customer funds.
Nor does the alternative segregation calculation affect only foreign customers, since any resulting shortfall is shared by all customers. American customers of MF Global have lost approximately $900 million, and foreign customers about $700 million, according to Mr. Koutoulas.
“It’s obvious that the alternative calculation let firms understate the segregation requirements,” Mr. Koutoulas said. “The industry lobbied aggressively to introduce loopholes so firms could be more aggressive with customer funds. At MF Global, cash management was designed and carried out at every level of the firm to use customer money as a piggy bank to fund the firm’s operations. They were deliberately and systematically taking customer money to fund their operations.”
The alternative calculation not only jeopardized customer assets, but also obscured MF Global’s mounting problems and shielded the firm from regulators. The commodity commission was aware that MF Global was using the alternative calculation in the daily segregation reports it submitted to the agency as well as the CME. But MF Global officials also calculated the net liquidating amount — the real amount it owed customers — and withheld that number from regulators while circulating it internally. According to Mr. Giddens’s report, that calculation showed a glaring shortfall in the firm’s waning days. Jeff Malec, chief executive of Attain Capital Management in Chicago, pointed out, “The alternative calculation methodology functionally allowed MF Global to live on borrowed time — presenting themselves as more stable than they really were until the clock ran out.”
To its credit, the commodity commission is taking action. This month the commission sent a letter to all regulated futures brokers telling them the agency expects them to use the net liquidating calculation — and not the alternative calculation — for all accounts, American and foreign, “pending adoption of the new rules.” It said those new rules would include “the elimination of the Alternative Method.” The letter also said that all firms still using the alternative method had agreed to discontinue using it.
It remains to be seen if the alternative method will also serve as an escape hatch from liability for MF Global’s top officials, who remain under investigation for possible criminal and civil actions. They and their lawyers will surely argue that taking customer funds cannot be a crime or a fraud if it was sanctioned by the commodity commission rules.
But in Mr. Malec’s and Mr. Koutoulas’s views, the officials shouldn’t be allowed to hide behind the calculation. Based on the trustee’s report, “they knew they were in trouble long before the public knew, and some of the decisions made in the final hours showed blatant disregard for the law,” Mr. Malec said. Mr. Koutoulas was more vehement: “I unequivocally think crimes were committed.”
Whatever the outcome, MF Global will be a sorry chapter in the history of federal regulation. The alternative method blatantly put the interests of regulated firms over their customers, and it never should have been enacted. That it now seems likely to be repealed may be a “silver lining,” Mr. Malec said. “The whole scandal really opened the eyes of the futures industry participants. Everyone had assumed that segregated funds were sacred, and why not? Prior bankruptcies had always been resolved without clients losing money. MF Global was a disaster, but we believe the end result will be a stronger, better futures industry.”