Almost two weeks after the bankruptcy of commodities firm MF Global Holdings Ltd., customers at rival firms are all asking the same question: How safe is my money?
MF Global's collapse is confronting clients across the industry with the harsh truth that although their accounts may be termed "segregated," that does not mean they are off-limits from trouble at a commodity futures firm, much less backstopped by any government insurance fund.
MF Global revealed to regulators in connection with its Oct. 31 bankruptcy filing that it was short perhaps $600 million in customer funds -- money which the firm was supposed to keep in "segregated" accounts maintained under a raft of laws and regulations.
The concerns among investors have reached such a pitch that futures exchange operator CME Group announced late Friday that it will provide a guarantee for $300 million of the missing money in the MF Global case.
"I've lost a good deal of money already over this. Now I'm a big boy who should have known better, with over 25 years experience in the futures industry, but what they were doing with client funds is to me outrageous," said Stuart McClellan, an independent trader from Norfolk in the United Kingdom, who previously worked for Schroders in London.
McClellan has more than $110,000 tied up in MF Global, which he doesn't know if he will get back.
"Using the excess collateral in clients' funds to trade is not illegal, but to my mind it's immoral. There is a huge risk," he said.
Futures commission merchants, as brokers in the industry are known, have always been allowed, with certain restrictions, to invest customers' so-called "excess margin," or the funds in their accounts over and above the collateral required to maintain trades. The brokers then book any profits for themselves.
Segregation simply means that customer deposits can't be mixed with the firm's own money or used to cover firm expenses. They must always be available for customers to trade with or withdraw at a moment's notice. In other words, customers' segregated money isn't some big cookie jar for the firm to dip into when it is short on cash.
"That is what is so shocking about MF Global's situation," said Michael Greenberger, a former director of the Division of Trading and Markets at the Commodity Futures Trading Commission (CFTC) and now a law professor at the University of Maryland.
"If that stability is not present, people will not want to go into what is already a highly volatile trading environment," he said.
Now with each passing day that missing money has not been found, there is growing concern that MF Global may have abused its legal latitude with the segregated customer accounts.
The fear is that MF lost the segregated funds in bad trades or used them illegally to meet other obligations. By this time, traders and investigative sources say, it should have been possible to trace the money, if it still exists, in some account with another financial institution.
Some traders who tried to withdraw funds from MF Global prior to the bankruptcy received checks that bounced.
Commodity traders and investors are now saying they will demand their brokerage houses reveal exactly what they plan investing customer funds in.
Don McAfee, a private investor from the San Juan Islands in Washington state, said he had been a "novice" trader of commodities who had become interested in the sector, in part because he saw less risk from the fate of individual banks and brokerages than in equities or bonds.
"It was a way of diversifying out of just playing stocks, and I was very attracted to the fact you did not seem to have any counterparty risk," McAfee said, who has around $220,000 still frozen at MF Global.
"In the future I am going to want an ironclad guarantee that my account is fully segregated. And if it's not, I need to know that at most it's being invested in U.S. Treasuries, not commercial paper or foreign bonds."
Pressure Mounts on Rivals
Brokers at rival firms, who had perhaps hoped to benefit from the disappearance of one of their fiercest competitors, are fielding endless calls from concerned customers and fearing a run on their own accounts.
"I'm getting calls from people, wanting to know if this could happen again, if I can give them proof that the banks I'm dealing with are OK and that their money is safe," said one broker on the floor of the Chicago Board of Trade (CBOT) on Thursday, who asked not to be identified.
"That's never happened to me before. There's a lot of fear,' he said.
Other traders said they were looking to spread their accounts across multiple brokers to limit their risk, after watching friends and colleagues get locked out of the market over the past two weeks. Others said they were looking into insuring their funds.
The failure to free up client funds quickly after the bankruptcy was further undermining faith in the safeguards in the commodities market, said Michael "Mack" Frankfurter, co-founder of commodity trading advisor Cervino Capital Management LLC in Beverly Hills, Calif.
"There is unintended consequences and systemic risk evolving in this situation. It's not about what needs to be done going forward... It's about what needs to be done immediately to save the industry," he said.
Who Do You Trust?
MF Global's standard agreement with customers permitted the firm to "borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan or invest any of the collateral" in customer accounts. The language is typical of agreements throughout the industry, said one longtime futures trader and industry consultant who did not want to be identified because he does work for the CME Group.
The largest customers might be able to get that language tweaked in their favor a bit, perhaps with an agreement to split revenue earned on the customer deposits. But smaller investors generally have to accept the firm's plans for the use of excess cash in their accounts.
Trading in commodities has exploded over the past 10 years, increasing by more than 600 percent according to some estimates, and bringing in a new breed of Mom-and-Pop investors hoping to protect themselves against, and benefit from, the rising costs of food and energy.
The practice of firms using customer excess cash to make money has been a basic source of revenue for the industry for decades, if not centuries. In fact, it is revenue from those investments that has allowed the firms to cut their commission rates to attract more business.
The practice is codified in U.S. law and regulation, which until 2000 limited use of the funds to basically U.S. Treasury, state, and municipal obligations. Over the next five years, the rules were eased to permit firms to use customer money to enter into repurchase agreements and buy foreign bonds, money-market funds, and assorted securities.
When the financial crisis prompted second thoughts from the CFTC, the industry fought to stop proposals to cut back on how much the firms could do with customer money.
MF Global, which was led by former Goldman Sachs CEO and former New Jersey Gov. Jon Corzine, teamed up with Newedge Group, a major competitor, and warned in a December 2010 letter that reducing the stream of revenue could force some futures commission merchants to shut down.
The Futures Industry Association, an umbrella organization representing futures traders such as Goldman Sachs Group Inc. and Jefferies & Co., as well as MF Global, also pushed back against plans to stop firms investing in foreign bonds and other riskier assets with customer funds. The proposal was eventually shelved.
The MF Global collapse prompted CFTC Chairman Gary Gensler to say on Nov. 7 that he will push again to tighten the restrictions. Industry experts say that may improve the security of segregated funds, but it could also force brokers to charge higher fees.
Meanwhile, the building outrage over the missing money is rattling industry veterans. Dennis Gartman, a board member of the Kansas City Board of Trade known for his daily market commentary, wrote Friday that if industry leaders do not act quickly to make good on the MF customer money, "the futures markets shall be under real and permanent assault."
Todd Thielmann, a former MF Global broker on the floor of the CBOT, said fear was spreading fast among customers. "They've taken any excess money out of all firms now, and they don't know who to trust."
(Reporting by David Henry, David Sheppard and Matthew Goldstein in New York. Additional reporting by Jed Horowitz, Barani Krishnan and Josephine Mason in New York, Samuel Nelson and PJ Huffstutter in Chicago; editing by Edward Tobin and Martin Howell)