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One Year After MF Global: Are We Better Off?
October 22, 2012
MF Global 1 year later: Are we better off?
A year after MF Global declared bankruptcy and left the futures industry in a state of disarray, where are we? Do we really understand what transpired? Have we made the reforms necessary to prevent it from happening again? Here, we take a look at how the story played out, the reforms we've instituted to date, and the steps we need to take moving forward, both as an industry and as individual investors, to avoid a campy sequel.
This time of year, our homes and streets are swathed with cotton cobwebs, goblins and ghouls as we indulge in the chills and thrills of the latest horror movies and ghost stories of the year. The monsters beneath our bed come to life in polyester costumes and garish face paint, and macabre goes mainstream. It's a time where, instead of running from our fears, we embrace them - if only momentarily - for a rush of adrenaline and a few good laughs.
Except, last Halloween, the worst fears of the futures industry played out in agonizing slow motion without the superficial sheen of the holiday season. Amidst the candy corn and taffy apples came a sharp blow to investor confidence. The demon plaguing our central cast of characters did not don a cape nor boast a set of horns; he wore a suit and scraggly beard. Victims did not lose their lives, but some lost their livelihoods.
It has been a year since MF Global began a maddening descent into bankruptcy and scandal, but for many of us, it feels as though it was just yesterday. The story has, by and large, faded from the headlines, but the lessons of the past remain poignant today, and there is still much work to be done. We take a moment here to look back over the past year and look at what happened, how things have changed since, and what challenges await us on the horizon.
The harrowing tale of MF Global's demise is one with more twists, turns and intrigue than a good Grisham novel - a story that will one day make someone in Hollywood very wealthy, indeed. Fortune delved into the devilish details about four months ago, and their exposé is certainly worth a read. But here's the short version:
MF Global was one of the larger Futures Commission Merchants catering to retail and managed business. While they seemed tiny compared to a Goldman Sachs, they held considerable sway in the futures industry, and were generally well-respected. A little over a year before the story truly began, a Goldman Sachs veteran and former politician - Jon Corzine - took the helm. He saw the firm languishing a world of near-zero interest rates - the former bread and butter of the FCM industry - and decided that what the company needed was a little bit of his Goldman flavor.
Enter the risky bets on European debt.
In an effort to bolster profits for the company, Corzine began betting on an improving economic climate in Europe by buying distressed nations' bonds. However, in order to make the firm look healthier on paper, he purchased them via what was called a repo-to-maturity trade, which meant that the bonds did not show as a liability on their balance sheets. Instead, they were valued at their projected future profits. MF Global, suddenly, was looking good.
Or were they? The thing was, with these trades, there was always a chance that things would get worse in Europe before they got better. Corzine, as some have said, was well-known for weathering the storm as he chased profits, and apparently hoped he'd be able to do the same here, meeting margin calls as needed until payday came around. As time went on, though, regulators began to question the health of the company beyond the accounting tricks on their books, and pushed them to reveal the bets they had placed on Europe. Shareholders began to panic, scrambling for the door and pushing the value of MF Global stock into a rapid downward spiral.
The firm was running out of options. They needed to find a savior, and fast, but the public watched in horror as each and every suitor bowed out of a potential buyout. On Halloween, MF Global filed for bankruptcy. The futures industry had seen FCM bankruptcies before, so by itself the move, while unsettling, didn't necessarily mean the of the world. It was not the bankruptcy announcement that rocked all of us - it was the follow-up announcement that about $900 million in client money was missing.
$1.6 Billion Missing
It would take months of political drama to even scrape the surface of what had really happened, but through the efforts of the initially-maligned Trustee James Giddens and the futures industry advocacy group The Commodity Customer Coalition (CCC), a clearer picture began to emerge. It seemed as though, in order to meet margin calls on some of Corzine's trades, and in order to meet financial obligations with JP Morgan, MF Global, under Corzine's direction, began to dip into client money. The idea was that they would be able to replenish the funds rapidly, but as the requirements grew larger and larger, such moves became riskier and riskier. The massive sell-off in their stock caught MF Global off guard, which meant there was no chance of a cover up.
As of today, according to James Koutoulas of the CCC, the bulk of MF Global clients have received 80% of their money back, though those trading on foreign exchanges have only received a paltry 5%. What about the rest of the money? The $1.6 billion is still "missing," which is a funny way to put it, as we know where it is - it's just not available to clients. Of that amount, around $700 million is in dispute in the UK, while another $900 million appears to have been used to meet margin calls issued to MF Global by JP Morgan.
