This development has, in turn, prompted many participants to ask:

1) Why is the clearinghouse allowed to retain a portion of the initial margin? Isn't that the customer's property?

2) How much of that initial margin will be recovered?

In this posting, we will explore those two questions.

The Clearing System

A clearinghouse guarantees that the parties to a futures contract will perform their obligations by, as often repeated, becoming the buyer to every seller and the seller to every buyer. To ensure the integrity of the clearing system, only qualified members are permitted to keep a trading account at the clearinghouse. Non-clearing member market participants (i.e., customers) must open an account with a clearing member to trade cleared products.

Both the clearing member and the customer must abide by all of the applicable clearinghouse rules. Among other duties, these rules require the clearing member to maintain a sufficient level of capital, contribute to a guarantee fund maintained by the clearinghouse to backstop its obligations to the market, and to collect a specified amount of initial and variation margin in support of trades entered into by the customers of that clearing member. The Commodity Futures Trading Commission regulates any market participant that collects initial margin from customers as a "futures commission merchant".

Some or all of the initial margin posted to the clearing member FCM by its customers is deposited by the FCM to support its obligations to the clearinghouse arising by virtue of providing customers with access to the clearing system. Any initial margin collected from a customer must be kept in an account that is segregated from the FCM’s own property. Federal laws and the CFTC's rules make this initial margin unavailable for use by the FCM, except in very limited and restricted circumstances.

If a clearing member defaults on its obligations to the clearinghouse - including the obligation to post a sufficient amount of initial and variation margin in support of its customer's trades - then the clearinghouse has a right to be made whole. The reason? Simple (in theory) - a clearinghouse guarantees the continued proper functioning of the futures markets - even (especially) in times of an FCM's failure - and guarantees that the parties to the open futures contract continue meet their contractual obligations. If the clearinghouse fails, so does the relevant market and perhaps THE market (and, nothing in Dodd-Frank prohibits the government bailout of a clearinghouse.)

Under applicable rules, there is a waterfall of assets from which the clearinghouse will be made whole for obligations owed by a defaulting clearing member. As explained by the CFTC in a December 2, 2010, rule proposal:

"Typically, [a clearinghouse] uses a variety of resources in addressing defaults arising from a member's customer account. These resources, which are frequently referred to as a "waterfall," typically include, in order, the property of the Defaulting Member, the margin posted on behalf of all of that members' customers, a portion of the capital of the [clearinghouse], and the default fund contributions of other members of the DCO. (Emphasis added; citing to CME Rule 802). 76 FR 75163

"The [clearinghouse] has recourse to all [money, securities and other property collateralizing a futures contract] in the event of any failure of [an FCM] to meet a margin call (initial or variation) with respect to the [FCM's account] at that [clearinghouse]". 76 FR 75164

In other words, if an FCM clearing member fails and owes money to the clearinghouse, then the clearinghouse first uses the defaulting FCM's assets to meet any obligations owed by that member to the clearinghouse. If the FCM's assets are not sufficient to satisfy the obligations owed to the clearinghouse, then the initial margin posted by the failed FCM's customers (and, in turn, posted by that FCM to the clearinghouse) is next in line in the waterfall.

MF Global SIPC Proceeding

MF Global , Inc. was a registered futures commission merchant and a clearing member that offered its customers access to cleared products and, by extension, the clearing system. As has been widely reported, there was a significant shortfall in the amount of initial margin received by MF Global from its customers. Some of this initial margin was, in turn, required to have been posted by MF Global to the relevant clearinghouses, such as the CME's clearinghouse.

In order to keep the futures markets functioning and avoid disruptions in liquidity, the SIPC Trustee arranged for a bulk transfer of the futures positions and, as noted earlier, a portion of the initial margin originally given to MF Global by its customers (and, in turn, by MF Global to the clearinghouse). However, a portion of the initial margin on deposit with the clearinghouse has been retained by the clearinghouse.

Although there are no official pronouncements from the Trustee to this effect, one can only assume that the clearinghouse is holding onto it  until such time as the Trustee is able to determine:

1) How much (if anything) MF Global owes the clearinghouse under applicable clearinghouse rules; and

2) Whether the value of MF Global's property is sufficient to satisfy the obligations owed to the clearinghouse.

Long story short, if there is an insufficient amount of estate property available to discharge the obligations of MF Global to the clearinghouse, then – at least for the time being – it seems possible for the clearinghouse to be made whole from the initial margin deposited with it by MF Global (and, originally, with MF Global by its customers).

Now, getting back to the two questions...

1) Why is the clearinghouse allowed to retain a portion of the initial margin? Isn't that the customer's property?

Because that is how the clearing system works for futures contracts. Well, it is the customer’s property, but it is also available to make the clearinghouse whole if there MF Global’s assets are not sufficient to satisfy the obligations that it owed to the clearinghouse.

2) How much of that initial margin will be recovered?

That remains to be seen. Maybe all will be recovered…maybe none will be recovered…or maybe something in between all and none…Yet, the bankruptcy experts tell me that customers should not give up hope just yet - one of the Trustee's primary responsibilities is to preserve the property of the failed broker's customers and bankruptcy courts are supposed to be courts of equity.