While we will leave the question of the ridiculous Initial margin cut by the CFTC to the side (an action that should have been since reversed, even using the CME's troubled logic, if it was merely meant to facilitate onboarding of MF Global marginless accounts) a bigger, far more troubling question has emerged, namely whether CME has liability over the MF Global bankruptcy. Goldman's Daniel Harris explains: "CME has been under pressure (-9% wow vs. S&P +1% wow) owing to worries it may face liability over the timing of its communication with the CFTC following discovery of a shortfall in MF Global’s segregated client accounts, given its obligations as the DSRO (designated self regulatory organization). According to the CFTC, a DSRO must provide “immediate notification” when “a member has failed to segregate or has misused customers’ funds.” While details emerge, the stock remain under pressure pending more clarity on (1) the status of the reportedly missing $600 mn in client segregated assets, (2) incremental information on how CME satisfied its obligations as the DSRO with respect to MF Global, and (3) the status of CME/CME Trust’s offer to provide a $300 mn guarantee to the SIPC Trustee for the expedited return of client assets." Perhaps the CME should have stuck to just hiking gold and silver margins...
Some prehistory again via Goldman:
MF Global informed the CFTC and CME of a shortfall in segregated assets early on October 31, thus any potential liability relates to reports that CME had uncovered that information before MF Global notified the CFTC. Given the DSRO’s responsibility to provide “immediate notification” to the CFTC of such information, any potential liability is likely to hinge on the timing of when CME initially discovered discrepancies. With both uncertainty over CME’s liability as an SRO and negative headlines about the missing client assets at MF Global, it is challenging to expect CME shares to recover near term regardless of fundamental trends in 4Q. Further, the $250 mn guarantee to the SIPC Trustee could wind up an expense (the $50 mn from CME Trust would not be expense as it is not on the CME balance sheet) if the Trustee disburses funds beyond what is recoverable in bankruptcy.
So is there a reason to be worried? You betcha:
From within the Division of Trading and Markets organization of the CFTC, we highlight an interpretation of Financial and Segregation of accounts. While these are not the specific rules, they are the interpretation and practices followed by the Division of Trading and Markets in administering the Commodity Exchange Act as it relates to Self Regulatory Organizations. We see four key areas that relate to a SRO’s obligations as they relate to current events unfolding with regards to the MF Global bankruptcy, shortfall in client segregated accounts, and CME’s obligations as the SRO. The below is quoted at length from the Advisory Interpretation, which is available on the CFTC’s website.
Protection of Customer Funds
13. The primary focus of a DSRO’s Program should be on those members that handle regulated commodity customer funds. In this connection, the DSRO should have in place procedures to ensure prompt implementation of its regular surveillance and examination procedures, as soon as such firms begin handling customer funds. In addition, an SRO which is a contract market should establish procedures for monitoring those clearing members of theirs which are not Commission registrants to satisfy itself that they have adequate financial resources to meet their obligations to the SRO’s clearing organization.
Notices to the Commission
18. When material apparent violations of the Commission and other SROs’ rules are discovered, the DSRO must promptly notify the Commission and such other SROs. The following situations will call for immediate notification: a member is not in compliance with the net capital rule; a member’s net capital falls below early warning levels; a member has failed to segregate or has misused customers’ funds; a member has denied the SRO access to its records; or a member has failed to maintain current books and records. However, these notification standards are not in lieu of any other notification requirements imposed on SROs by existing regulations.
19. An SRO must promptly file appropriate notices with the Commission and with other SROs when required to do so by regulation, the SROs’ rules, or this Interpretation. If an SRO becomes aware that a member has not filed a required notice, it should promptly advise the member of its filing responsibility and ascertain whether the member has then made such filing. If the member fails to file, the SRO shall immediately notify the Commission and such other SROs as may be appropriate.
Close Monitoring of FCMs and IBs with Financial or Operational Problems
22. A DSRO must monitor closely each member-FCM and -IB for which it is responsible and which it knows or suspects is experiencing financial or operational difficulties. It must take prompt and effective action to satisfy itself that the member remedies such difficulties. Where a member has failed to remedy such difficulties promptly, or where the member has recurring financial or operational difficulties, the DSRO must take action to limit the activities of such member until it can affirmatively demonstrate its ability to remain in compliance, or take such other remedial action appropriate to the seriousness of the difficulty. A member-FCM generally will be considered to have recurring financial or operational difficulties when it fails to meet minimum SRO/Commission net capital or segregation requirements, or fails to maintain current books and records, on more than one occasion during any one year period. The Division wishes to make it clear that a DSRO must not automatically and repetitively allow an FCM or IB to continue operating without the registrant’s taking substantive action to remedy the cause of the financial or operational difficulty.”
Hmm, this sure puts that whole very generous offer to offer a $300 million financial guarantee to MF Global accounts in a slightly different light now, doesn't it.
Update: here is the CME response:
CHICAGO, Nov. 17, 2011 /PRNewswire/ -- In response to inaccuracies reported yesterday, CME Group confirmed today that it followed CFTC requirements and CME Rules and procedures in reviewing MF Global's segregated funds statements and coordinating that review with the CFTC. CME was advised in the early hours of Monday, October 31 that there was an actual shortfall in the segregated funds account and was told the CFTC was advised concurrently. Shortly thereafter, CME Group discussed the shortfall in a conference call with the CFTC and other regulators. CME Group is confident that it complied with all its obligations as a DSRO pursuant to the Commodity Exchange Act.