MF Global: back to the futures

November 3, 2011

The implosion of MF Global Holdings Ltd, the largest independent U.S. futures broker until it filed for bankruptcy protection on Monday, calls to mind the collapse of Refco – which in its time was the largest independent U.S. futures broker – after revelations that Refco’s CEO had defrauded his investors. (London hedge fund company Man Group Plc bought Refco’s futures brokerage just about six years ago, and later spun off its brokerage and renamed it MF Global.)

But now that questions are arising on the whereabouts of assets that clients entrusted to Jon Corzine’s firm to back their futures trades,  it may also be worthwhile to bear in mind the bankruptcy of another futures brokerage – that of Sentinel Management, in 2007.

Sentinel was a different kind of futures brokerage than MF Global. The company largely managed money for other futures brokers, delivering outsized returns that, Sentinel’s bankruptcy trustee says, were juiced up by improperly using customer money to secure bank loans that went to fund risky trades.  When the credit crisis hit in the summer of 2007, the scheme unraveled, and Sentinel quickly plunged into bankruptcy. Sentinel managed about $2 billion in customer assets; about $600 million of it was never recovered, and clients are still wrangling over how to divvy up what remains.

Futures brokers are required to keep their customers’ funds in dedicated accounts to protect them from being used for anything other than client business. At Sentinel, customer funds were allegedly moved from those protected accounts to other accounts so they could be used as collateral for loans to Sentinel’s  own trading operations. What happened at Sentinel “is one of the biggest regulatory violations you can commit,” explains Sentinel’s bankruptcy trustee Frederick Grede, because keeping customer accounts separate is a bedrock of the futures industry.  “It is so rare that when you first look at it, you can’t believe that it happened.” (Update: Sentinel’s former owner and head trader both deny they mixed client accounts with the house account.)

Still, it does happen. In fact, Refco was slapped with a $1.25 million fine in 1994 and another $925,000 fine in 1996 for failing to segregate customer funds. But no customers lost money because of it. At Sentinel, it appears they did.

MF Global has not been accused of any wrongdoing, but on Tuesday its exchange regulator, CME Group Inc, said it was “not in compliance” with requirements to keep customer money separate from the firm’s other money, and the Federal Bureau of Investigation was showing preliminary interest. UBS analyst Alex Kramm says:

Money is supposed to be segregated at all times. If it’s not, clearly something was not right.

It’s unclear whether the problem is a book-keeping error, if funds were intentionally moved, or if there might be some other explanation. Reports suggest that MF Global cannot account for hundreds of millions of dollars of its customers’ money. In a best-case scenario, Grede said, customer funds will turn up in other accounts and will eventually be returned to the rightful owners. Still, Sentinel’s case offers a cautionary tale, Grede says:

Normally what would happen in an under-segregated situation, when a company files bankruptcy and you can’t recover the missing funds, then all customers are going to share pro rata in the loss.

CME Group, MF Global’s main exchange regulator, said it appears that the broker secretly transferred funds out of protected customer accounts after CME completed an audit last week, and only disclosed the transfers to regulators early on Monday. The shortfall in customer accounts, at the close of business on Nov. 1, was $633 million, the Commodity Futures Trading Commission said on Wednesday.

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