“The protection of its customers’ funds is MF Global’s paramount concern”

MF Global used client money to trade from its own accounts in violation of government rules, reports the AP citing a “federal official”.

The discovery of a reported $700m hole in MF Global client accounts — which according to the Commodity Exchange Act and the Securities Exchange Act should be segregated from the firm’s proprietary trades — jettisoned the rumoured takeover of Jon Corzine’s brokerage by rival Interactive Brokers, according to various media reports.

Earlier on Tuesday, Craig Donohue, chief executive of the Chicago Mercantile Exchange (CME), said in an earnings call that ”MF Global is not in compliance with CME and CFTC regulations related to customer segregation.”

If Donohue and the unnamed federal official are right, then MF Global has been very naughty indeed, and could face civil penalties. It could also throw into chaos the orderly return of money to creditors and lead to legal suits.

Don’t take our word for it — this pdf explains MF Global’s very own Client Asset Protection strategy (emphasis ours):

The protection of its customers’ funds is MF Global’s paramount concern. In this regard, the key components of the futures and securities regulatory regimes with which MF Global must comply are risk-based margining, capital and the segregation of customer funds.

The SEC’s Customer Protection Rule. Rule 15c3-3 (the “Customer Protection Rule”) of the Securities Exchange Act of 1934 Act (“1934 Act”) is the SEC’s customer protection rule which details the procedures that a broker-dealer must observe to protect any of its customers’ assets that the broker-dealer holds.

…

Probably the cardinal safeguard of both futures and securities customers’ funds required by the relevant provisions of the Commodity Exchange Act, the Securities Exchange Act of 1934 and the rules and regulations of the CFTC and the SEC is that they be segregated from the funds of the FCM [futures commission merchant]/broker-dealer and may not be used to meet any obligations of the FCM/broker-dealer.

From the document, here’s MF Global on how it will protect all futures customers trading US futures or options…

Section 4d(a)2 of the Commodity Exchange Act provides that a U.S. FCM must keep all money, securities and property of its customers used to margin their futures or options trades on U.S. exchanges and all monies accruing to its customers as a result of such trades segregated from the funds of the FCM. CFTC Regulations 1.20 to 1.30 provide specific requirements for the handling of customer funds.

… and US futures customers trading foreign futures or options:

CFTC Rule 30.7(a) provides that a U.S. FCM must maintain in a separate account or accounts money, securities or property in an amount at least sufficient to cover or satisfy all of its current obligations to U.S. customers trading foreign futures or options. This formulation allows an FCM to employ a risk-based analysis in determining the secured amount required to be set aside. For this purpose, MF Global employs a method that is permitted by the CFTC. The account(s) must be denominated as the foreign futures or foreign options secured amount and may not be commingled with the money, securities or property of the FCM nor be used to secure or guarantee the obligations of the FCM.

Interestingly, foreign customers trading foreign futures or options don’t seem to have the same level of protection (caveat: we did not go to law school; emphasis ours):

Although CFTC Rule 30.7(a) does not require that money, securities or property of non-U.S. customers trading non-U.S. futures or options be held in separate secured amount account(s), CFTC Rule 30.7(b) permits a U.S. FCM to do so. At this time, MF Global Inc. does maintain funds of its foreign customers trading foreign futures or options in a separate secured amount account in the same manner and employing the same risk-based analysis used for U.S. customers. Such funds are segregated from the funds of the FCM and may not be used to secure or guarantee the obligations of the FCM.

Securities customer service seems more straightforward:

The SEC’s Customer Protection Rule. Rule 15c3-3 (the “Customer Protection Rule”) of the Securities Exchange Act of 1934 Act (“1934 Act”) is the SEC’s customer protection rule which details the procedures that a broker-dealer must observe to protect any of its customers’ assets that the broker-dealer holds. In general, the Rule prohibits broker-dealers from using customer assets as working capital by ensuring that the funds that the broker-dealer holds as a result of its customer business are used only to finance customer liabilities and not to finance its proprietary positions. There are two main principles of customer asset protection: (1) possession and control of customer securities by the broker-dealer, and (2) the maintenance of a required deposit in a special reserve bank account.

That could be a very important “in general”. Time to go long lawyers, again.

– By John McDermott and Cardiff Garcia

Related links:
Does It Seem Strange To Anyone Else That CNBC Is MF Global’s Seventh Largest Creditor? – Dealbreaker
MF Global : 99 Problems And Auditor PwC Warned About None – The Auditors
Official: MF Global Admitted Using Client Money – AP
MF Global and the repo-to-maturity trade – FT Alphaville