Your collateral is only as safe as your futures trader's risk management system.

That's the key lesson fund managers should learn when it comes to the surprise demise of brokerage firm and futures commission merchant MF Global, said Andrew Cross, a partner with the law firm of Reed Smith of Pittsburgh, which is representing creditors caught in the collapse.

MF Global made costly multibillion-dollar bets on European government bonds. That was risky-and when its gamble didn't pan out, it filed for bankruptcy on Oct. 31. The filing is considered the eighth-largest in U.S. history and prompted Jon Corzine, the former co-chief executive officer of Goldman Sachs Group Inc. to resign as MF Global's CEO on Nov. 4.

The CME Group has moved the trading positions of fund managers and a portion of the margin held by a clearinghouse it operates for futures transactions to new futures commission merchants: ABN Amro Clearing Chicago, ADM Investor services, Dorman Trading, FCStone, R.J. O'Brien and Rosenthal Collins Group.

The operative word is portion.

That means not all. Some of the initial margin on deposit with the clearinghouse has been retained by CME.

Meanwhile, the Federal Bureau of Investigation and other regulatory agencies are trying to figure out just what happened to what MF Global's trustee says is a $1.2 billion "shortfall" in customer property that was supposed to be segregated from MF Global's own money.

At press time, trustee James Giddens was set to appear in a New York court to figure out how to deal with the "bulk transfer and distribution" of about $2.1 billion in customer assets. That figure is supposed to restore about two-thirds or more of the collateral to customers of MF Global which used the firm to clear their futures contracts. The process is similar to what occurred in 2005 to Refco, which collapsed in a fraud scandal. Further details on MF Global's proceedings can be found at http://www.mfglobaltrustee.com.

Futures commission merchants-futures traders-such as MF Global, are members of clearinghouses. A clearinghouse guarantees that the parties to a futures contract will perform their obligations by, as often repeated, becoming the buyer to every seller and the seller to every buyer. Only qualified members are permitted to keep a trading account at the clearinghouse. Non-clearing member market participants must open an account with a clearing member to trade cleared products.

In the world of futures trading, that clearing member is called a futures commission merchant or FCM.

Clearing members-such as MF Global-place collateral on deposit when they accept orders from customers. The fund manager clients of clearing member post funds to firms such as MF Global.

All of the margin a clearing agent collects from its customers must be kept in an account that is segregated from the FCM's own property. By many accounts, MF Global didn't always do that and it used some funds to meet its own financial obligations. The $1.2 billion represents an estimated 22% of all the collateral that should have been segregated.

"In the futures market, the clearing member must maintain a sufficient level of capital, contribute to a guarantee fund maintained by the clearinghouse to backstop its obligations to the market, and to collect a specified amount of initial and variation margin in support of trades entered into by the customers of that clearing member," Cross said.

The Commodity Futures Trading Commission regulates any market participant that collects initial margin from customers as an FCM.

If a clearing member defaults on its obligations to the clearinghouse, then the clearinghouse has a right to be made whole. If an FCM goes bust and owes money to the clearinghouse, then the clearinghouse first uses the defaulting FCM's assets to meet any obligations owed by that member to the clearinghouse.

If the FCM's assets are not sufficient, then the initial margin posted by the failed FCM's customers is next in line. The CME has not disclosed whether it will follow what is commonly called a waterfall approach to divvying up the collateral posted by the failed FCM's customers. A "waterfall" shows whose collateral a clearinghouse such as CME plans to tap first and then the sequence and expected amounts after that.

MF Global's demise and the search for customer funds poses the question: Could fund managers have figured out sooner that their assets were not segregated?

It's unlikely, according to Cross. Two other securities law experts contacted by Money Management Executive, who declined to be named, agreed.

"Under current regulations, the collateral posted by a fund manager to futures commission merchant is commingled with the collateral of other fund manager clients and that collateral is usually posted with a clearinghouse in an omnibus account," Cross explained. "All the fund manager sees on its statements is its share of the total collateral in the omnibus account."

Bottom line: the fund manager wouldn't be able to suspect any wrongdoing on the part of the futures commission merchant just looking at account statements. And the manager would have no cause to ask further questions.

What could an auditor or regulator have spotted? That's far more unclear. Apparently, brokerage Interactive Brokers noticed recordkeeping discrepancies when it looked into buying some of MF Global, as it was collapsing; a deal with Interactive Brokers could have averted MF Global's bankruptcy filing. Several auditing firms contacted by Money Management Executive declined to speculate on what might have been missed.

Industry executives reportedly have said that MF Global used customer funds for "several days if not weeks" rather than just a few days before the firm collapsed. Regulators had previously thought the firm was using customer funds on the Thursday and Friday before it filed for bankruptcy on Oct. 31.

CME Group said it had reviewed the company's books a week before the bankruptcy and found no issues with the customer money. It has also disputed the $1.2 billion figure MF Global's trustee cites.

Will regulations be changed? There is one provision in the Dodd-Frank Wall Street Reform Act that requires the CFTC to come up with rules for investor swaps accounts at commodity futures merchants. Corporate pension funds want the regulator to mandate that FCMs allow investors to put their collateral in third-party bank accounts in the name of the fund company. They believe the MF Global fiasco could drive the CFTC to set up similar independent account requirements for futures and options trades.

Cross doesn't think so. The segregation model for futures is so well-established it is unlikely to change, he said.

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