Is your money really safe at an FCM?

http://www.forbes.com/sites/robertl...lion-of-other-peoples-money/?partner=yahootix


11/08/2011 @ 9:17AM |286 views
Did MF Global "Embezzle" $633 Million Of Other People's Money?

I’ll tell you why I ask this probing question. I received an email this morning from a seemingly enlightened fellow quite conversant with the foibles of the futures trading business. He makes a quite convincing case for the ease by which MF Global might have grasped onto customers’ cash to meet its own margin calls on trades going south or just to resolve trading it was doing in its own name. I’m now hearing from another expert that MF Global could use customers funds IN ANY WAY THEY LIKED>

I am printing this email from a private investor conversant with commodities clearing firms and their inadequacies. You can read it yourself. Pay especial attention to the conclusion; “that any futures commissions merchant can easily embezzle customers funds, call it an error, and no longer be liable to its customers. Market participants should really be doubtful about the CME and the ICE’s financial safeguards.”

Hmmm. I inquired of my private investor what not so kosher machinations might be going on out there– and he sent me this answer; “What if other clearing firms are commingling customers funds with their own so that grain warehouses and metals vaults are at risk of losing t heir integrity?”

Just minutes ago, another reader, who seems quite well informed told me; customers “are not protected in an segregated account.” MF Global– or any other dealer “are perfectly within their right to make a free bet on European or Junk bonds with your money. Nothing illegal in it. All of it can be parked off the balance sheet… It might be difficult to find in the accounts.”

Its obviously time for a full court press on all commodities exchanges as trading in gold, copper, metals, and agricultural products has become a massive asset class. Let’s just hope it hasn’t become a massive asset rip off.

 

Who Wants In?
By John J. Lothian and Jim Kharouf

On Oct. 30th, the day before MF Global declared bankruptcy, I (John Lothian) wrote an email to some industry leaders expressing my strongly-held belief that there would be no deal to buy MF Global. The reason biggest reason was that there “has not been any player in recent years that has come into the futures brokerage business and acquired companies with MFG’s model and proven successful,” I wrote.

The futures commission merchant (FCM) business model is broken, with no better example than by the struggles of MF Global. It is hard to earn profits when a major revenue input to your business model includes interest income and short-term rates that are, practically speaking, zero.

In order to earn a return on capital in the form of interest income, you must take more risk. The problem of course is that the more risk you take, the less liquid the investments and the more variance the price will be when you need to get your funds back quickly.

Short-term U.S. Treasury securities are a deep, liquid market that makes it easy for FCM executives to sleep at night knowing they can turn those instruments into cash quickly and easily. Other instruments cause increasing amounts of insomnia.

Commissions

Of the three major revenue inputs for FCMs - commissions, interest and principal risk - the sure thing has always been the interest income. Commissions have been on a downward spiral since the deregulation of commissions led to the rise of discount brokers. However, since the rise of electronic trading commission, prices have cratered.

Electronic trading led to a disintermediation that eliminated costs, including personnel (floor brokers, phone clerks, floor messengers and off the floor brokers) and transcription errors. With customers entering their own orders online, a smaller support staff is required to support the customer when they have problems or questions. This trend is no better represented than by the firm that was the last reported to be interested in buying MF Global, Interactive Brokers.

One cost that did go up was technology. With the cost of systems and telecommunication lines to access electronic markets so great, firms found refuge in merging with rivals to cut costs and improve profitability. This is true in the brokerage space as well as the proprietary or principal trading space.

Locals and Clearing

And clearing has also had its challenges. MF Global did not even want to be in the business of clearing local traders. They acquired some of that business through various deals when they were Man Financial but would always seem to spit those customers out later. It was only with the acquisition of the FCM assets of Refco after its 2005 meltdown that they got back into the local clearing business to stay. That local customer base proved helpful when Man Group decided to spin off Man Financial in 2007, as it allowed the broker to boast huge volume numbers as part of its IPO.

With the CME’s stock soaring at the time, anything that looked and smelled like an exchange was bound to get a premium value attached. Man Financial even bought an interest in US Futures Exchange in 2006, nee Eurex US, so they could get more of this aroma for their IPO.

Today, with the MF Global bankruptcy, the CME Group could not find any takers for the local trading business.

Retail and Institutional Business

ABN AMRO was awarded the institutional business from MF Global by the CME, and R.J. O’Brien stepped up (reportedly adding $100 million in capital to the firm) to take the retail business. Other firms took on some business too as those deals were privately negotiated, including my firm (The Price Group) moving to ADM Investor Services.

ABN AMRO though is owned by the Dutch government as a result of the implosion in the banking sector following the financial crisis and some very bad mergers preceding it. So who wants into the the institutional side of the futures business? The Dutch government? (Hey, at least its not Bawag, the former - and now most famous - fourth largest bank in Austria.)

R.J. O’Brien was sold to a couple of private equity firms back in 2007 for an unreported sum. The O’Briens maintained a minor interest in the firm, though in December 2010 they bought back controlling interest for what was whispered as pennies on the dollar from the 2007 sale price.

Next!

So you have the Dutch government and the O’Brien family, one a reluctant forced buyer and the other a recent seller (and later buyer back), who want in to the futures brokerage business.

One thing to me is clear, and that is that if interest rates continue to stay near zero for an extended period of time, then it could kill the futures commission merchant business as we know it.

Commissions will need to rise to compensate for the non-existent interest income. Some local traders, unable to find a new clearing broker home, will likely end up as customers of Interactive Brokers or some similar deep discount online broker. The higher commission rates they will be charged as a result will impact their style of trading, even potentially leading them to drop their exchange trading rights as they don’t need the volume discounts. Or, they may need the money from the trading rights if some of their capital is stuck in the MF Global bankruptcy proceedings for an extended time.

Some of the firms coming into the futures brokerage space are coming out of the equities world, firms like TD Ameritrade, Charles Schwab and E*Trade. They offer a different model than MF Global’s. They run a house business, not a broker-driven customer business like MF Global. Maybe the future looks more like them, offering multi-asset class products from a single relationship, than the standalone futures brokers of today.

So who wants in to the futures clearing brokerage business? Step right up.

 

It's worth noting when something as mainstream as Forbes is raising these very questions. I think that there has been far too much blind optimism and complacency these past few years in light of what we witnessed in 2007-08.

 

Once again ZIRP rears its ugly head. An abomination of a monetary policy. Four years of this bullshit.

 

Prescient. Yet another "unintended consequence" of ZIRP.