If a $40 Billion Firm Collapses, Has Anything Changed? A Zen Koan for the Dodd-Frank Age
The $40 billion firm is, of course, MF Global, Inc., the now bankrupt futures commission merchant and broker-dealer headed by Jon Corzine, whose presence was so important MF Global once promised potential bondholders an extra 1 percent if he left the firm because President Obama needed him to run the Treasury Department.
So far, MF Global’s collapse has not had the contagious effect of Lehman Brothers’ bankruptcy, even though it’s the largest bankruptcy of 2011 and the eighth largest since 1980. Some have said its failure is more like that of Bear Stearns, and should be treated as a warning of possible things to come.
Which raises the question, has anything changed?
Because MF Global was only a $40 billion company, it would not have been treated as a systemically important financial institution (“SIFI”) under the Dodd-Frank rules even if all of the proposed rules were in place. The preliminary threshold for treatment as a SIFI has been set at $50 billion. The fact that a firm the size of MF Global could collapse without serious repercussions to other financial institutions suggests that the $50 billion threshold might be about right.
The systemic non-event of MF Global’s collapse also confirms the importance of exchanges and clearinghouses. Because MF Global’s trades were of the standard (albeit highly leveraged) type, they were cleared on exchanges, which ensured performance. This should strengthen regulatory resolve to standardize the trading of swaps and limit exemptions and exceptions.
MF Global’s demise brings with it a certain Zen irony. On October 18th, just 13 days before MF Global declared bankruptcy, the CFTC adopted final rules regarding derivatives clearing organizations (“DCOs”), the clearinghouses where derivative and swap trading occur. The Dodd-Frank Act gave the CFTC explicit authority to adopt rules governing the risk management of DCOs. The newly adopted rules include Rule 39.11, which requires a DCO to maintain sufficient financial resources to, among other things, meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO. Given that MF Global boasted that it was the largest derivatives trader on the New York Mercantile Exchange and Comex, and one of the three biggest traders on the Chicago Mercantile Exchange, the CFTC’s requirement appears prescient. In the adopting release the CFTC notes it may revisit the issue as international regulators complete their recommendations for DCOs and as the treatment of systemically important DCOs is addressed. MF Global will certainly be part of the discussion.
Where the CFTC’s DCO rules may fall short, however, is with respect to the financial resources required of clearing members. Newly adopted Rule 39.12 sets the capital threshold for clearing members at $50 million. It justified that relatively modest figure by also requiring DCOs to impose capital requirements that are scalable to the risks posed by clearing members. Whether that restriction provides DCOs with sufficient protection remains to be seen.
Popular wisdom places the blame for MF Global’s collapse on its proprietary trading and concludes that proprietary trading should be banned. Of course the Volcker rule’s prohibition against proprietary trading would not have covered MF Global, since it was neither a FDIC-insured institution nor a SIFI. Moreover, the currently proposed regulationsimplementing the Volcker rules may not prevent the type of trading and leveraging in which MF Global was engaged. Why? First, MF Global used repurchase agreements to finance its trades, which the proposed rules view as secured loans and therefore less risky. Second, MF Global traded in foreign sovereign debt. Question 122 of the Volcker rule proposal specifically asks whether trading in such securities should be exempted from the proprietary trading prohibition. The regulators may have received their answer.
Finally, the implosion of MF Global may also require the SEC to revisit its October 12th swap dealer registration proposal, which allows potential security-based swap dealers and security-based swap participants to self-certify their operational, financial, and compliance capabilities. Given MF Global’s high-profile and once sterling reputation, its self-certification would have been accepted without question.
Which leads us back to the question we started with: Has anything changed?