JP Morgan has been the subject of increasingly harsh criticisms on the latter missing amount. Essentially, despite the fact they were holding the client accounts from where this money was transferred, and despite the fact that MF Global refused to sign an assurance that the money they were posting did not belong to clients, JP Morgan accepted the MF Global transfers. Why is this an issue? Under a component of the bankruptcy code known as "Safe Harbor Laws," counterparties in a bankruptcy may not have payments made clawed back to meet obligations in the bankruptcy proceedings, as long as they can demonstrate that they had no knowledge of wrong-doing prior to payment. One would think that the margin posted to JP Morgan would clearly not qualify for protection under Safe Harbor provisions, but that's where things stand today.
The Department of Justice has yet to take action against Jon Corzine, despite emails which indicated these actions were taken at his behest. The CCC has stated that they have other options waiting on the backburner, but many at this point are wondering if MF Global victims will ever see real justice.
What Reforms Have Been Made to Date
The thousand words or so above is grossly insufficient when it comes to capturing the depth and breadth of this scandal, and its impact on, not only the former clients of MF Global, but the industry as a whole. For decades, it was assumed that client money, held in a segregated account, was sacred. And following MF Global there was a renewed push to ensure that the segregated account structure was iron clad.
But just as we were all coming up for breath and starting to put proposals in place for better protections, we were dealt another blow as PFGBest went down in fraud-fueled flames.
In many ways, it's been the nightmare from which you can't wake up, with the actions of two men causing investors to doubt the integrity of hundreds of hard working professionals across the futures industry. Fortunately, we are far from a legion of Freddy Kruegers in this industry, and these two scandals (plus the dedication and hard work of the folks trying to do the right thing) have led to a series of industry changes designed to make sure this kind of thing never happens again:
- The MF Rule - In the early days of the MF Global scandal, the belief was that Corzine may have actually legally used client money to place his bets on European debt. Many investors had assumed that their money could only generate revenue for an FCM via investments in things like treasury bills, but a closer reading of CFTC rule 1.25 indicated that there was a much more broad swath of investment opportunities for FCMs looking to turn a profit with client funds. While time eventually revealed that 1.25 was not at the heart of the problem, the outcry from futures investors prompted the NFA and CFTC to amend 1.25 in order to protect against such behavior in the future, restricting the investments to U.S. Treasuries.
- The Corzine Rule - One of the more infuriating components of the MF Global case was the idea that Corzine would never see the inside of a jail cell for what the rest of the world would view as a crime. After all, it was his company, and the theft of client funds took place on his watch. The idea that technicalities, loopholes, and innuendo would serve as a shield against justice was not what anyone wanted to see. As a reactionary measure, the NFA ultimately proposed what came to be called "The Corzine Rule."
FCMs must add additional money to the customer funds pool of money on their books to make posting of margin to the exchanges, wiring out money, and so forth more efficient. This way they can "cover" money for a customer in the short term while it is being wired in, etc., and create a buffer to protect against other customers losing all the money in their account and impacting other customers.
Under the new rule, should an FCM choose to withdraw more than 25% of their funds within the customer pool of money, the CEO or another designated top officer will have to sign off on the withdrawal, rendering them liable for any wrongdoing associated with such movements. This eliminates the possibility of plausible deniability as a defense against fraud in the future.
- Electronic Verification - This change was under way prior to MF Global, but as we found out in the PFGBest scandal, was forced upon all FCMs after MF Global for a better level of verification. It is pure simplicity itself, with the NFA enlisting a 3rd party firm (confirmation.com) to verify FCM bank account balances electronically (not snail mail and paper statements). In an era where you can deposit a check by taking a picture of it on your phone, it's shocking that it took this long to implement such a procedure.
The digital auditing revolution didn't stop there, however, with the NFA Board approving a rule change which would require FCMs to provide "always on" electronic viewing of their bank accounts. Now, not only are we protected against forged documentation a la Wasendorf, but those wishing to live on borrowed time the way Corzine did may be more easily identified with real time glimpses of FCM balances available to the regulators.
- NFA Internal Reviews - In the MF Global case, the NFA was able to evade severe criticism, as the CME, and not the NFA, was the designated self-regulatory organization overseeing regular monitoring of the FCM's behavior. However, there were certainly some lingering doubts in the background related to how they had constructed the framework of monitoring and compliance- doubts driven to the forefront of our minds in the wake of the PFGBest case. As a result of strong public outcry and industry pressure, the NFA launched a series of internal reviews, including a review of their internal policies by respected law firm Jenner & Black, and hiring the Berkeley Research Group to evaluate their audit procedures. Though these steps do not necessarily guarantee the kinds of results we would like to see, it is certainly a step in the right direction.
