Lesson 13 of 25 · 7 min

A futures broker, 2011: a sovereign position and a customer shortfall

Segregation is an operating promise kept by the same institution that is running out of cash.

MF Global was a futures and options broker that also held, for its own account, a large position in short-dated European sovereign bonds during 2011. The position was financed through repurchase agreements arranged to mature on the same day as the bonds, a structure whose accounting treatment removed the holdings from the balance sheet while the price exposure and the margin obligation remained.

That is the first mechanism: an exposure can be economically present and structurally invisible. As the bond prices fell through 2011, the financing required more collateral, and the requirement grew from a base that outside observers could not size. Public disclosure of the position and a ratings downgrade in October 2011 turned the funding demand into a general one, as counterparties raised margin and clients moved accounts.

The second mechanism is segregation. A futures broker must hold customer margin separately from its own money. That separation is an operational and legal arrangement executed by the same treasury function that is trying to fund the firm. When the firm filed for bankruptcy protection on 31 October 2011, a shortfall in customer funds reported at around 1.6 billion dollars was identified. Legal proceedings followed.

Customer funds were frozen and returned through a trustee-led claims process over the following years, ultimately at a high recovery rate. The cost to a customer was therefore not principally the money; it was a period of years without access, and the discovery that a segregation rule is an instruction to a firm rather than a wall between two buildings.

Where your collateral is held is a different question from whose name is on it, and only the first one matters on the day the firm files.

Key terms

Repurchase to maturity: Financing a bond with a repo that ends when the bond does. It can be accounted for as a sale while leaving the price exposure and margin obligation in place.
Segregated funds: Customer margin a broker must hold apart from its own money. A legal requirement performed operationally, by the firm, daily.
Off-balance-sheet exposure: Risk that a firm carries without it appearing as an asset or liability. Invisible to outsiders and fully present in the margin call.

Worked example

A small price move on a 2 percent haircut

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. $24,000,000 of face value bought at 97.40 and financed at a 2 percent haircut.

Market value at the start: $23,376,000
Borrowing against it: $22,908,480
Equity committed: $467,520
Price falls to 92.10: $22,104,000 of market value
Permitted borrowing at the new value: $21,661,920
Cash demanded: $1,246,560

A 5.3 point fall in a short-dated government bond demanded two and two thirds of the entire equity behind the trade. The haircut that made the position cheap is what made the call large.

Check yourself

$12,000,000 of face value is bought at 96.80 and financed at a 3 percent haircut. The price falls to 91.50. How does the call compare with the equity committed?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.