It’s been over a year since the implosion of MF Global, yet the final settlement of the positions of all clients and creditors has still not been fully resolved.
Just to recap: logically this should have been a very straightforward bankruptcy to settle, since the company was a broker trading in exchange-traded products. One would expect – provided the margining had been correctly handled – that customer positions could have been relatively easily transferred to the customers’ second choice of broker.
That would have left the presumably negative net position of MF Global itself in the hands of the liquidators.
It should have been very simple, but it has not worked out that way. There seems to be a mismatch between how the system should work and how it actually does.
It is quite understandable that London Metal Exchange clients, from the biggest mining house to the smallest one-man band, do not like paying cash margins. They have far better things to do with their cash than to lodge it with their broker as collateral.
So, since LME positions are only settled on the prompt date, the practice of establishing broker credit is part and parcel of the business.
What this means is that at the point where the trade is opened, an actual, real cash margin is not necessarily in place. The unique principal-to-principal nature of the LME allows the arrangements between the clearing house and its members to be different from those between member and client.
For many years this has been a robust system, which has allowed business on the LME to flourish.
However, in a world trying to reduce financial leverage from the levels it hit in 2007/2008, it is no longer clear that this model can survive.
Margining
There is no question that regulatory authorities the world over would infinitely prefer markets to function on the basis of full cash margining. That way, they do not have to worry about the granting of credit, and the attendant need to monitor the levels of exposure versus collateral.
For the regulator, the preferred route would be to require all accounts to be segregated, because that way they can see security without the grey area where brokers or banks are funding open positions on behalf of their clients.
On the surface, that sounds attractive – make everybody responsible for cash funding their own positions and it will impose a necessary discipline on market participants. At the end of every trading day, each market user would cover its margin requirement directly with the clearing house, thus securing the integrity of the market.
This would be good for the regulators, but I am not sure it is that attractive a prospect for LME members.
It levels the playing field, of course, by negating the advantages of big balance sheets that enable brokers to grant bigger credit lines and thus “buy” business.
But it also removes one of the additional profit centres. At present, where customers do pay margins to brokers, the latter have the ability to net off those amounts against their clearing house exposure, giving them a potential interest income.
For the customers of the market – particularly the trade customers – segregation, and therefore full cash margining, are not attractive prospects. That would tie up cash which could be more profitably deployed elsewhere in the business. It may disincentivise hedging, which would expose them to greater price risk.
I find myself in two minds on this issue.
To go back to MF Global, had the regulatory regime required segregation and full margining, the customer position would have been as simple as it should have been and therefore easily resolved.
The bankruptcy would probably still have happened, since it seems to have stemmed from irresponsible prop trading, but customers’ funds would have been protected.
So from the security point of view, segregation is attractive.
But having grown up in a more liberal era, I am concerned by the restrictions on legitimate business. I think the LME, along with all markets, will come under increasing pressure to go down the segregation route. I am just not sure it is the right one.
Risk markets require control of risk, but cannot expect its complete elimination. Monitoring of capital adequacy is a key part of the regulators’ role – if that is done correctly, surely there is nothing inherently wrong with credit?
Lord Copper
editorial@metalbulletin.com