- Congressional Hearings - The futures industry, in many ways, is usually discussed in one of two ways by the nation's leaders: small farmer financials, or high-risk derivative betting driving up the price of oil. Such characterizations range from gross oversimplifications to out-and-out falsehoods, but a silver lining to this nightmare has been the institution of far more informed conversations on Capitol Hill about the future of the futures industry. Attain, along with many others, have reached out to representatives in hopes of helping them better understand exactly what's happening in our realm, and what changes need to be put in place. While the learning curve may be substantial, and progress may be slow, this development is a promising one, and a demonstrable change in the regulatory climate that is far overdue.
The Work that Remains
These are all changes we're happy to see, and should make you feel more comfortable investing in the futures industry. That being said, we would be remiss in our dedication to protecting our clients to say the war is won. There are a variety of battles we still need to win:
- Establishment of Futures Investor Insurance Fund - Following MF Global, and then again after PFGBest, investors were left wondering why their investments in the stock market received more protection than those in the futures markets. Entities across the board have called for an insurance fund to be launched to protect investors, providing them with recourse in the event of another instance of fraud. In the beginning, this was discussed many - including us - as a form of SIPC for futures investors, but as John Roe of the CCC correctly opined, "SIPC seeks to protect customer assets from within a bankruptcy proceeding. Futures customers need a mechanism which clears them from bankruptcy immediately."
Roe and the CCC have proposed a different structure, following procedures similar to what exchanges like the CME use to hedge against defaulting members, whereby futures industry participants would have a defined contribution to a fund whose sole purpose would be to extend what amounts to a bridge loan of sorts to those impacted by an FCM with missing client money. You can read the full text of the CCC discussion here, but as those still waiting to get their hands on ANY of their money following PFGBest will tell you, this could have saved a lot of heartache.
While some have argued that such a program would be cost-prohibitive or create a moral hazard, one need look no further than our neighbors to the North in Canada for empirical proof against the claims. In fact, the proposal for an insurance fund floated by the CCC is not dissimilar from Canada's program. It is high time that investors in the futures markets receive the same types of protection as those in equities, and this is the way to do it. If the cost is still a worry - have it be an optional program, with customers choosing to participate or not (and pay or not) when they open their accounts.
- Bankruptcy Code Reform - In our corner of finance, it had always been assumed that futures client money was always protected first in a bankruptcy court, but developments in the Sentinel, MF Global and PFGBest cases have called such ideas into question. With recent court decisions casting doubt on such classifications, the application of Safe Harbor laws to the MF Global case, and significant concerns related to charges being racked up in the PFGBest bankruptcy proceedings, one thing is clear: we need to be more clear about futures client priority in bankruptcies. These individuals are not entering into a creditor agreement with a firm; they are functionally opening a specialized bank account, and should be protected as such under the law. Unfortunately, it appears as though such reforms must be executed under the bankruptcy code, which means that Congress will have to act. This is actually one of the reforms that the NFA Board has explicitly endorsed.
- NFA Liability Investigation - While we were pleased to see the NFA being proactive about reviewing their internal procedures, the pat on the back comes with a grimace and an eye roll. Yes, protecting investors moving forward is critical and should be taken seriously, but what about the errors to date? We're still arguing that there should be a full investigation into the people, practices and policies of the NFA in the context of PFGBest and past failures, with the end goal of not only improving upon these elements, but holding those responsible for the shortcomings responsible. Such a move would be a signal to futures investors that we take self-regulation seriously, and even those in the industry believe anything less than exemplary to be insufficient.
- NFA Staff and Policy Enhancements - If you talk to people who were in the industry during the formative years of the NFA, they tell a story that seems the stuff of fairy tales today. Those brought in were well-established figureheads in the futures world, with extensive experience in futures-specific auditing, regulatory procedure, trading, and market analysis. They were the best of the best. This image contrasts sharply with the reports following the PFGBest scandal of inexperienced auditors steering the organization today. Those being audited should not have to explain to those minding the till how the industry works. There needs to be a return to the values that guided the NFA when it was founded - values that placed a premium on experience and knowledge. Perhaps even more importantly, if we want to make sure that such a return is durable, we need to make sure that the restructuring is paired with enhanced transparency. The NFA should willingly comply with FOIA requests, and engage in public forums with industry participants. Such measures would allow the industry to, in effect, regulate the regulators, and solves for many of the stereotypes associated with self-regulatory organizations.
- Fire Dan Roth - Dan Roth is the President of the NFA, and has been a part of the organization for decades. Yet, during his tenure, the organization has devolved into a loose collection of inexperienced auditors with no understanding of the industry. During his tenure, there have been two unprecedented FCM collapses, and another damaging one in Sentinel. We have stopped short of this call to action in the past, but a year into the aftershocks of MF Global, and three months after the stunning implosion of PFGBest, we have yet to see the leader of the NFA do what good leaders should: take responsibility. With the industry footing the bill for his reported salary of $687,000 a year, we deserve better. It's time for him to go.
