IBs, FCMs, and the Impact of MF Global

Happy Thanksgiving, guys! I thought I'd take this market holiday to cover the mechanics of the brokerage relationships in the futures markets, especially as they relate to the potential impact of MF Global's missing millions. With the tally now over $1.2 billion in missing customer funds and former CEO Jon Corzine being called before Congress next week, things could get very ugly very quickly.

We had a thread last week about Barnhardt Capital Management deciding to shut down in the wake of the MF Global bankruptcy. You can say what you will about Ann Barnhardt, she is certainly...how shall I say this...eccentric, but it would be a mistake to dismiss the points she made in her letter to investors explaining why her firm was shutting down. If the relationship between IBs and FCMs is no longer intact, then it's impossible to have any faith in the futures markets.

Let me back up and explain the roles of the different players in the futures market. First, you have the exchanges themselves. This is where all the trading happens. The job of the exchange is to provide an orderly market for the given commodities that exchange handles. Aside from membership and transaction fees, the exchanges don't handle any actual money. In other words, you can't just walk down to the CME with two grand in your pocket and buy a corn contract.

The next level of customer interaction is the Futures Commission Merchant, or FCM. FCMs handle all the money involved. When a trade is placed, the exchange relies upon the FCMs involved to handle the actual settlement of funds. Because FCMs are so closely tied to exchange operations, they very rarely deal with individual clients. Under all but very few circumstances, the FCM's clients are Introducing Brokers, or IBs.

The Introducing Broker, or IB, is who the public deals with 9 times out of 10. If you see an advertisement for a futures trading firm, it is most likely an IB. IBs deal with individual customers, they make trading recommendations, but they never touch customer funds. When you open an account with an IB, the money you use to fund the account is sent directly to that IB's FCM.

This provides an important layer of insulation for the IB. Brokers within the IB can tell customers that the customer may very well lose every penny he invests with the broker, but not one of them will be stolen because that would be impossible - all funds are held at the FCM. In other words, individual customers are exposed to market risk but not moral hazard. It's an important distinction.

Perhaps now you can see why FCMs don't handle individual clients, and why they sure as hell don't have proprietary trading arms. An FCM is a utility company, plain and simple. It is there to clear trades and disburse funds, and that's it. If they step outside those boundaries, moral hazard looms large because they have all those customer funds just sitting there and they're the ones who handle all the accounting for those funds.

A million years ago there was a firm called Lind-Waldock. It was started by Barry Lind, an absolute giant in the futures business. For decades, Lind-Waldock was the only game in town for discount futures. They catered to a sophisticated trading clientele and were pioneers in electronic trading. Barry was even the head of the NFA for several years.

A strange thing happened in the year 2000, though. Lind-Waldock was acquired by Refco, a huge New York FCM. If that name rings a bell, it's because the whole thing was a sham. Plenty of people thought it was a bad idea for an FCM to take over an IB, but no one had any idea what was really going on over at Refco. In 2005 everything came to a head after REfco went public and then blew up 60 days later. On the heels of a massive accounting fraud, Refco (and Lind-Waldock by extension) went tits up. I never personally understood why Lind-Waldock sold out to Refco in the first place (money, I guess) because Refco was slimy since day one. Whenever a buddy of mine at another firm told me they were clearing through Refco, I was never surprised to later hear that they'd had problems.

Lind-Waldock's story doesn't end there, though. The company was sold at auction a few months after the Refco scandal broke to none other than Man Financial, Inc. And if that name rings a bell, it's because Man Financial was the parent company of MF Global. When MF Global was spun off in 2007, Lind-Waldock went with them. Not content to run an FCM and an IB, MF Global decided they needed a prop trading arm, too. And we all know how well that went.

The problem that Ann Barnhardt outlined is that there needs to be several degrees of separation between the guys taking the risks and the guys holding the money. And she's right about MF Global being a harbinger of extremely negative tidings for the futures market if it is proven that they misappropriated customer funds. Because then it's not just the investing public that loses faith in the system, but the Introducing Brokers as well. Believe me, if you can't guarantee to your customer that their money won't be stolen, you're out of business. Unlike equities, which have SIPC insurance and often private insurance in much higher amounts to indemnify investors in cases like this, there is no insurance in the futures markets. If your FCM steals your money - you're screwed.

And if it's proven that funds were stolen by MF Global, the US attorney needs to go all Sarbanes-Oxley on Corzine's ass and see that he's locked up under the jail. The very viability of the futures markets could depend upon it.