CME’s reputation gets a stress test

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Jon Corzine | AP

Updated: December 28, 2011 10:03AM

For a trader, timing is critical. The traders who led the Chicago Mercantile Exchange and the Chicago Board of Trade over the years had an excellent sense of it, both in building their own fortunes and in establishing a futures industry here that has put the city on the world financial stage.

The markets that make up CME Group (CME) created financial futures here in the 19th century as a service to agriculture, which needed certainty and a centralized information source for prices. In the 1970s, our exchanges brought the same concept to financial contracts in interest rates, stock indexes and other areas that are today staples of investing.

The Merc was the first exchange to “go public” and issue stock in itself so it could better compete as technology was remaking the business. It absorbed the Chicago Board of Trade a few years later. Traders who used to own the joints sold out for their benefit, or kept shares and watched them rise more until the financial crisis undercut stocks. But they were no longer in charge. Shareholders and heavy users of the markets, the big investment banks, were in control.

Suddenly, the gift of timing has eluded CME. It is dealing with a scandal in the ranks of its biggest customers, one not of CME’s making but potentially aggravated by it. At the same time, the company, with steady profit margins greater than 30 percent, is rattling its tin cup in Springfield in hopes of getting tax relief. CME Executive Chairman Terrence Duffy has threatened to remove the corporate headquarters from Illinois if he doesn’t get it. The Legislature is expected to consider a CME break this week, but the political pros aren’t sure about its prospects.

The timing hurts CME because of one word: credibility.

MF Global, one of the largest clearing firms in futures, declared bankruptcy on Halloween. Its chairman, Jon Corzine, made a bad investment on European debt and the firm may have broken rules to try to save itself. Federal regulators identified $600 million missing from its customer accounts, an amount the trustee hired to settle its affairs later estimated at $1.2 billion. The deficit occurred even though CME said MF Global came up clean in an audit it conducted late in October. CME blamed MF Global for raiding customer accounts after its auditors left.

But CME is involved here because it clears, or legally guarantees, the trading on its markets. It sets itself up as the first financial backstop for customers and firms when a clearing member fails, and that’s what MF Global was. Yet it took CME three weeks to present a $550 million guarantee to the bankruptcy court to assist the process of returning some customer money.

The total shortfall is not known and CME will be responsible for only some of it, so its $550 million may be adequate. But MF Global customers have been angry that it didn’t act immediately to transfer accounts to another clearing member firm.

Two articles of futures faith have been punctured here: that brokerages cannot tap into customer accounts and that, in the words of a CME marketing brochure, “there has never been a failure of a clearing member resulting in a loss of customer funds.” Instead of being out front in customer protection, CME has issued legalistic releases and started a spat with the trustee over his estimate of the shortfall. As a public company dependent on trading volume, it has not shown that its regulators were on top of a large customer.

“Other than Jon Corzine, I think the second worst actor in this debacle is CME,” said securities fraud attorney Andrew Stoltmann. He said he has 20 MF Global clients. “To a person, they are saying they will never do business with another commodities or futures firm again. The ultimate nightmare has happened for those folks.”

While this tire fire burns in its business, CME awaits word from the Legislature about its tax reduction, worth perhaps $100 million a year. It has a compelling case that the state tax code treats its unique business unfairly, but the timing is horrible. Not even the Republicans, the natural allies here, have been eager to blow wider the state’s deficit. And making threats to lawmakers isn’t good politics. If he doesn’t get what he wants, Duffy will either have to cave or start a relocation when there should be other matters getting his attention.

Is the CME serious about taking operations out of state? Possibly. As I said, the old-line traders there answer to higher powers now.

Put MF Global together with the tax issue, and CME faces a margin call in its credibility. Markets resume Monday.