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A Relative Case for Commodity Funds

Customer segregated funds were once thought inviolable. My, how the times have changed.

Abraham Bailin, 08/01/2012

Investors have plenty to worry about in merely allocating capital. Now it seems that even unallocated capital (cash positions) is at risk. As we've all read recently, several disconcerting events have unfolded throughout the derivatives industry.

Given that so many people have a pessimistic outlook on the global state of economic affairs, many folks have flocked to commodity investments over the past few years. Those who have used commodity exchange-traded funds and mutual funds may have been disappointed with their recent performance, but at least that was only a consequence of market performance. Many others that have gained access to these asset classes through specialized brokerage firms have had much more to fret about.

MF Global
Back in 2011, MF Global, the brokerage giant run by former New Jersey Governor and Goldman Sachs CEO Jon Corzine was faced with a large liquidity crisis. Historically, institutions like MF would borrow funds on an unsecured basis. Recent times, however, have seen these firms' counterparties implement collateral requirements.

As an enormous repo-trade moved into the red, MF found itself in hot water. Assuming that none of the bonds involved in the trade defaulted, the repo trade was relatively low-risk. So long as MF could maintain the positions until maturity, they would net out in the black. As circumstances in Europe continued to look bleak, however, additional collateral was required to prevent the firm's counterparty from pulling the loan. The trade was so large that coming up with additional collateral was no small task.

MF Global provided services for a large number of market participants. Among them were traders, hedgers, market makers and everyday investors. In their desperation, MF Global breached Customer Segregated Fund regulations. To mask its lack of liquidity, the firm transferred significant sums from its 51,000 customer segregated accounts. Effectively MF Global abused its position as a trusted custodian and converted private funds for its own proprietary trading. The final accounting of missing customer funds tallied up to $1.6 billion, much of which is still missing.

In the best possible scenario, MF Global's trade would have been seen through to maturity, and the stolen funds would have been returned. As it turned out, the scenario was far from optimal, and MF Global customers are likely never to be fully recompensed.

Peregrine Financial Group Inc.
More recently, the futures brokerage firm PFG was found to have committed similar trespasses. The CEO of PFG, Russell Wasendorf Sr., is accused of having misappropriated significant sums of customer money, nearly $200 million in total.

The NFA alleges that, after breaching Customer Segregated Funds regulations, the firm and its CEO falsified financial statements to cover it up. When the NFA found out, Wasendorf attempted to take his own life.

Abraham Bailin is an ETF Analyst with Morningstar.
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