The collapse of MF Global has left many questions in its wake, some still unanswered. How much money is missing, exactly? Who authorized the use of customer funds to cover its debts? Where were the regulators in all this?
Fortunately, that last question does have an answer. The Financial Industry Regulatory Authority, or Finra, grew concerned about MF Global when reviewing the firm’s disclosures filed on May 31, 2011. They pressed the firm to increase its cash reserves, a request backed in later months by the Securities and Exchange Commission, which had the power to enforce such a demand. The idea was to ensure the firm had enough funds to withstand a collapse of the European bond market, in which MF Global had bet heavily. The brokerage had difficulty raising the money, and partially in response, ratings agencies downgraded the firm. On October 31, MF Global filed for bankruptcy.
That timeline would be unfortunate under any circumstance, but what turned the MF Global case into a disaster was news that an estimated $1.2 billion in customer funds were used to shore up positions in the week preceding the bankruptcy. CME Group, the exchange at which MF Global was a member, revealed today that it was alerted to the transfers mere hours before the bankruptcy filing. It is the first concrete confirmation that such illegal use of funds had taken place.
The rapid unravelling of MF Global highlights the difficult position in which financial regulators find themselves. “Because markets move so fast and there are so many trades, a huge amount of activity could occur before regulators or even senior management in the firm knows about it,” said Kathleen Hagerty, a professor of finance. “If MF Global had segregated customer funds properly and the record keeping was more careful, the risky proprietary trades would not have put the customer money at risk.”
There are civil and criminal repercussions for using customer funds to losses, but with the fate of the company on the line, it seems the threat of prosecution wasn’t enough. To prevent such temptation, Hagerty suggests regulators should make sure brokerage firms both adequately protect customer money and maintain diligent records to “keep track of the incredibly large number of transactions which occur at these firms.”
Hagerty also points to an article in the Financial Times by Darrell Duffie and Joe Grundfest, both professors at Stanford. The pair recommends two solutions. The first is to segregate funds with an independent custodian, who would be able to block actions like those taken by MF Global. If that proves too resource intensive, they suggest a sort of “virtual custodian,” consisting of an IT firewall within the brokerage’s network. Transfers of funds would trigger automatic notifications to the broker, clearing house, and customer.