What About Individual Investors?
It's been a year since MF Global started a radical reorientation of how those within and outside of the futures industry view this investment realm. Confidence has been shaken; there's no doubt about that. However, as many sophisticated investors have realized, the actions of a few do not necessarily reflect the intentions of the many, and should not scare them away from seeking out non-correlated investments, like managed futures, for their investment portfolios. That being said, it is not unreasonable to view the Corzines and Wasendorfs of the world as fat tail events, and as any good investor knows, it's good to take steps to prevent such events from wreaking havoc on your world. What can you, as an investor do, to protect yourself in an imperfect investing climate?
The first thing to do is be particular in selecting which FCM you work with. As we wrote in late July:
- Public v. Private - Their stock price, while not necessarily reflective of responsible handling of client funds, can serve as the canary in the coal mine for financial complications at the company. In the vein of, "better safe than sorry," paying attention to such indicators can provide early warning of potential headaches on the horizon, giving you the opportunity to transfer business before issues arise. For instance, MFGlobal experienced a precipitous decline in their stock price ahead of their bankruptcy and subsequent abuse of clients. One case does not a trend make, of course, and determining where your "line in the sand" might be on price declines can be tricky, but it's something to consider. To be fair, not all publicly traded firms will take your business; in fact, there are some that refuse to work with smaller clients at all, preferring to work with clients with tens of millions of dollars. However, there are a few which accept individual investors with whom we work.
- Size of the Independent Auditor - Another potential requirement might be to only select FCMs which use large, well-known auditing firms in their annual certified audits. This, as we explained last week, is not necessarily a guarantee of flawless execution; there are smaller auditors that are just as competent, if not more so, than some of the titans, who have, admittedly, dropped the ball in cases such as Enron and MFGlobal. That being said, and as the Sentinel case highlighted, auditors can and will be held liable if their errors result in hardship for investors. If the FCM you're clearing with were to encounter an issue that impacted your funds, and the auditor was small, your ability to recoup losses via a lawsuit would be diminished, whereas larger firms with deeper pockets and larger insurance policies may be easier to hold accountable. These safety nets are the kinds of things clients are looking for now.
- Designated Self-Regulatory Organization (DSRO) - Until a full investigation takes place, we know some investors are refusing to work with FCMs whose DSRO is the NFA, instead giving preference to those firms audited by the CME. You know where we stand on the question of NFA; we are, after all, calling for Congress to investigate them. While some point to the CME's role in the MFGlobal case as a rebuttal to this factor, remember that the pilfering of funds at MFGlobal really took place in the final hours of the firm's existence; the PFGBest fraud spanned 20 years without NFA detection. Food for thought.
Beyond that, another consideration is how you keep the money with an FCM. If, despite using stricter criteria in selecting your FCM, you are still concerned about the safety of your money, you might consider using a "sweep" method in managing the cash you have on hand. Instead of depositing all funds into your FCM account, you would only keep what is absolutely necessary with the FCM, sweeping out the excess on a daily, weekly, or monthly basis. This would mean that, should the unthinkable happen, only a small amount of your investment would be frozen or at risk. To be fair, this is an imperfect solution. It requires regular monitoring of your account, fees associated with the movement of money, and a potentially vast array of headaches and paperwork. However, if it provides you with enhanced peace of mind, it may be worth the costs.
In the days, weeks and months that have followed MF Global, those in the industry have had to call everything they believed into question. Was client money really safe anymore? Were they doing the right thing by clients? Could they be doing anything differently? These conversations are the right ones to be having during times like these, and they'll keep on going for months to come.
But what is there to say to those who have watched this horror flick play out since last October? Perhaps the best way to think about it is in the context of the film genre. Take, for instance, the Halloween franchise. Michael Myers, to many people, was terrifying. He inflicted pain and suffering without conscience. We’ve seen there are people in finance cut from the same cloth, but that doesn't mean that everyone falls into that category, and you should stay locked up in your house for the rest of your life. You lock your doors at night, you park in well-lit places, and you take steps to make sure you're safe.
Corzine and Wasendorf are our Halloween villains, and investors today are faced with a choice similar to that of a moviegoer. You can choose to be afraid of the things that go bump in the night, or you can choose to make smart, defensive investment choices in order to gain access to the asset classes you need for diversification. For us, it's a simple question to resolve. We'll reserve our fears for the next slasher blockbuster, and hope you will too.
IMPORTANT RISK DISCLOSURE
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.