MF Global's collapse bolsters Dodd-Frank aims, efforts

Jon Corzine’s disastrous tenure at MF Global will boost something that Jon Corzine, the liberal senator from New Jersey, undoubtedly would have supported: the Dodd-Frank Act.

The financial reform law passed last year by Congress was aimed at a preventing a relapse of the crisis that nearly brought the U.S. economy to its knees in 2008. But efforts to implement the law have been stymied in part by congressional Republicans and industry lobbies that view the 848-page law as having gone too far. The law requires various federal regulators to write and pass about 400 rules, according to an analysis by law firm Davis Polk & Wardwell. Of those, only 74 rules have been finalized.

That may now change. While the failure of MF Global, which Corzine oversaw as its chairman and CEO, did not have the same seismic impact as the collapse of Lehman Brothers, experts say the shuttered futures firm speaks directly to the need for certain aspects of the regulatory framework envisioned by Dodd-Frank. It also gives ammunition to those who want to push through the mountain of rulemaking that remains to be done.

"It adds fire under our feet to get these regulations done as soon as possible," said Bart Chilton, a member of the Commodity Futures Trading Commission, in an interview. A staunch advocate for strong regulation, Chilton called MF Global the "new poster child" for the need to beef up market oversight. The CFTC is tasked to write 64 rules, of which it has completed 22, according to Davis Polk.

MF Global was brought down the last week of October after the publicly traded firm reported a record quarterly loss; saw its credit rating slashed to junk; and spooked its trading partners and shareholders with its vast and highly leveraged exposure to European sovereign debt. A last-ditch attempt to sell the firm to a competitor crumbled after a gaping hole was detected in customers’ segregated futures accounts. Roughly $600 million remains unaccounted for, and a federal investigation is underway into both the whereabouts of the money and possible violations by the firm over its disappearance.

The CFTC took the unusual step Thursday of announcing an investigation into whether federal laws were broken with respect to the shortfall of customer funds. Neither MF Global nor any of its current or previous employees has been charged with wrongdoing. Meanwhile, the court-appointed trustee overseeing MF Global’s liquidation on Friday fired more than 1,000 of the firm’s broker-dealer employees to preserve funds for the claims process.

About 50,000 futures customers had their trading accounts frozen and partially transferred to other firms when MF Global entered bankruptcy. But otherwise the market disruptions have been minimal, attorneys and experts noted. Part of this due to MF Global’s size: at about $41 billion in assets and $39.7 billion in debt, it was far from too-big-to-fail.

But another reason is the fact that MF Global belonged to an organization that is a central tenet of Dodd-Frank, said Kevin McPartland, senior analyst with the TABB Group.

As a futures commission merchant, MF Global was a member of a clearinghouse operated by the Chicago Mercantile Exchange. In this capacity, CME acts as a buffer against counterparty risk, guaranteeing transactions between buyers and sellers in the event that one should fail. It does so by requiring trading partners to post margin, monitoring members’ credit risk and establishing a member-funded guarantee that can be tapped in case one member firm defaults and cannot cover its obligations.

The authors of Dodd-Frank sought to apply this structure to the $601 trillion, and largely unregulated, market for over-the-counter derivatives such as credit default swaps, which are insurance-like products that pay buyers in the event of a bond default or bankruptcy. These instruments were blamed for exacerbating the financial crisis because they were traded in the dark between two counterparties, with no safety net in the event that the seller failed to meet its obligations. The near-obliteration of the American International Group was in large part due to its swaps exposure.

"It drives home the importance of clearing," McPartland said of MF Global’s failing. "Had MF Global been a major swap player rather than a major futures player, it would have been much, much worse."

MF Global’s collapse, however, will test the clearinghouse model in other ways.

A debate in the run-up to setting rules for swap clearinghouses was whether its membership should be open only to the largest broker-dealers that currently dominate the swaps market, or if smaller firms such as MF Global should be allowed to participate as well. Firms like MF Global argued that limiting membership would be anticompetitive, but others warned that smaller firms may not be able to absorb the impact of another member’s default and could introduce more risky trades for clearing.

In the end, MF Global won its lobbying effort. On Oct 18, just weeks before the firm collapsed, the CFTC agreed to open up clearing membership to firms with $50 million in net capital, far below the current industry standards. Kristin Johnson, an associate law professor at Seton Hall University, said the failure will force CFTC and others to keep close eye on how the new clearinghouses set themselves up.

"MF Global will encourage regulators to shine a much brighter spotlight on questions of clearinghouse governance," she said.

Others are using MF Global’s failure as a clarion call for imposing Dodd-Frank’s ban on federally insured banks using their own capital for speculative investments, otherwise known as proprietary trading.

Two senators who wrote the provision, known as the Volcker Rule after former Federal Reserve Board Chairman Paul Volcker, said Wednesday the firm’s collapse highlights why the eventual rule, which currently is being hammered out by various regulators, need to be as strong as possible.

Another area of Dodd-Frank where MF Global’s collapse may be felt is how futures firms can use customer funds for certain investments, a common practice that’s been criticized for its lack of transparency. The CFTC had proposed barring the activity but Corzine and others over the summer lobbied the agency to back away from the plan. The commission subsequently tabled a vote on the rule.

It’s unknown if this practice led to the customer fund shortfalls that have been detected at MF Global. But Chilton, the CFTC commissioner, said questions about the missing money should push the agency to pass the restrictions soon.

"It’s high time that we get on it," he said, adding that he’s hopeful the commission will finalize 10 or 11 other outstanding proposals before year-end.