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Naming Calls: MF Global’s Comments on the CFTC’s Proposed Amendments to Rule 1.25

November 17, 2011

Photo by sc63. Some right reserved.

In Patrick O’Brian’s “Master and Commander” novels, set during the Napoleonic Wars, British naval superstitions are frequently featured. One such superstition is “naming calls,” which says, if you think something might happen, you’d better not mention it.

MF Global would have done well to have heeded that warning.

A little less than a year before MF Global collapsed — 362 days, to be precise — the CFTC proposed amendments to Rule 1.25 under the Commodity Exchange Act.  Rule 1.25 provides that a futures commission merchant (“FCM”) or derivatives clearing organization holding customer segregated funds may invest those funds in certain “permitted investments,” subject to specified requirements designed to minimize exposure to credit, liquidity, and market risks.

The proposed amendments would remove from the investments permitted by Rule 1.25 securities issued by government sponsored entities (“GSEs”) that are not backed by the full faith and credit of the United States, corporate debt obligations not guaranteed by the FDIC, foreign sovereign debt, and in-house transactions. The proposed amendments also would limit investments in any one class of assets (other than U.S. government securities) and extend “issuer-based” concentration limits to money market funds and repurchase agreement counterparties.

When the CFTC proposed these amendments, Fannie Mae and Freddie Mac required a massive bailout, the Reserve Primary Fund had “broken the buck,” and offerings of auction rate securities had failed. The vast majority of comments submitted to the CFTC, therefore, focused on proposed limitations on investments in money market funds and GSE-issued securities.

Like many of its fellow commenters, the now-defunct MF Global opposed restrictions on investments in money market mutual funds and GSE-issued securities. But it also made some eerily prescient comments in response to the proposed elimination of foreign sovereign debt as an investment option.

Just 334 days before MF Global collapsed because of questions surrounding its investment in foreign sovereign debt, made in accordance with Rule 1.25, and the discovery that approximately $600 million in what-should-have-been customer segregated funds had disappeared, it said:

[W]e believe the specific amendments being proposed … are unnecessary, considering that the current permissible investments under Rule 1.25 have not, to our knowledge, resulted in any FCM’s inability to provide customers their segregated funds upon request or to continue as a solvent entity…. We believe strongly that the CFTC’s proposed amendments endeavor to ‘fix something that is not broken. ‘ … [W]e are not aware of any FCM that has been unable to liquidate and provide to their customers upon request any segregated funds invested under Rule 1.25…. Further, since this expansion, no FCM to our knowledge has failed or otherwise been unable to meet any other of its financial obligations as a result of investments made under Rule 1.25. In short, we believe the current investment criteria set forth under Rule 1.25 have worked….

The CFTC may vote on whether to adopt the proposed amendments as early as December 5, 2011.

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