I rarely comment on current events, but today I’m going to make an exception. We’ve had enough time since the explosion of MF Global to get a pretty good understanding of what happened. This is a “teachable moment” about the dangers of counterparty risk and things you can do to avoid it.

For those who haven’t been following the news, MF Global was a major futures brokerage and clearing firm. On October 31st of this year they filed for bankruptcy, and as a result of the bankruptcy proceedings it has become clear that the firm is missing between 30% and 40% of the customer money entrusted to it. The story has an added political twist to it because the Chairman and CEO of MF Global was Jon Corzine, former Goldman Sachs CEO, Democratic governor of New Jersey, and top Obama fundraising bundler.

In order to understand what’s going on here, you need to know something about the rules governing brokerages, and how customer money is handled. When you deposit money at a stock brokerage or futures commission merchant (FCM) they start a new running account for you which tracks your profits, losses, and fees and applies them to your starting balance. But your actual money is not kept separate – it’s co-mingled with all the other customer money and kept in a pool in one customer account. Assuming you’re a US customer of a US brokerage, there is a very important rule here: customer funds must be kept segregated from the brokerage’s own funds. Similar rules apply in most other countries.

So what this means is that a brokerage actually has two piles of cash on the back end – one belonging to all the customers (mixed together) and one belonging to the company itself – the company’s equity stake. Customer trades are cleared against the customer cash, and the firm’s own trades are cleared against the firm’s cash.

Wait, stop. Firm’s own trades? Yup. Here’s where things get problematic for customers. Brokerages are run by traders. They typically evolve out of bank or proprietary trading operations. The process goes something like this:

Firm X is a proprietary trading shop. They’re successful and start trading a lot of capital. As a result, the make a very high volume of trades.

Firm X decides that they could save money by clearing their own trades since they do such a large volume of business. So they buy exchange memberships, set up a back office, ditch their broker, and set out on their own.

Firm X now has a big fixed overhead for back office. So it makes economic sense for them to start clearing trades for other people – they may take other prop operations under their wing, etc. But eventually it makes sense to become a brokerage. So they take on clients. If their brokerage services are attractive, they’ll grow.

Point being, hidden at every brokerage is that original prop shop – a group of traders making bets in the market on the firm’s behalf. Now, if these traders are successful they’re a huge boon to the brokerage in the form of additional returns on the firm’s capital. But from the brokerage customer’s perspective, they’re a nothing but risk. Because if the prop operation loses too much money, the result is that the brokerage goes bankrupt.

When a broker goes bankrupt, bad things happen to the customers. First off, they lose trading privileges – the exchanges won’t accept trades through a bankrupt firm. This can be very bad for the brokerage customers if they have speculative positions they want to close but can’t. Usually exchanges arrange a way to make trades only to close positions fairly quickly after the bankruptcy to relieve this problem. Second, the customer accounts are temporarily frozen while the bankruptcy proceeds.

Now, here’s how it’s supposed to go: since customer funds are segregated, there should be enough funds in the customer account to allow all the customers to close positions and withdraw their money. Then the firm’s side of the accounting proceeds through bankruptcy and other creditors are paid (or partially paid, more likely). Historically, this has mostly been what happened when brokerages go bankrupt. It’s painful for the US customers, but ultimately they get paid and usually fairly quickly. The same can’t be said for non-US customers of US brokerages – they may not benefit from segregated funds (the law doesn’t require it) so they can end up as just another creditor in bankruptcy and get paid cents on the dollar years later when the lawyers are done.

The MF Global situation started out along the same lines, but quickly took a turn for the worse. Their internal prop desk placed a massive bet on various European bonds, notably those of Italy and Greece. Those bonds haven’t been doing so hot. Prices have plunged as the likelihood of bond defaults across southern Europe have risen. As a result, MF Global lost a lot of money. What’s worse, their bond position was much larger than it should have been – they made use of various margin and borrowing agreements to buy many more bonds than they should have been able to. As the losses mounted, their counterparties in those bond trades started asking for more money put up as collateral or margin – MF Global experienced what were in essence a series of margin calls for more cash. Now, the way it should work is that cash should come out of the firm’s pile. When the firm’s pile runs out, the bond positions should have been liquidated due to lack of margin and MF Global should have taken their losses and moved on. But it appears that’s not what happened. It appears they started taking money out of the customer pile too, and using that to meet margin.

I say appears, because it is very hard to track what money actually went where. The customer money doesn’t actually just sit in a pile (or a stagnant bank account). It’s continually moving in and out as customer trades are cleared, deposits come in etc. Much of the money is “in flight” at any given time. So it’s normal that the customer account doesn’t have as much money in it as the sum of the custmers’ notional cash balances. But it should be close, and if trading halted (as it does after bankruptcy) that money should all appear in short order.

