Two Major Commodities Market Developments: OTC/Listed Derivatives Convergence and MF Global

Commodities as an Asset Class

The commodities market is undergoing a significant transformation; the culmination of commodities as an asset class for investors, and increasing global demand for commodities. This is the secular trend of underlying demand from end users and financial demand from investors, both individually in form of ETFs and in managed funds including hedge funds well as two major recent developments.  

GFC amd MF Global

But two other major factors are reshaping the commodities markets as well as energy and finance. These relate to the Global Financial Crisis (GFC) fallout in terms of regulatory developments and a scandal for the FCM (Futures Commission Merchant) sector equal to the GFC, in the MF Global raiding of customer segregated funds.

The GFC Legislative Response

The GFC legislative reaction has been Dodd Frank in the United States which regulators from the SEC to the CFTC are implementing to prevent GFC II. Fundamentally, GFC in regards to the derivatives markets accelerates, if not forces convergence of the increasingly electronic based OTC derivatives and the exchange based listed derivatives.

Convergence of Listed and OTC Derivatives

This convergence has enormous implications for market making, liquidity provision, data management and compliance, risk management, transaction processing and settlement.  The convergence challenges the historically separate credit systems, the OTC credit extension to participants and collateral to exchange based margin and clearing corporation structures. As a result there will be a need for thinking through cross asset margining, portfolio margining, and fundamentally collateral efficiency.

The Seachange of Violating Customer Segregated Funds

Separately, an industry bomb exploded in the form of MF Global violating the exchange listed FCM historical and legal separation of proprietary and customer funds. In the FCM world customer funds for initial margin and maintenance margin are segregated from other FCM funds. The US and other countries treat bankruptcy different and manage customer positions of a bankrupt firm entirely different. US attempts to transfer positions, and therefore margin monies, while other countries liquidate customer positions and refund monies.

MF Global Ignored All the Risk Failures of the Last 30 Years

MF Global was all the lessons of the last 30 years in financial markets not learned. It was speculating long and funding short. It was ignoring the reputation risk and the implications of short-term access to funding. It was a classic “bet the ranch” bet that put many primary government security dealers out of business in the 80s when the yield curve flipped, the S&L crisis, Continental Bank collapse, MG collapse, etc. This was not a failure due to market developments that a firm could not overcome; this was a failure of initiating a “bet the ranch” position. The problem with the MF Global failure, albeit a failure that prompts many questions about why either laws are inadequate or are not enforced on negligence of senior executive officers, is that in the last days of impending, inevitable, and unavoidable failure segregated customer funds were raided. Ironically, the MF Global crisis, like the GFC, benefits the largest banks the most and punishes the exchanges and FCMs short term.

Implications for CTRM and Other Systems

The development of new regulatory regimes such as Dodd Frank and the need to process customer funds, margin, and track utilization of such funds will impact the execution platforms, the retail trading platforms and the funding of positions. This will have enormous impact, both positive and negative on traditional futures, options, and derivatives trading software.

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