The credibility of the U.S. futures industry is based on the trust bestowed on it by the clearing house system. The principal behind this is simple:
1) Brokerage firms are required to be member of a “clearing house.”
2) Those brokerage firms, called “clearing firms” are then able to accept customer money. As a requirement of being a clearing member firm this money is held in a specially segregated account (so that a failure of the clearing firm does not result in a loss of the customer segregated funds).
3) The clearing house in turn stands behind all customer transactions. So the customers are not entering into “principal” transactions with each firm, they are entering into transactions with the clearing house. Again, this is to protect each customer from the failure of any individual clearing firm.
In exchange for this protection the clearing house receives a part of every commission paid on every trade by every customer. But the failure of MF Global shows that this protection was always just an illusion and never really existed. Here’s why.
In the case of MF Global customer funds were illegally comingled with corporate funds, putting customer funds at risk. MF Global made a big bet on European sovereign debt and lost. (Of course if that bet were successful Jon Corzine and his minions would have racked up huge bonuses). Because customer funds were included in that bet, those funds were lost as well. It appears that as much as $630 million was comingled, and potentially lost, in this way. So this is where the clearinghouse system should prove its worth. After all, those customers trades were not made with MF Global, they were made with the clearing house.
But apparently that is not so. In a statement on Tuesday, November 1st, CME Group CEO Craig Donohue suggested that CME Group was not responsible for the lost customer money and that the customers themselves would ultimately be responsible for those losses. “Customers have the risk of other customer losses in the customer segregated pool and there’s always the risk as well that customer funds are not properly protected,” he said.
So that’s how the clearing system works. If there are profits to be had, they get distributed among the clearing house and its members. And if there are losses due to the fraudulent activity of one of those clearing members those losses are to be paid by the customers. Well, guess what, there will be no more customers if that’s really how the system works.
For Donohue to make that statement is completely inexcusable and breaks the bond of trust that has existed between the clearing house and its customers for 150 years. Unfortunately it appears that trust only existed if it produced the potential for profits. Donohue’s comment trades honesty, obligation and integrity for expediency, shortsightedness and a breach of trust and in doing so places a limit on the price of that trust. We now know it is not worth $630 million. When customers start to figure out that the protection money they’ve been paying has not protected them, they will find other venues on which to conduct their business. But maybe that’s how the system works.
Once Craig Donohue and CME Group realize that it will ultimately be far more costly for them to abandon their obligation than to save a few bucks today, they may be forced to “do the right thing.” In a world where doing the right thing is defined as doing what produces the most profit, maybe this will get the attention of Craig Donohue. If not, then the protection they have been offering is no better than that provided by your local gangster.
So due to their abandonment of the core principles of trust in the face of fraud at one of the member firms, I present a Jackass Investing “Poor-folio” Award to Craig Donohue and CME Group.