MF Global Spent Customer Money That Was Never Its Own
A futures broker failed in 2011 with a large shortfall in segregated client funds. The rule it violated is the most fundamental protection a brokerage customer has.
The Segregation Rule
When a customer deposits money with a futures commission merchant, that money must be held in segregated accounts, kept apart from the firm's own capital. The firm may not use it to fund its own trading or to meet its own obligations.
The reason is straightforward. If the firm fails, customer property should be returnable because it was never the firm's to begin with. Segregation is what makes a brokerage account different from an unsecured loan to the broker.
The Trade That Created the Pressure
Under Jon Corzine, formerly a Goldman Sachs chief executive and a United States senator and governor, MF Global built a large position in European sovereign debt from countries under stress during the eurozone crisis.
The structure used was a repurchase to maturity. The firm bought the bonds and simultaneously financed them through repo agreements running to the bonds' maturity dates. The accounting treatment permitted removing the positions from the balance sheet and recognizing profit upfront.
The accounting removed the position from the balance sheet. It did not remove the obligation to post more collateral when prices moved.
Why It Failed
The firm's argument was that holding to maturity eliminated credit risk, since the bonds would either pay or default and none of these issuers ultimately defaulted in the relevant window.
That reasoning ignored the path. As the bonds fell in value and the firm was downgraded, counterparties demanded additional collateral. Those margin calls had to be met in cash immediately, regardless of what the bonds would eventually be worth.
This is the same lesson as LTCM in different instruments. Being right about the destination is worthless if you cannot fund the journey.
The Shortfall
As liquidity pressure intensified in late October 2011, funds moved out of segregated customer accounts, and when the firm filed for bankruptcy a shortfall in the range of a billion and a half dollars was identified.
Investigations described a chaotic environment with inadequate controls over cash movement rather than establishing a deliberate scheme, and no criminal charges were brought against senior executives. Customers eventually recovered their funds through the bankruptcy process, though it took years and the recovery was not certain during that period.
What It Changed
The failure produced tightened rules around customer fund segregation, including requirements for more frequent reporting of segregated balances, senior officer sign off before large withdrawals from customer accounts, and daily reconciliation with regulators.
The broader lesson for anyone with assets at a broker is to understand the difference between segregated customer property and a general claim against the institution. In securities accounts, protections differ again and involve separate insurance arrangements. Knowing which regime applies to your assets is worth the fifteen minutes it takes to find out.
The Bottom Line
MF Global's positions were arguably right about credit and fatally wrong about liquidity, and the pressure reached money that was never the firm's. Segregation is the protection, and it only works if the controls around it hold under stress.