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A Lesson From MF Global: Trading Foreign Futures? Ask for FCM to Use Net Liquidating Equity Method

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Home Perspectives A Lesson From MF Global: Trading Foreign Futures? Ask for FCM to Use Net Liquidating Equity Method

For better or worse, it turns out that market failures tend to be the best teachers. Case in point...The trading of non-U.S. futures contract through a U.S. futures commission merchant. Here is a selection from the April 24th Report from the MF Global Trustee to the Senate Banking Committee (available here):

Under current rules, FCMs are not required to calculate "secured" amounts for customer funds held for trading on foreign exchanges per Commodities Futures Trading Commission Rule 30.7 ("30.7 funds") the same way that they must calculate "segregated" amounts for customer funds held for trading on U.S. exchanges per section 4d of the Commodity Exchange Act ("4d funds"). Specifically, the rules allow a FCM to calculate the "secured" amount according to one of two methods:

A. Net Liquidating Equity Method: the net liquidating value of the net equity of all customer accounts plus the market value of any securities held in customer accounts; or

B. Alternative Method: a risk-based measurement based on margin required, plus or minus the unrealized gain or loss on futures positions, plus long option value, minus short option value.

In the case of MF Global, reliance on the Alternative Method in the time period leading up to the liquidation resulted in substantially fewer funds being segregated than under the Net Liquidating Equity Method. This allowed the FCM to believe that it was in regulatory compliance, with hundreds of millions of dollars to spare, even when the amount in segregation was actually in or perilously close to being in deficit. If FCMs were required to compute the secured amount under the Net Liquidating Equity Method, it could help ensure that all customer funds are properly segregated at all times and eliminate a difference in treatment among customers of which most customers are unaware.

The moral of the story: If you intend to trade non-U.S. futures contracts, then ask your FCM to represent that it will determine its customer segregation obligations under "net liquidating equity method," rather than the alternative method found in CFTC Rule 30.7. If the answer is no, then ask why not.

Good day. Good luck. TSR

Post-Script - Referenced on 6/26 under "Learning by Failing" at Financial Times Alphaville by Lisa Pollack of the "Further Reading" blog (available here).