Maybe This is What Market Discipline Means

Take yourself back to the early 1900s.  You are rich, and you just bought a ticket on a worldwide tour offered by a touring company.  But then the tour company goes bankrupt.  Assume it had enough cash on its balance sheet just before its bankruptcy to refund the advance you gave them.  Except for one thing — they also owed money to the same bank where they deposited the money you sent them.  And the bank said no, sorry, that money of yours isn’t there anymore, and the tour company bankruptcy trustee can’t get it either. 

A few years later, in 1913, in Studley v. Boylston National Bank, these basic facts were the nature of the case, and the Supreme Court of the United States effectively ruled against you, citing ‘the absurdity of making A pay B when B owes A.’  This important decision helped cement something called the ‘right of set-off,’ with the Supreme Court concluding:

“But to deny the right of set-off, in cases like this, would in many cases make banks hesitate to honor checks given to third persons, would precipitate bankruptcy and so interfere with the course of business as to produce evils of serious and far-reaching consequence.”

But you are left wondering whether making A pay B is really all that absurd.  Why should the bank get money before you do?  Was it those ‘evils of serious and far-reaching consequence?’ 

OK, now let’s get out of the time machine, at least until a few months ago.   In October 2011, one of the largest futures brokerage companies in the world files for bankruptcy protection – less than a year after the Federal Reserve Bank of New York grants the organization ‘primary dealer’ status, allowing the organization to trade directly with the Federal Reserve.  Then, all hell breaks loose.  One estimate comes out that the company, MF Global, ‘lost’ about $600 million in customer funds.  Then, another estimate has it that the amount ‘lost’ is closer to $1.2 billion.  The company’s CEO then testifies before the United States Senate, stating that “I simply do not know where the money is.”

Well, when lawyers can get involved, and legal uncertainty arises similar to determining setoff and netting rights in insolvency, that’s one way you can have discrepancies as large as $600 million to $1.2 billion, and a CEO testifying “I simply do not know where the money is.”  This is a true statement, at least until the courts make a decision whose rights are respected.

So, how can I assert that the system actually worked? 

Well, it certainly didn’t work all that well for the people who found out, or were otherwise made more certainly aware, that their funds with MF Global were at risk. 

This scandalous situation has had its share of ink spilled on it in recent months, and deservedly so, given the politically well-connected nature of MF Global’s leadership, and the fact that the largest U.S. Federal Reserve Bank in history (and one whose balance sheet remains bloated following its massive effort to ‘rescue’ the financial system) had certified MF Global as a primary dealer even after its stock price had fallen over 80% following the financial crisis.  

Once the Federal Reserve granted MF Global primary dealer status, that status allowed MF Global to enter into transactions directly with the Federal Reserve Bank of New York, and to expose the Federal Reserve Bank of New York to new forms of counterparty risk.   As MF Global became bankrupt, the Federal Reserve Bank of New York acted, in a way, like the Boylston National Bank cited above.   On Monday, October 31, 2011, after MF Global had failed to meet a margin call, the New York Fed declared an event of default, and then exercised what it asserted as its contractual right ‘to set off the calculated loss against the margin provided to the New York Fed by MF Global.’ 

The New York Fed was certainly not the only party trying to defend its position against MF Global.  But if the setoff arrangement proves a solid one through the litigation certain to follow (and this appears probable, at least in light of Federal Reserve Bank of New York’s general counsel Thomas Baxter’s testimony that “To be clear, the New York Fed sustained no loss from its relationship with MF Global”), it means that U.S. taxpayers did not take a direct hit from the resolution of the MF Global bankruptcy, at least through this channel.

Say what?  Taxpayers were protected?

So, what’s the scandal all about?  Perhaps this should be cause for celebration!   Sophisticated futures market participants relied on the existing system of ‘self-regulation,’ including the work of the Chicago Mercantile Exchange (the CME, where MF Global was a clearing member) as well as the not-so-self-regulation Commodity Futures Trading Commission (the CFTC, a federal government agency).  The safeguards established through the markets tend to do an effective job, but they aren’t foolproof. 

And we avoided the result where risky things are made less risky by applying our resources generally, and to have We, the People stand behind the well-connected few. 

This case helps illustrate what market discipline is all about.  The CME is going to work harder, and so is the CFTC.  So will futures market participants, while monitoring their counterparties.  This is a good thing, not a bad thing.

We have more to learn from this affair, including the possible indirect channels through which taxpayers absorbed more underpriced risk.  But consider the alternative.  Like the banking debacle in recent years.  Self-regulation looks like it beats regulation by a mile.

Bill Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. Mr. Bergman is currently working with Social Movement Sciences LLC, a new enterprise developing evaluation and funding services for not-for-profit organizations.

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