U.S. Regulators' Epic Fail

Most readers of The Motley Fool don't have a futures trading account for dealing in contracts for commodities like wheat, butter, and cattle. So perhaps it's easy for many investors to gloss over what's going on at MF Global (OTC: MFGLQ) right now.

I'm not referring to the fact that MF Global went bankrupt, nor am I thinking about the missing $600 million. What's got me worked up right now is the fact that billions of dollars of customer money at MF Global has been frozen, and those customers have been left grasping at straws, begging the company's bankruptcy trustee to release those funds.

Imagine this
You wake up Monday morning to find that your stock broker has gone belly up. Your life savings is with that broker -- your funds for retirement, college savings for your kids, perhaps a down-payment for a house. You try calling a telephone number posted on the broker's website and are told simply that the bankruptcy trustee is working through the books and that it's unclear when you'll have access to your money.

Or, worse, imagine you find out your bank has gone under. Again, your funds are frozen and nobody's able to tell you when you might see them. Meanwhile, bills are due, your mortgage payment is coming up, and, oh yeah, you'd like some groceries this week.

Fortunately, equity investors and bank depositors don't have to worry about these scenarios. The Securities Investor Protection Corp., or SIPC, guarantees up to $500,000 for securities, while the Federal Deposit Insurance Corp., or FDIC, steps in with up to $250,000 per account to protect depositors at failed banks.

As a result, when my online broker, E*TRADE (NAS: ETFC) was teetering due to a terrible foray into the housing market, I didn't feel any need to flee to another broker. Likewise, when Bank of America (NYS: BAC) and Citigroup (NYS: C) were on the brink, depositors didn't have to panic.

Not so for futures traders
There is no guardian angel for futures traders that's ready to step in and backstop the customer accounts of a failed futures broker. There's no insurance fund sitting around waiting to make right the wrongs of that failed broker.

But customers didn't feel they had to worry about that. The funds of customers at a futures broker are kept in segregated accounts. Some of the money in those accounts can be used to earn interest for the broker, but the funds are under no circumstances supposed to be commingled with the company's money or used to provide funding to the broker.

The word seen most often to describe these segregated funds is "sacrosanct" -- defined by Merriam-Webster as "most sacred or holy."

The initial outrage over the MF Global bankruptcy was that these supposedly sacrosanct funds were apparently violated by MF Global. A cool $600 million went missing from the customer accounts and it's yet to be determined what was done or where that money went. But there is speculation that MF Global used customer money as last-ditch financing in its final throes before succumbing to bankruptcy.

At this point, though, thousands of MF Global brokerage customers care far less about the missing money -- which represents roughly 11% of total segregated accounts funds -- and far more about the fact that they've been locked out from what is still in the accounts. This has been particularly infuriating for customers who were the most conservative, since open securities positions have been transferred, but those with hefty amounts of cash in their accounts had been stiff-armed by bankruptcy trustee James Giddens until very recently.

Not academic
This is affecting a huge cross-section of people and having major real-world consequences.

In a letter to the bankruptcy judge, trader "C. Howard" writes: "I had a futures account with MF Global. Trading is my job and I can't work while all excess margin equity remains frozen."

Walter Augustine has a similar tale, writing: "As a small trader I rely on my daily activities for a living. Without the funds from my MF Global account I am dead in the water."

Howard Feldman wrote to the judge on behalf of his 85-year-old mother, whose funds have been locked up by the MF Global mess:

As the segregated accounts remain frozen as of this writing, my business and personal life have been tremendously affected in that these are my elderly mother's assets. In this day and economy where jobs and income are essentially impossible to find, I respectfully plead with the compassion of the court to allow for immediate access to our funds to allow our businesses and lives to continue.

But it's about even more than small traders that have been put out of work and people whose life savings have been tied up (as if that's not enough). As trader Edward Heming wrote to the judge, liquidity in the futures markets has the potential to impact all of us:

[It] is of the utmost importance that this release is acted upon in a timely manner to ensure that customers conduct business and provide liquidity to the futures markets. Although the effect of reduced futures liquidity may not be readily visible, ultimately what we pay in the grocery store and at the gas pump is largely influenced by the liquidity of the markets.

The Progressive Farmer interviewed Marty Klinker, a small Montana farmer who's been squeezed by not having access to the excess margin funds he had in his MF Global account. He's worried that his problems are likely echoed all over the country:

This is me, a small farmer from Montana. Contemplate the situation of a large elevator in Montana that backs all of their hedged-to-arrive contracts (HTAs) with futures. Someone with 10 million bushels on HTA back on the Kansas City or Minneapolis exchanges and no margin money could be in deficit by $5 or $6 million. How many elevators or commodity merchants are in similar situations across the heartland?

In other words, there may be many commodities producers gritting their teeth and dealing with the lack of access to their funds at MF Global, but if the issue persists and margin deficits mount, there could be market dislocations as they scramble to address the shortfall.

But that's not all. Major futures exchanges like the CME Group (NYS: CME) and IntercontinentalExchange (NYS: ICE) rely on transaction fees. A big drop in volume due to futures traders' money being locked up could be bad news for their businesses. And when you consider that futures contracts -- like equity options -- are inherently leveraged, the money locked up at MF Global has the potential to drive a truly massive amount of trading volume. In that light, it's no wonder that CME Group has offered to put up as much as $300 million to help expedite the return of funds to MF Global clients.

Help on the way?
Today, the bankruptcy judge approved a motion to release $520 million to thousands of MF Global customers that had cash-only accounts. This would represent 60% of the value of those accounts and is expected to happen "within a matter of days" (according to The New York Times). This is absolutely a step in the right direction and adds to the initial $1.5 billion that was transferred shortly after the bankruptcy.

However, this still leaves substantial question marks for customers whose accounts weren't all cash, but had substantial amounts of excess margin. It also leaves a very significant amount of the all-cash customers' assets tied up -- and, again, around 89% of the customer segregated accounts appear to be accounted for.

Further, there are considerable concerns surrounding how the rest of the claims process will unfold. Time is of the essence for many of those affected, and customers are worried that "nimble" and "quick" aren't adjectives to describe Giddens, who has spent more than three years unraveling Lehman Brothers. There are also concerns mounting for many customers that their supposedly sacrosanct accounts could end up getting converted to unsecured claims and they will have to fight tooth-and-nail with other creditors like JPMorgan Chase (NYS: JPM) and Bank of America.

The significance of this is huge for the U.S. futures trading industry. If customers of brokerage firms suddenly feel that they can't trust the safety of the funds they have with their brokers, then they'll start pulling their accounts, potentially hampering liquidity in the futures markets. This would have a direct effect on financial markets, but through the widespread use of futures by companies throughout the economy to hedge certain exposures, this could produce a chill for the broader economy as well.

Rules are supposedly on the books to prevent a mess like this from happening. As of right now, it would appear that those rules failed miserably. It's time for a change.

If you have any information to share about the MF Global situation, the team at The Motley Fool is all ears. You can email tips@fool.com or call 703-254-1546.

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