So far the number one voted-on question on is “The Number One Priority: Make the Customers Whole.”

I put that question on the site.  I have heard lots of people express this sentiment: that in order to restore customer’s confidence in the futures markets, those that are out money in the MF Global bankruptcy need to get the money back.  First that; then comes any changes in structure or industry plumbing in order to prevent future occurrences.

I did not suggest any particular mechanism for the clients getting their money back.  However, there is an idea that has been floated by several people and I have championed in private circles in order to accomplish this number one priority.  That idea is fronting insurance.

Fronting insurance is a type of solution used where, when you have an event, you raise the money first and pay for it going forward.  My thought was that the industry through some organization or body should sell some bonds, pay off the impacted MF Global customers, and then step in their place for the bankruptcy.  Whatever the ultimate shortfall, should there be one, it would be paid off through higher fees by said organization or body.

In the private circles where I promoted this, the idea was discarded.  Moral hazard, some people said.  What if there was another bankruptcy, other said.  It sets a bad precedent.  Clients of MF Global should have been aware that they were dealing with the low cost broker and that presented certain risks which they assumed.  They had ample time to move their accounts once the MF Global news broke, they said.

I disagree with all of this on a number of levels.  First, I believe the industry will pay for this loss one way or another.  Either we pony up the money somehow to make the customers whole, or the loss of confidence will lead to lower volumes and lower profits for exchanges and market makers, and higher liquidity costs for the hedgers that remain.

You could say that the prudent thing to do, after seeing MF Global’s rating service downgrade, was to liquidate your positions and request a check for your balance.  I had someone do that. They ended up with a check that was no good and had to go through extra hoops to get the 72 percent  back.

You could say clients should have known they were dealing with the low cost provider of services.  But only the proprietary trading firms, those who get the lowest cost commissions, really know those numbers.  The average retail customer at MF Global was not paying prices that would lose MF Global money.  They were paying prices that make up for some of those break-even-at-best deals MF Global did with some proprietary trading firms.

You could say customers should have known the risks they were taking, sending money into an FCM.  But the truth is that every other time customer segregated funds had been at risk in brokerage bankruptcies, the exchanges or clearinghouses or brokerages chipped in the money to make the customers whole.  There was a myth, believed and promoted by many in the industry, that your money was safe in a segregated account.  It was not true, we so sadly learned.   And because of this pattern of protecting the customer segregated funds, clients had little reason to do due diligence outside of checking the government reports about FCM financial rankings.

There was an expectation in the industry, even to the highest levels of the exchanges and the regulators, that MF Global would be sold and all the accounts would seamlessly move to the new firm.  There was an expectation, that even if MF Global went bankrupt, the positive balance accounts would be moved to new clearing firms and customers would hardly miss a beat in their trading.

How wrong we all were.

The futures industry does not have an in insurance scheme like SIPC.  It has a history of dealing with each problem separately and uniquely.  Some of this information is in the public record, like when the CME and CBOT or their clearing houses paid $1 million a piece to make the customers of Stotler whole.  Or when Volume Investors went bust at the COMEX or Klein at the NYBOT.

In each of these instances, the exchanges, the clearinghouses or related trust funds stepped up and took care of the problem in order to maintain the reputation of the industry, and ultimately perpetuated the myth.

The difference today is that the major US exchanges are mostly all owned by one company, which is public and for profit.  And the number is really big.  The CME Group would face an onslaught of shareholder lawsuits should they step up to pay a potential $1.2 billion shortfall.  That is simply not an option.

Tomorrow, I will share with you an idea of mine that could become an option.  Stay tuned.

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