A Derivatives Fight Over MF Global

MF Global
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MF Global

“MF Global’s debacle was a result of complex swaps deals it had struck with trading partners. “MF Global’s debacle was a result of complex swaps deals it had struck with trading partners. While those partners owned the underlying assets — in this case, government debt — MF Global held the risk relating to both market price and default,” Morgenson wrote.

This assertion led to howls of outrage from deep in the weeds of the derivatives business. They saw Morgenson’s assertion that “complex swaps deals”—a sort of anagram for credit default swaps—destroyed MF Global as part of the larger campaign to demonize derivatives.

Morgenson, for her part, helped them along in this impression by going on to say, “These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral.”

The International Swaps & Derivatives Association, an industry lobbying and standards setting group, fired back with the claim that “MF Global did not use derivatives to make its bets on European sovereign debt. ”

Here’s the ISDA:

As the company stated in its third-quarter earnings release on October 25th: “As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland.”

So it seems clear that MF’s European sovereign debt holdings were just that, bond positions financed via repo transactions. Repos, of course, are NOT OTC derivatives. (They’re also not listed derivatives.) They are basic tools of corporate finance commonly used to finance cash bond positions.

We would have thought that, with a little checking, this point would be pretty obvious to one and all. We would have also thought that reporters (and consultants who are used as expert sources on financial matters) would know that because MF Global was an SEC registered Broker-Dealer and CFTC registered Futures Commission Merchant, regulators at all times had full transparency into the nature and extent of MF Global’s trading and risk positions.

In short, there were no derivatives, no opaque financial instruments and no hidden risks in the story of MF Global’s downfall. There were, though, a lot of inaccuracies in the way that story was told.

Shots fired!

So did Morgenson get this wrong?

Well, it’s not as simple as the ISDA would like you to believe. Sure, a repo-to-maturity might not count in the ISDA’s definition of a derivative. But no normal person who doesn’t actually work dealing derivatives needs to care about how the ISDA defines derivatives.

In a brilliant—if wordy (TL;DR, as we used to say)— post on DealBreaker, Matt Levine explains how the repo deals that MF Global engaged in are pretty damn near functionally and economically equivalent to a credit default swap.

In a credit default swap, MF Global would not directly own the underlying bond but would receive some of the benefit of owning the bond in the form of payments from the bond owner. MF Global would also bear the risk if the bond defaulted. MF Global would also run the risk of collateral calls as the bond's value fell.

In the repo deals MF Global actually did, MF Global did not directly own the underlying bond but received the benefit of owning the bond in the form of coupon payments from the bond. MF Global bore the risk if the bond defaulted. MF Global had to supply additional collateral as the value of the bond dropped.

There is a difference between how the two arrangements are financed at origination and in some operational and accounting details. But both, quite obviously, create payment streams and risks “derived” from an underlying bond. They are, in other words, both derivatives.

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