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MF Global and the Failure of the System: What We Now Must Consider


Systemic risk isn't just about handling firms that are too big to fail. It's about ensuring a system works for all of its participants.

There has been a lot of talk over the past few years about systemic risk and systemic failure. Most of it has been in the context of how a company's failure damn near brought the whole system down, whether it was Lehman Brothers or AIG (AIG), or if any of the other "too big to fail" companies actually failed. Catastrophic to think about, certainly, but there has been a systemic failure of a different kind in the ongoing saga surrounding MF Global (MFGLQ.PK).

I've not followed the MF Global story blow-by-blow, but the things I see and hear are dreadful. From the way it was funding its operations (see this and this from FT Alphaville) to reports of fraud involving segregated customer funds that MF Global was supposed to be the custodian of, there has been a string of management missteps that could be characterized as perilous bordering on reckless at their very best, or as criminal at their worst.

Francine McKenna has done a superb job chronicling this sordid affair, as well as the many culpabilities to go around among many parties. You can find her posts on MF Global here and here. And after reading the travails of John Cassimatis, who is an active futures trader, it's clear to me what we have now is an issue where the system has a huge, gaping hole in how to resolve failed futures brokers.

Because while the banks and bank depositors have the Federal Deposit Insurance Corp. and securities investors (specifically stock and bond investors) have the Securities Investor Protection Corp., futures traders don't have such an insurance fund. Indeed, the following snippet from the SIPC's website describes exactly what is going on with the MF Global situation:
Without SIPC, investors at financially troubled brokerage firms might lose their securities or money forever … or wait for years while their assets are tied up in court.

Indeed, as more time passes, the likelihood of additional recoveries from the MF Global bankruptcy will decrease. This is why bank failures are resolved over the course of a weekend. Depositors can get their money back quickly and get on with their lives while the resolution for the troubled institution progresses. Collateral damage where depositors are held hostage during a bankruptcy resolution is drastically reduced and the system – along with the people in it – can move on with their lives.
Sometimes the truth isn't good enough, sometimes people deserve more. Sometimes people deserve to have their faith rewarded...
-- Batman, The Dark Knight

Investors and traders that had MF Global as their broker have had their confidence in the system shaken to its very core. CME Group's (CME) reputational risks have increased dramatically in the wake of this ordeal, and the perceived risks of trading in futures markets are higher now than before MF Global. Indeed, I wonder if we're already seeing liquidity vanish from the futures markets. If we have, that has implications for price discovery, and the thin red line between cost and value gets a bit thicker and harder to discern.

But the funny thing is, there was always a risk of a broker-dealer doing exactly what MF Global did. It just took a pinch of sovereign risk, a healthy helping of systems knowledge to move money around and commit fraud, a couple tablespoons of neglect, and a couple teaspoons of antiquated regulation. Voila. The perfect recipe for exposing flaws in the current system has been created.

Another issue this exposes is the growth in complexity in the broker-dealer operating model. I doubt MF Global was operating itself in a much more complex manner than its peers, but then again, what we've seen over the past four or five years is just how complicated it has become to run a financial intermediary. And yet, we still operate with rules, regulations, and even regulators that largely predate this rise in financial complexity. And I'm doubtful anything in Dodd-Frank or the new rules being written post Dodd-Frank will address a situation such as this. Maybe we shouldn't be asking "Why this happened?" as much as we should be asking "How did this not happen sooner?"

So, what should we do? Well at the very least, we need to consider two things. First, we need to evaluate how futures brokers like MF Global are regulated. This consists of looking at current regulation and how it is enforced. And second, we need to think about what to do to minimize the collateral damage that comes if/when the system is confronted with a broker-dealer failure.

If current regulation is still relevant and has the safeguards for ensuring safe and sound operations, then the way in which broker-dealers are checked to see if they are in compliance may need to be changed as well as how those rules and regulations are enforced. Something has to change because the system is short on trust at the moment and long on fear.

Again, counterparty risk has reared its ugly head. Because if counterparty risk is heightened among brokers and between brokers and their clients, then you can put a nail in all of those pontifications assuming efficient markets. How can a market be efficient if participants can't discern reliable counterparties from unreliable ones?

If we can get past the regulation hurdle, then it's time to deal with the problem of a broker that fails. Safeguards should be put in place so that what happened to MF Global's clients don't happen to someone else. To say it's just a question of due diligence misses the mark. Brokers are very complicated these days, and in the fog of war, any person or institution will either do things you don't expect it to do or do things it shouldn't do.

MF Global probably figured if it could just "fake it 'til it made it," the customer funds would be put back and nobody would be the wiser. If you put the onus of judging these risks on a broker's customers, then you might as well tell folks to start hiding cash in coffee cans in their backyards again. We created deposit insurance for this very reason. It may be time we think about setting up some insurance fund to safeguard against another situation like this, and by borrowing a page or two from banks, we might be able to develop a plan to pay for it all that reduces costs to the government and taxpayers.

The system we have now is far from perfect. But if we spend some time seriously thinking about what happened at MF Global and how to prevent it from happening again, maybe we can take comfort in the fact we're building a system that's a little bit better than the one we inherited.

Twitter: @japhychron
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