Recently we posted a phone text conversation between two financial services professionals (Roy and Steve) discussing MF Global (OTC:MFGLQ) lost funds. The one thing that people found striking in that the discussion raised the possibility that MF Global may not have violated U.S. law or CFTC/SEC rules by tapping "customer" collateral for the purposes of posting margin on its own proprietary repo positions. That sounded a bit odd - clearly there must have been improprieties associated with such actions.
Let's start with the fundamental rule dealing with customer accounts:
Section 4d(2)3 of the Commodity Exchange Act ("Act") provides among other things that: (1) customers' funds shall not be commingled with the funds of the FCM; (2) an individual customer's funds may, for convenience, be commingled with the funds of other customers for deposit with a bank, trust company, or clearinghouse; (3) customers' funds may be invested in obligations of the United States, in general obligations of any State or any political subdivision thereof, and in obligations fully guaranteed as to principal and interest by the United States; and (4) the Commission may prescribe by rule, regulation, or order the terms and conditions under which these things may be done...
FCM of course stands for Futures Commission Merchant, and MF Global clearly was one. Looks like an open and shut case - MF Global violated (among other things) Section 4d(2)3 of the Commodity Exchange Act. The media certainly seems to think so:
NY Times Dealbook: Wherever the money went, MF Global violated basic commodities laws that require firms to keep their customers’ money separate from the firm’s.
Not so fast. Let's dig a bit deeper into the rules governing such accounts.
Rule 15c3-3 -- Customer Protection--Reserves and Custody of Securities
Securities Exchange Act of 1934
The term customer shall mean any person from whom or on whose behalf a broker or dealer has received or acquired or holds funds or securities for the account of that person. The term shall not include a broker or dealer, a municipal securities dealer, or a government securities broker or government securities dealer. The term shall, however, include another broker or dealer to the extent that broker or dealer maintains an omnibus account for the account of customers with the broker or dealer in compliance with Regulation T (12 CFR 220.1 through 220.19). The term shall not include a general partner or director or principal officer of the broker or dealer or any other person to the extent that person has a claim for property or funds which by contract, agreement or understanding, or by operation of law, is part of the capital of the broker or dealer or is subordinated to the claims of creditors of the broker or dealer. In addition, the term shall not include a person to the extent that the person has a claim for security futures products held in a futures account, or any security futures product and any futures product held in a "proprietary account" as defined by the Commodity Futures Trading Commission in § 1.3(y) of this chapter.
Therefore the definition of "customer" does not include a person holding any security futures product and any futures product held in a "proprietary account". And what exactly is a "proprietary account"?
According to 17 CFR 1.3 (Title 17 - Commodity And Securities Exchanges; Chapter I - Commodity Futures Trading Commission; Part 1- General Regulations Under The Commodity Exchange Act; Definitions), the term proprietary account means “a commodity futures or commodity option trading account carried on the books and records of an individual, a partnership, corporation or other type association (1) for one of the following persons, or (2) of which ten percent or more is owned by one of the following persons, or an aggregate of ten percent or more of which is owned by more than one of the following persons:
(i) Such individual himself, or such partnership, corporation or association itself;
(ii) In the case of a partnership, a general partner in such partnership;
(iii) In the case of a limited partnership, a limited or special partner in such partnership whose duties include:
(A) The management of the partnership business or any part thereof,
(B) The handling of the trades or customer funds of customers or option customers of such partnership,
(C) The keeping of records pertaining to the trades or customer funds of customers or option customers of such partnership, or
(D) The signing or co-signing of checks or drafts on behalf of such partnership; (iv) In the case of a corporation or association, an officer, director or owner of ten percent or more of the capital stock, of such organization;
(v) An employee of such individual, partnership, corporation or association whose duties include:
(A) The management of the business of such individual, partnership, corporation or association or any part thereof,
(B) The handling of the trades or customer funds of customers or option customers of such individual, partnership, corporation or association,
(C) The keeping of records pertaining to the trades or customer funds of customers or option customers of such individual, partnership, corporation or association, or
(D) The signing or co-signing of checks or drafts on behalf of such individual, partnership, corporation or association;
(vi) A spouse or minor dependent living in the same household of any of the foregoing persons;
(vii) A business affiliate that directly or indirectly controls such individual, partnership, corporation or association.
(viii) A business affiliate that, directly or indirectly is controlled by or is under common control with, such individual, partnership, corporation or association ...
This convoluted list is saying is that a "proprietary account" would be a futures account held by certain partnerships. That means interests in hedge funds, family offices, family trusts, Commodity Pool Operators, etc. would often be classified as "proprietary accounts" at MF Global. These accounts are in fact excluded from the definition of "customer" under Section 4d(2)3.
Such account segregation rules are really meant to protect the retail investor. When it comes to the more "institutional" types of clients, an FCM has far more room to maneuver. It is a fairly good assumption that the bulk of MF Global's accounts by dollars constitute "proprietary accounts".
As a general matter when it comes to account protection, in a paper titled The (sizable) Role of Rehypothecation in the Shadow Banking System by James Aitken, Manmohan Singh, one can find the following quote:
Derivatives, repos and futures are not covered by SIPA, so any collateral associated with those products may not be covered (so there is uncapped rehypothecation in the United States, if collateral is associated with these products). To clarify, SIPA’s regime does not relate to collateral; rather it relates generally speaking to the return of a customer’s equity as calculated through something called the net equity claim.
Margin posted constitutes separate moneys from the futures account cash or gains on futures trades. In most cases collateral posted in MF Global's futures accounts could be used for general corporate purposes, including for posting margin on MF's own proprietary highly leveraged (via repo) eurozone sovereign bond holding. So what happened to the "missing customer money"? If you post margin against positions that lose money, and those positions are then liquidated, the margin will be used to cover losses. Thus client's margin posted became MF Global's margin posted which went to cover MF Global's losses.
In a bankruptcy, such account holders become general creditors (possibly subordinated) of the bankrupt organization in the amount of collateral posted. MF Global is required to return the gains on the clients' futures positions and unencumbered cash (cash not used as margin), but when it comes to margin posted, these clients will need to line up along with the MF Global's bond holders and wait for the liquidation process.
Obviously the facts in the case are not public and it remains to be seen what laws/rules were violated. But as much as nobody wants to hear this, it may have been perfectly legal for MF Global to do what they did with at least some of the accounts. FCMs long-held but not widely known benefit of having access to large amounts of customer cash will become well known and if the regulations change (and likely they will), it may severely impact their business models going forward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.