December 14, 2011

Ken Kinkopf, a commodity-trading adviser, ran a profitable futures strategy -- executing trades mostly in securities such as the S&P 500 e-mini futures. Business was good. A part-time IT consultant, Kinkopf recently moved to Chicago from Cherry Hill, N.J., to focus on trading full time and work on a second, high-frequency trading strategy that he is developing for his own proprietary capital. He was also seeking prospective investors.

All seemed to be going well for the founder and president of Kinkopf Capital Management ... until his brokerage -- MF Global -- crashed and burned in October. Now half of Kinkopf's $240,000 in proprietary capital is frozen in MF Global's bankruptcy process and Kinkopf is unable to trade. He was also seeking prospective investors at the time of the MF Global collapse. "They weren't mom and pop small accounts; they were large accounts," explains Kinkopf of his investors, which were required to put up at least $100,000 each. One potential investor was going to use the futures for an I.R.A.. Since the collapse, the interest has gone cold, says Kinkopf.

The MF Global scandal rocked the futures industry and pushed many commodity trading advisers (CTAs), hedge funds and even farmers to the brink of going out of business. It also has caused customers to lose faith in the integrity of the futures markets and the safety of segregated accounts, which had been regarded as sacrosanct. "This is going to create a run on the FCMs [futures commission merchants] -- I see it already," says Kinkopf.

His and many other firms' client funds are locked up in the bankruptcy of MF Global, a futures and commodities brokerage firm led by Jon Corzine, the former top executive at Goldman Sachs and a former New Jersey senator and governor. A luminary on Wall Street and a Democratic political insider, Corzine came to MF Global in November 2010 to return the firm to profitability by transforming it into an investment bank and beefing up its proprietary trading.

When Corzine first arrived, MF Global had an estimated 36,000 accounts with $5.5 billion in segregated funds. But the firm, estimated to be worth $40 billion in assets, filed for bankruptcy Oct. 31 as a result of heavy bets made on European sovereign debt from five countries: Belgium, Italy, Spain, Ireland and Portugal.

In his first public appearance since the firm's demise, at a Congressional hearing, a chastened and apologetic Corzine defended his actions, claiming that the positions in European sovereigns had not lost their value or been restructured. The former senator and governor explained how MF Global used "repurchase-to-maturity" transactions-- dubbed RTMs -- to purchase the European sovereign bonds, leveraging customer money as collateral to finance the firm's positions in the bonds.

[Related Article: 10 Takeaways from Corzine's Testimony]

While showing remorse and offering apologies to customers, Corzine, who resigned as MF Global's CEO Nov. 3, said he had no idea where the missing money went. "My understanding was that our books and records were reflecting chaos in the last two days," Corzine told Rep. Frank Lucas (R.--Okla.), the chairman of the House Committee on Agriculture, which oversees futures and derivatives.

[Related Article: MF Global's Disappearing Cash]

Follow the Money

Teams of regulators from the F.B.I., the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) still are searching for the missing customer money. Meanwhile, though CTAs and farmers trusted that their money was held in segregated accounts at MF Global, they were shocked to find out that the capital they left on deposit at the firm had vanished.

"I'm getting emails from other FCMs that everything is safe, but it's not stopping me from pulling that money out," says Kinkopf Capital Management's Kinkopf, adding that he has written to congressmen, senators and CFTC chairman Gary Gensler requesting assistance in recovering his firm's funds. "My business has basically stopped," he continues. "You have to feel abandoned that the regulators have forsaken the customer."

Kinkopf is not alone in his discontent. Thousands of investors, traders and farmers are questioning the integrity of the futures market and blaming MF Global's regulators -- including the CFTC and the Chicago Mercantile Exchange, operator of the exchange on which MF Global did most of its futures and commodities trading -- for not raising red flags in the days leading up to the firm's bankruptcy filing. In fact, MF Global, while portrayed as a sleepy brokerage, accounted for approximately 28 percent of the total volume in futures, according to James Gellert, CEO of Rapid Ratings, an alternative ratings agency that had a junk rating on MF Global since 2009. "It doesn't get the same cache as Lehman Brothers, but it's as big a failure within the futures and commodities world," Gellert asserts.

While it's still not clear exactly what transpired at MF Global, and while Corzine and the firm have not been accused of wrongdoing, witnesses say MF Global raided customers' segregated accounts in the last few days of its existence to meet margin calls or demands for more collateral from its counterparties and banks. If this is true, then MF Global could have illegally moved the customer money held in the FCM to the broker-dealer side of the firm for proprietary trading.

"What is really troubling is the illegal misuse of customer funds. That means the operational controls were either lax or overridden," says Philip Lawton, senior analyst at Aite Group. "It's going to be interesting to see the timing of the raids on customer accounts. These might be a panicky attempt to ride out the firm's trouble more than they reflect deficient controls."

Corzine testified that he strongly advocated the European debt trades, and he made it clear that MF Global's board of directors was aware of the trades and had approved risk limits for investments in each country. "Indeed, the trades were described, analyzed and debated at multiple board meetings," Corzine told the House Committee on Agriculture. He also said that the trades were discussed with other MF Global senior managers and traders and were known to the firm's accountants.

Even though MF Global had a chief risk officer and a compliance officer, those professionals may have been afraid to stand up to Corzine, observers suggest. "You bring in a guy who has a rock star reputation, plus he's the CEO -- it's hard to tell the emperor that he has no clothes on," says Michael Manning, retired president and CEO of Rand Financial Services, a Chicago-based FCM. "Even if he didn't have an intimidating personality, here's a guy who was managing director at Goldman and a senator and a governor."