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If Only MF Global Had Spirited Away Some Customer Money To Fund Its European Trades

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DealBook today dug up some neat stuff on MF Global that, if you let it, will make your head hurt and fuel your conspiracy theories about Goldman alumni:

Months before MF Global teetered on the brink, federal regulators were seeking to rein in the types of risky trades that contributed to the firm’s collapse. But they faced opposition from an influential opponent: Jon S. Corzine, the head of the then little-known brokerage firm. ... The agency proposing the rule, the Commodity Futures Trading Commission, relented. Wall Street, which has been working to curb many financial regulations, won another battle.

What they're talking about is a proposed revision to CFTC regulations 1.25 and 30.7, proposed about a year ago, which would have cut back on the securities that futures commission merchants like MF Global can purchase with segregated customer money. In the olden days, and also now, FCMs could put that money in a variety of safe and safe-ish and mock-safe investments, including notably foreign sovereign debt. The proposed changes would cut back that list dramatically, eliminating foreign sovereigns. A summary of the changes is here.

Besides foreign sovereign bonds, the CFTC also tried to get rid of "in-house" repos and reverse repos, in which futures merchants used segregated customer cash to fund their own securities portfolio. As the CFTC explains it:

[A]n FCM may exchange customer money for permitted investments held in its capacity as a broker-dealer, it may exchange customer securities for permitted investments held in its capacity as a broker-dealer, and it may exchange customer securities for cash held in its capacity as a broker-dealer.

The CFTC proposed to eliminate that due to worries about "the concentration of credit risk within the FCM/broker-dealer corporate entity." Also playing a role may have been a sense that, well, using customer money to fund your own principal investments doesn't feel exactly like "segregating" it.

MF, among others, lobbied against a lot of these changes, writing an unfortunate comment letter stuffed with now regrettable phrases like:

In our view, thc CFTC's proposal [on sovereign debt] is unnecessary, and will eliminate a liquid, secure, profitable and necessary category of investment for FCMs. We believe the CFTC should recognize that (a) no foreign country that actually defaulted on its debt resulted in any FCM being unable to return funds to its customers upon request ...

And they won, in the sense that the changes have not been adopted, though it's ... it's not totally clear that MF Global's comment letter, out of the 67 comments submitted, was what convinced regulators to hold off. But Jon Corzine worked at Goldman.

Now, if you sort of let your eyes drift over all of this, you might think:
1. Hmm.
2. The CFTC was going to prevent MF from borrowing money from its customers' segregated accounts,
3. without telling them about it,
4. and investing that borrowed money in foreign government bonds.
5. But it decided instead to let them keep doing that.
6. Now MF blew up because it borrowed money to invest in foreign government bonds,
7. and seems to be missing lots of customer money that was supposed to be segregated.
8. WTF?

Or as DealBook puts it:

The proposed rule would have restricted a complicated transaction that allowed MF Global in essence to borrow money from its own customers. ... Without that oversight, regulators worried that firms could use such internal customer money inappropriately, including bolstering the business in hard times. ... Regulators are now examining whether these transactions explain the missing money at MF Global, according to people briefed on the investigation.

Now, first of all: maybe! Like, it is very possibly the case that MF used client money in a legal though now kind of awkward way to fund some positions, and then went and lost it. [Though apparently not.]

But, also: no, not in the way you're thinking. You're thinking "huh, they took $6.3 billion of customer money, blew it on European debt, and now are sheepishly looking under couch cushions for $700mm of that money."

But that's clearly wrong. They didn't take $6.3 billion of customer money in in-house repo trades to blow on European debt, because we know that they took $6.3 billion of non-customer money in repo-to-maturity trades to blow on European debt. And we know that that money didn't come from customers, but instead from big mean (sophisticated, well-protected) outside counterparties, because they asked for it back:

However, the trade’s greatest folly was that as the market prices of the bonds fell sharply, it would have to pay higher amounts of collateral, soaking up its liquidity. ... [A]s concerns about MF Global itself spread, it also came under greater demands for collateral from counterparties on trades.

The irony is that if MF Global had been funding its European positions with customer segregated funds (which are after all basically demand deposits that can go away at any time), rather than with matched-maturity repo trades with sophisticated counterparties, their funding might well have been safer. Their funding would be short-term, but it would come from people whose incentives and desire and ability to monitor it and ask for it back are mostly pretty low ... until they're very high.

The analogy might be to retail bank deposits. Banks do lots of borrowing in longer-term markets to match maturities, but in the FDIC age retail deposits are pretty stable unless you're a complete cock-up. Customer accounts in the SIPC age are similarly sort of a binary: you keep your money there until you don't, and you're not really carefully monitoring it day to day. The average customer pulls out only when the run on the bank seems inevitable. Big bank repo-to-maturity trades, on the other hand, can be marked to market - via repo haircuts - pretty much at the lender's whim, meaning that it's easier for those trades to start a slow roll downhill that soon accelerates into a fall off a cliff.

Here's what law firm Allen & Overy said about the CFTC's proposed ban on in-house repo transactions:

The proposed prohibition on repurchase transactions with affiliates should be reconsidered. To date, the CFTC has not pointed to any evidence that a repurchase transaction with an entity not affiliated with the FCM would necessarily be safer than one with an affiliate. In all repurchase transactions, whether with an affiliate of the FCM or some unaffiliated entity, the FCM would retain the cash received from the repurchase transaction in the customer account. Given that repurchase transactions with unaffiliated entities may give rise to greater concerns regarding liquidity and the timing involved in exchanging cash and securities, it may even be possible that repurchase transactions with affiliates may provide greater systemic stability.

That's not much comfort for MF Global's customers, but it might have been right.

As Regulators Pressed Changes, Corzine Pushed Back, and Won [DealBook]