The Fall of MF Global: Lessons for Futures and FX Traders Asset Protection
In October 2011, the financial world woke up to the shocking news of the report of a quarterly loss of $191million by MF Global, a financial services firm which had widespread operations in the financial market. But the worst was still to come. A week later, it was reported that the company was seeking Chapter 11 bankruptcy protection after its $6 billion investment in speculative European bond trades went bad. Trading in the company’s stock was halted and the company was suspended from primary market dealership activities. The credit rating of the company was cut to junk by Moody’s and Fitch, effectively sealing the company’s collapse.
Perhaps even more jolting was the announcement by bankruptcy administrators that about $891million of segregated customers’ funds had gone missing. Officials of MF Global would later admit that $700million was transferred from the accounts housing the segregated customers’ funds to the firm’s coffers, while another $175million was transferred to a subsidiary firm in an attempt to hide the trading losses and massive drop in liquidity. However, the trustees of the liquidation believe that the true shortfall from this segregated account may be up to $1.6billion.
Now the essence of this article is not to highlight what is already known or what has been circulating in the news, but to use the MF Global case as a flashpoint to make a case for better protection of the assets of traders who domicile their accounts with brokers who on face value, appear too big to fail.
Trading the financial markets is a global business, and a typical brokerage firm will have hundreds of thousands or even millions of accounts belonging to traders from all over the world. Many of these traders may never set foot into the countries where their trading accounts are domiciled or where their brokers are located. As such, measures have been put in place to ensure safety of traders’ funds in countries where regulation exists. One of these measures is the requirement by law, for financial services companies to “segregate” customers’ funds from the main account of the firm. In other words, if XYZ Brokerage has an account with a particular bank A, the company is not allowed to lodge customers’ trading funds into that account; rather a dedicated bank account in a different bank is opened for that purpose. The segregation account is not subject to withdrawal transactions for the company’s business. It is only to be pulled on for settlement of the withdrawal requests of customers.
However, regulation is a complex business and has been seen in the case of Lehman Brothers and MF Global, it is not always fool-proof. Financial services companies typically have branches scattered in several countries, and the regulatory jurisdiction of the countries where the parent branches of these companies are located does not extend to other countries. The regulatory framework differs on a country to country basis. An over-exposure to a bad trade position undertaken by even one branch of a financial services company can have disastrous consequences for the whole company. The concept of segregation is supposed to insulate the customer from these losses, but in the case of MF Global, this does not seem to be the case as the company is alleged to have withdrawn money from the segregated accounts for the company’s use. This raises a lot of questions as to how the regulators did not detect this activity. Obviously, this does not inspire a lot of confidence among traders as traders can no longer be sure that their funds are safe even if the company that houses their trading accounts collapses.
As regulators try to unravel what went wrong at MF Global, one thing is very obvious; there needs to be tighter control on the financial activities of brokerage firms. There has to be in place a fully efficient early warning system that sets off a red flag anytime a financial services company attempts to remove funds for purposes that are outside the legally allowed uses.
Presently in the banking industry, the FDIC insures customers’ accounts to the tune of $100,000, effectively protecting depositors from total bankruptcy if their banks collapse. Such a structure is badly needed in the financial trading industry, especially in the forex market where traders have virtually no protection from the fraudulent activities of brokers.
Traders also have a role to play in their own protection. If you ask 10 traders today if they have conducted a due diligence on the financial state of the brokerage they intend to do business with, you will most likely get a negative answer from 9 of such traders. This is a global problem. Most traders open accounts with certain brokers out of recommendation from family, friends and associates, or from the beautifully worded sales pitches on the internet and on TV. If you tune in to a cable TV station focused entirely on business news and see some of the adverts from brokerage firms, there is virtually no indication that there may be a problem with any one of them. Hardly is a choice of a brokerage firm done out of personal investigative due diligence.
The role of due diligence is best explained by this true-life story, in which the stock of a particular brewery somewhere in a country in Africa was on strong bid on the stock market, appreciating daily as demand for the stock increased. However, there was some small talk of a problem in the company, and the chairman of a stock investors’ advocacy group decided to pay a personal visit to the factory of this brewery. His fact-finding mission revealed a totally dilapidated brewery with zero production. As members of his group began offloading their holdings in this stock, news of the true situation of this company hit the market and panic selling crashed the price of this stock as the brewery folded.
The lesson here is that traders should step up to take some positive actions to ensure the security of their trading funds, with the efforts of the regulatory agencies complimenting these efforts. If this is done, occurrences of customers’ funds disappearing such as occurred at MF Global, would be a thing of the past.