MF Global, 2011

At a glance

What happened

In its final year, futures broker MF Global started trading for its own account, buying about $6.3bn of short-dated Italian, Spanish, Portuguese, Irish and Belgian government bonds and betting they would be repaid at maturity. As the euro crisis deepened, its regulator demanded more capital against the positions, haircuts and margin calls rose, and in late October 2011 it reported a loss and was downgraded. Clients pulled out, and within a week it was bankrupt with about $1.6bn missing from accounts meant to hold customers' money separately.

Why it went wrong

The bonds were financed with repo-to-maturity, which the accounting rules of the time treated as a sale. Both the bonds and the borrowing left the balance sheet, and the expected profit was booked up front, so the position's size was hard to see. But the credit risk stayed with the firm, and so did the obligation to post margin if the bonds fell. In the final days, customer segregated money was used to meet the firm's own obligations.

What it teaches

Client money is the line a broker must never cross, and segregation has to be reconciled daily, especially under stress. Accounting treatment does not change economic exposure. Accounting standards were later changed to treat repo-to-maturity as secured borrowing, and US customer fund rules were tightened. Futures customers eventually recovered their money through the bankruptcy.

Key terms

Repo-to-maturity

A repurchase agreement that runs until the underlying bond matures, so the financing never needs rolling.

Segregation

Keeping customer money and assets apart from the broker’s own, so they are not available to its creditors.

Haircut

The discount applied to a security’s value when it is used as collateral for borrowing.

Derecognition

Removing an asset from the balance sheet because accounting rules treat it as sold.

Futures commission merchant

A US broker that holds customer money for futures trading and must keep it segregated.

Principal risk

Risk a firm takes with its own capital, as opposed to acting as agent for its clients.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of funding and liquidity risk; client money segregation. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• Lehman Brothers, 2008Nine hundred thousand trades, closed out at once

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Collateral and the CSAThe cash and bonds that back an OTC exposure
• Central ClearingA central counterparty steps into every trade