MF Global, the failed derivatives brokerage firm, is the first big U.S. casualty of the euro zone debt crisis, having gone into bankruptcy last week. What’s more, some $600 million in customer accounts seem to have gone missing from the firm, which the FBI is now investigating. Which raises an obvious question in the post-Dodd-Frank world: Where were the regulators?


The Financial Industry Regulatory Authority—the private independent regulator supported by the industry—told MF Global in June that its leverage on complicated bets on European sovereign debt was too high. The firm put up more capital by September, but it wasn’t until it went down that the full picture emerged, with leverage reported to be more than 30:1. When it comes to brokerage firms, “regulators are really powerless,” says Jerry Markham, professor at Florida International University’s law school. “They’ll do spot checks, but they’re not going to be on sight, kicking tires. They’re not going to be preventers—they’re going to be law enforcement.”

While Dodd-Frank is meant to increase oversight and data-collection in certain areas, its focus is on big, highly interconnected firms that pose systemic risk, not smaller firms like MF Global. MF Global’s bankruptcy neither destabilized the financial markets nor required taxpayer involvement. “It’s a bankruptcy, not a bailout,” says Michael Greenberger, a law professor at the University of Maryland. “You could take some comfort that if it were Goldman that had done it, or Morgan Stanley—this kind of highly leveraged risky bet would have been caught early.” (Greenberger served as an expert witness in a 2007 lawsuit against the firm that was settled in January.)

Some argue, however, that the government should do more to restrict such highly leveraged bets. “Without meaningful leverage restrictions on borrowers and meaningful lending restrictions on those who are willing to underwrite this steroidal debt expansion, MF Global is likely to be the tip of yet another iceberg,” writes Eric Lewis, a lawyer at Lewis Baach who specializes in international insolvency. But others contend that MF Global simply decided to make a very bad investment decision by betting on the European debt crisis and that it’s not the government’s responsibility to prevent them from doing so. “Should we have protected them from themselves?...If they want to go to Vegas, that’s their choice,” says Markham.

More troubling, perhaps, is the question of whether the firm used some $600 million in customer money to back up its bad bets — money that has since gone missing. Brokerage firms are required to segregate customer money from company money and are subject to periodic audits to ensure that they do so. The missing money is of particular concern because futures—unlike bank accounts or stocks—aren’t insured by federal funds, so the process of segregation is meant to protect consumers who invest in such assets. CME—which is responsible for such audits and also runs a futures market that MF Global traded on—said that the firm hid the shortfall the last time the firm was reviewed. It’s not entirely clear what’s happened yet, but if the customer funds were truly misappropriated, it could be a “first of a kind violation” that flies in the face of a fundamental rule in futures trading, says Greenberger. “It’s really touching the third rail.”

Should regulators do more to sniff out such malpractice? If it turns out that MF Global committed outright fraud, or massively mismanaged its own books, it raises the question about whether private entities like the CME are up to the task of enforcing segregation of such funds. “Do we leave enforcement of segregation to private, self-regulators? Or should it be taken to the CFTC?” asks Greenberger.

In fact, MF Global had lobbied the CFTC against a proposal that would have limited what it was allowed to do with customers’ funds. Jon Corzine—the former New Jersey governor who led the firm until he resigned last week—pushed CFTC chair Gary Gensler to oppose a rule that would have prevented firms from using segregated customer funds to lend money to itself, the New York Times reported. But even had such a rule protecting consumers been in place, it wouldn’t necessarily have stopped the firm’s downward spiral, nor kept that $600 million in plain view.