We were all overjoyed to learn Monday that the money missing from MF Global (OTC:MFGLQ) customer accounts had suddenly been found. One problem. It wasn't true. About $650 million is still missing. Where is it? Nobody knows. The aftermath of the MF Global debacle has been a lesson for people like Fed Chairman Ben Bernanke who believe that "increased regulation" of financial firms will solve future problems. MF Global was a supposedly a "highly regulated" entity. Its regulators are the CFTC and the supposedly "self-regulating" futures exchange CME Group, Inc. (NASDAQ:CME).
But where was the CFTC and/or the CME when MF Global customer money was being either stolen or converted to other uses by company executives? According to a publication of CME Group, Inc., titled "Financial Safeguards".
Clearing members must calculate segregation and secured requirements and ensure compliance with capital requirements on a daily basis.
CME Clearing monitors intra-day price movements and trading activity throughout the trading session. To assess the impact of these price changes on clearing members, intra-day mark-to market calculations are performed on clearing member positions and reviewed by CME Clearing throughout the day and overnight. Additionally, CME Clearing monitors its clearing member firms’ settlement variation and performance bond activities at non–CME cleared exchanges and clearing organizations daily. The risk management team may contact the exchanges or clearing organizations to follow up on this activity.
That is all very interesting and impressive, but it seems like a lot of hot air given what we've seen so far in the MF Global affair. If CME really does all that it says it does, how in the world did $650 million dollars go missing? How did so much cash manage to slip out of supposedly segregated client accounts and into MF Global's corporate account? The fact that it did implies that the clearing house hasn't been doing anywhere near what it says it does. It was certainly not doing an automated computer-based audit everyday, although that would have been relatively easy to set up. The overall picture appears to be one of negligence on the part of CME Group, Inc. with respect to its regulatory duties and obligations.
In truth, it doesn't matter whether or not CME Group was negligent in supervising MF Global. It has a contractual duty that it created itself to reimburse customers for any and all of their segregated fund losses-- because it promised to do so. The promise is legally binding and inures to the benefit of every customer who opens an account with a CME Group approved clearing member. Specifically, CME's promise is as follows:
If a clearing member were unable to meet its financial obligations to CME Clearing and a default occurred in its customer segregated or customer secured account, CME Clearing may act immediately to:
...Apply the clearing member’s guarantee fund and house performance bond deposits to the failed obligation...
In spite of all this, I see no evidence that CME Group has walked up to the plate and done what it is supposed to do. Perhaps CME will now claim that it didn't mean that passage to say what I say it meant. However, all ambiguities in a contract are to be construed against the writer. That is basic law. The CME Group wrote up the pamphlet from which I am quoting for the purpose of convincing customers to have confidence in the system and to do business with it. The failure to immediately credit customer accounts with the full amount of all cash, even if it means dipping into the CME emergency fund to do that, therefore, is shameful. It will result in unjustified margin calls against people with plenty of cash, and involuntary liquidation. That sounds to me like punitive damages material, given that CME Group has a clear obligation to immediately make customers whole, as it promised it would.
CME Group's behavior is surprising and shameful. The company should immediately compensate customers for any losses. This is not only because of its negligence in supervising MF Global, but also because those failures caused the losses, and the company promoted itself as the supposed guarantor of the "safety" of customer funds.
For years, the company has droned on about the supposed billions in a CME "emergency fund" that stands behind its clearing house guaranty. Where is that money now?
CME's failure to act immediately to make MF Global customers whole is not just a legal and moral failure. It is bad business in the long term. Why should customers put their money at risk in futures markets when the clearing house guaranty is worthless? No one will ever again take the promises of exchange clearing houses seriously. Few people will be interested in participating when money can be and is stolen so easily, and the clearing house fails to keep its promises.
It is imperative that CME Group, Inc. immediately tap its funds to make MF Global customers whole. It must take its place on line as investigators try to find the missing money. If the money is found, the company will be reimbursed. If not, the solemn promises given to futures market customers will be fulfilled. This will impose substantial costs upon the remaining clearing members, like JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Jefferies-Bache (JEF), Morgan Stanley (NYSE:MS), New Edge, Citigroup (NYSE:C), Bank of America/Merrill Lynch (NYSE:BAC), RJ O'Brien, Penson (OTC:PNSN), and others. But, it is the right thing to do, it is legally mandated under the circumstances, and it is a good long term business decision.
However this turns out, the MF Global debacle is a call for massive reform. Reform in the here and now means holding CME Group to its promises. But in the future, it means completely overhauling governance in the securities, banking and futures markets. It means adding rules that prohibit firms which process customer orders from engaging in ANY proprietary trading. That sounds like the Volcker rule but it is not. The rule must apply not only to banks, but to ALL broker-dealers who take customer orders. If there is one good thing that comes out of the MF Global bankruptcy, it will be the demand for implementation of these reforms.