Many people are trying to wrap their heads around the MF Global debacle. A lot of funny terms are being tossed about; customer segregated funds, investable funds, hypothecated funds. All those funny words create confusion about what they did, what a trader perceives when they establish a clearing relationship, and the responsibility of the exchange.
So here is my attempt to put you in the shoes of the trader and to change the terms so you might understand.
First, traders need cash to make trades. The exchange requires the clearing firm to post margin to hold those trades, and the clearing firm guarantees that the trades have the requisite amount of cash behind them. That makes the relationship, or distribution channel look like this:
Cash flows between all parties. The trader establishes a relationship with the clearing firm. Essentially it is no different than you going into a bank and opening up an account. The trader deposits money into their account. The Clearing Firm in turn signs a formal guarantee to the exchange clearing house that they will stand behind this traders activity. That means if the trader loses all their money and more, the clearing firm is on the hook for it and will chase down the trader for the money. The exchange is out of the relationship. Get it?
The trader makes a trade. The exchange has a margin requirement that it charges the clearing firm, who in turn grabs the money out of the traders account and posts it with the clearing house to hold the position. If the trade turns out to be a good trade, a winner, after the trader closes out the trade the exchange pays the clearing firm the margin back plus the amount of money the trader earned, and the clearing firm deposits it into the traders account. If it’s a loser, when the trader closes the trade, the clearing firm takes money out of their account and gives it to the clearing house, who remits to the clearing firm on the other side of the trade.
Traders view the dollar amounts in their accounts just like a shop keeper looks at inventory. Idle inventory can be sold and add to profitability. However, the trader never knows exactly when the next opportunity is. They have little control over their supply chain. Because of that, they keep a lot of excess cash sloshing around in their accounts earning no interest.
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