Tuesday, December 6, 2011

The "MF Global Rule" can not be applied retroactively

The media coverage of the MF Global story continues to underwhelm. Here is a NY Times quote from today:
"...the collapsed brokerage firm that is believed to have improperly used millions of dollars of customer money."
What's missing here is the precision in the usage of the English language. Some would say that my tea drinking etiquette would be "improper" within certain circles in the UK. "Improper" could mean culturally inappropriate, in bad form, bad practice, unethical, immoral, illegal, fraudulent, etc. The exact usage here would make a tremendous difference to the clients of MF Global.

What's ironic is that the same NY Times story discusses the new rule to be imposed going forward, named appropriately the "MF Global Rule".
The new rule will limit how the brokerage industry can invest customer money, largely barring firms from using client funds to buy foreign sovereign debt. It also prevents a complex transaction that allowed MF Global, in essence, to borrow money from its own customers.
OK, so now we are getting somewhere. This is a new rule that didn't exist before. That means that legally MF Global could in fact do those things before the rule went into effect. It could legally use some of the money customers posted as margin for their portfolios for general corporate needs, including posting margin on its own positions.  It's a terrible practice, but until the MF Global Rule goes into effect it is not illegal.  In fact one of the reasons the implementation of this rule was delayed by the CFTC was because Corzine fought it.  Corzine knew that with the rule in place, MF Global would be immediately insolvent.

Therefore unless the MF Global Rule is applied retroactively - which in itself is illegal - the clients will be fighting with the MF Global bond holders in court for whatever is left from the liquidation. That's exactly what happened to those who posted margin to Lehman - they are still waiting for a payment on their claim.  And it is entirely possible that the bond holders will have a priority claim.

Going forward, this ruling will have tremendous implications for FCMs and other brokerage and derivatives operations' business models because many relied upon their ability to tap client "margin cash" for general corporate use. It will constrain their capital, ultimately making it more expensive for clients to transact.
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