What we know for certain about MF Global is that their accounting for the customer account was incredibly sloppy. We also know that when all the money came to rest, there wasn’t nearly enough of it. It’s a likely supposition that missing money was used to meet margin calls on the failing bond trades, but we don’t actually know that for sure yet. My bet’s on the accounting being intentionally sloppy to cover up the fraud. And fraud it is – maintaining the segregated customer accounts is job #1 of a brokerage. It’s the broker’s primary task, and thanks to brokerage licensing requirements everyone at MF Global definitely knew that. But they didn’t do what they were supposed to. Here’s to hoping that Corzine’s likely hefty political protection can be breached and he sees the inside of a prison ASAP.

Regardless of what happens to Corzine and the other MF Global higher-ups, the situation is horrible for MF-Global’s customers. They did manage to close out their positions, but their money is still tied up in bankruptcy and when they get paid they’re going to get 60-70% of the cash value of their accounts. The rest may eventually be recovered in bankruptcy or via SIPC insurance, but that’s rather limited and doesn’t necessarily help much for futures accounts. Basically, the customers got screwed. They experienced what’s known in the industry as “counterparty risk” – the risk that someone you’ve made a deal with (in this case, an agreement for MF Global to hold their money) didn’t keep up their side of the bargain.

The purpose of this blog is to teach people how to be speculators. Most of you will likely be operating through retail brokerage accounts not unlike MF Global. So the obvious question is how you manage counterparty risk – how do you keep what happened to the MF Global customers from happening to you. There’s no sure-fire recipe, but there are several things you can do to improve your odds:

If your brokerage is a publicly traded company, monitor their stock price. If it drops precipitously, find out why. If the drop is related to proprietary trading or other events likely to trigger bankruptcy, seriously consider closing the account and getting your money out. MF Global’s stock dropped about 1/2 its recent value almost a week before they declared bankruptcy. This was related to rumors of massive losses on sovereign debt trades, which turned out to be exactly correct. Had you closed down your account right then, you would have been paid %100 instead of 60%. To this end, I make checking my broker’s stock price as part of my trading ritual when the market opens at 9:30 ET. If

Understand the corporate structure of your broker. Who owns it? Are there shell companies involved? What part is public? How much capital is associated with the brokerage – in other words, how much big a loss could the brokerage sustain without entering bankruptcy? Part of this exercise should be finding your broker’s proprietary trading component and knowing where it sits in the corporate structure.

Check your broker’s financial statements and read them when they come out. Be particularly suspicious of proprietary trading losses.

Understand your insurance situation. How much of your account is covered by SIPC or equivalent insurance? If you trade derivatives products like futures or options, understand how the coverage does (and does not) help you (ie. cash may be covered but other assets may not be). Understand if your broker carries supplemental SIPC-like insurance through Lloyds or a similar firm and exactly what that covers.

Consider maintaining a backup brokerage account with enough capital in it to offset any short term leveraged positions taken in your main account. For example, if you hold ES contracts (~$60,000 of S&P 500) as swing trades overnight, it would be good to have a separate brokerage account where you have enough capital to take an offsetting short ES position or buy a put option on ES (if you don’t understand what that means, ignore if for now). Say you were long ES at brokerage one, and they went bankrupt. You want out of the position, but have no trading rights so you can’t close your position. Then you can go to brokerage 2, go short ES there, and the gains and losses in the two accounts will cancel each other out. When the first account unfreezes to allow people to close positions, you close out the positions in both accounts and get flat. This is mostly important for traders who hold leveraged or volatile positions overnight. Unrecoverable positions may not need to be closed out in a timely manner, and it’s unlikely you would lose trading privileges mid-day so day traders don’t need to worry quite so much. The capital required to have this sort of second account may seem costly, but it may be better than the alternative. The secondary account can also useful in the case of technical failure or natural disaster at the primary brokerage.

Pay attention to the vibe you get from your broker. The less interested they are in providing good customer service, and the less transparent they are, the more worried you should be. Good firms take their customer responsibilities extremely seriously, and if you don’t pick up on that with your broker then consider moving.

Search for independent reviews of prospective brokers on the internet and take them into account when deciding who to do business with.

Avoid privately held brokers and FCMs unless you really know what you’re doing and who you’re dealing with. There’s really no reason anyone who needs to be reading this blog should ever do business with a privately held broker or FCM given the publicly held options available.

Of course, none of this guarantees you won’t find yourself tied up in a MF Global type scenario in the future. But it does make it much less likely. Good luck – it can be a jungle out there.