What Preserves the Integrity of the Derivatives Market?

February 16, 2022

Agricultural producers are no strangers to risk. They grow, buy, and sell commodities in a global economy subject to the unpredictability of floods, droughts, and trades disputes, the whims of governments and politicians, and the devastations caused by pandemics and disease. Many if not most producers develop and employ hedging strategies in an attempt to manage these threats, judiciously buying and selling financial instruments called “derivatives”, such as futures contracts and options.

In simple terms, buying and selling derivatives allows a producer to offset or reduce the financial impact of declining prices for the commodities the producer raises and sells (called “going short”) and of rising prices for the commodities the producer buys (called “going long”). This process of buying and selling derivatives affords producers some ability to, in effect, “lock in” acceptable prices for these commodities and (hopefully) make a profit.

The effectiveness of these strategies and instruments as risk-management tools, though, is dependent upon the laws and intermediaries which regulate and facilitate the derivatives market. Indeed, many will recall MF Global and the circumstances of its demise a little over a decade ago. A prominent brokerage firm and a “clearing member” of the Chicago Mercantile Exchange, MF Global misplaced about $1.6 billion of its customers’ monies that, by law, were supposed to be segregated and protected.1

The MF Global disaster was a painful reminder that there are no riskless endeavors in life—even risk management itself. For many agricultural producers these events also served to bring from obscurity the complex web of laws, agencies, and intermediaries on which producers rely to protect and ensure the integrity of the derivatives market.

Futures Commission Merchants

MF Global was regulated under a federal law called the Commodity Exchange Act as a “futures commission merchant” (FCM).2 Any entity that accepts orders to buy or sell futures contracts and options and accepts money or other assets from customers in respect of such orders, as did MF Global, must qualify and register as an FCM with the Commodity Futures Trading Commission (CFTC), the federal agency charged with implementing and enforcing the Commodity Exchange Act.3

The CFTC has adopted exacting financial and reporting standards in order for an institution to qualify as an FCM. Not the least of these is the requirement that FCMs hold all customer funds – including all margin payments – in separate accounts and not commingle customer funds with the FCMs’ own monies or use the customer funds for other, noncustomer transactions. The segregated-accounts requirement helps ensure customers can access their funds no matter the financial condition or other business activities of the FCM – even if the FCM holding the customer funds is insolvent or has filed for bankruptcy protection.4

All FCMs are required to make reports to the CFTC on a monthly basis demonstrating their financial wherewithal and compliance with the requirements of the Commodity Exchange Act. Selected financial data from each FCM is published and publicly available on the CFTC’s website. This information includes each FCM’s adjusted net capital and the value of each FCM’s customer-segregated accounts.5

Derivatives Clearing Organizations and Clearing Members

As noted above, MF Global was a “clearing member” of the Chicago Mercantile Exchange (CME). CME is a registered “derivatives clearing organization” (DCO) under the Commodity Exchange Act. A DCO acts as an intermediary the clearing process, a DCO effectively becomes the buyer to each seller, and the seller to each buyer, in respect of every derivatives transaction. A DCO executes this role through the
several FCMs that serve as its clearing members.6

The Commodity Exchange Act requires DCOs, like CME, to adhere to several “core principles”. One principle is the obligation to establish financial and operational standards for participation as a clearing member in the DCO. Another is that DCOs institute procedures to mitigate the effects of a clearing member’s insolvency or other default of its obligations, however unlikely that may be.7

CME currently lists around sixty institutions as clearing members.8 CME has established comprehensive standards for its clearing members and procedures in the event any one of these members defaults due to its insolvency. For example, CME’s clearing members must maintain sufficient capital requirements, post a performance bond, and contribute to a “guaranty fund”. The proceeds of the performance bond and guaranty fund may be accessed to cover losses caused by a clearing member’s insolvency or other default. CME’s policies and procedures, moreover, permit CME to transfer a defaulting member’s customer accounts and collateral to another of its clearing members that is solvent and not in default.9

Systemically Important Financial Market Utility

Recognizing that not all DCOs are of equal significance, in July 2012 the U.S. Department of the Treasury’s Financial Stability Oversight Council designated CME as one of eight systemically important financial market utilities. CME garnered this distinction based on the unparalleled volume of U.S. futures and options cleared by CME and the Council’s opinion that no other DCO could serve as an adequate substitute for CME in the event of its disruption or failure. The Council’s decision is hardly surprising. The year prior to its designation CME cleared 96% of the U.S. futures and options market volume.10

The designation of CME as “systemically important” subjects it to a more demanding regulatory regime. These requirements include, among others, the maintenance of additional financial and liquidity resources, heightened business continuity and disaster recovery plans, the adoption of rules and procedures to adequately address losses resulting from a clearing member’s default, and recurring “stress tests” and other analyses regarding its financial and liquidity resources.11


Few agricultural producers could withstand the sometimes dramatic, and oftentimes unpredictable, commodity price fluctuations absent the ability to flatten and soften them by taking offsetting positions on the derivatives market. The various laws, institutions, and participants regulating and supporting the derivatives market is what makes this riskmanagement option available to producers. Some may view the demise of MF Global ten years ago as evidence that these laws, institutions, and participants were flawed then and remain so today. And to some extent they may be right.

A more charitable and realistic view, however, is that the events surrounding the MF Global bankruptcy and its fallout were an unfortunate aberration. Indeed, given all of its transactions and participants, there is an awful lot that must – and does – go right every day in order to maintain stability and confidence in the derivatives market. That so many agricultural producers have continued to utilize hedging strategies following MF Global’s devasting failure is a testament to this fact.

Ultimately, each producer must decide for itself whether and the extent to which it is comfortable using derivatives as part of its risk-management strategy. MF Global taught us that the laws and participants underlying the derivatives market are imperfect and, unfortunately, may at times be susceptible to failure. While the possibility of such systemic failure may not be eliminated entirely, agricultural producers are wise to balance this prospect with the perils of attempting to absorb the peaks and valleys of the commodities markets without a derivatives-based risk management strategy.

1 Most of these funds were margin payments posted by customers as security for their open futures positions. See Rena S. Miller, The MF Global Bankruptcy, Missing Customer Funds, and Proposals for Reform, Congressional Research Service, August 1, 2013, at pp. 2, 4 n.20.
2 Id. at Summary.
3 See 7 U.S.C. § 1a(28) (defining futures commission merchant); id. § 6d(a) (requiring futures commission merchants to be registered with
the CFTC).
4 See id. § 6f(b) (describing financial requirements for futures commission merchants); 17 CFR § 1.20 (describing customer account
segregation requirements and comingling prohibition); Rena S. Miller, The MF Global Bankruptcy, Missing Customer Funds, and Proposals
for Reform, Congressional Research Service, August 1, 2013, at p. 4 (noting that the bankruptcy code is structured to permit an FCM to
transfer customer accounts to another solvent FCM so that the customers may continue to access their funds).
5 See Commodity Futures Trading Commission, Financial Data for FCMs, https://www.cftc.gov/MarketReports/financialfcmdata/index.
htm (last visited January 8, 2022).
6 See Commodity Futures Trading Commission, Derivatives Clearing Organizations (DCO), https://sirt.cftc.gov/sirt/sirt.aspx?Topic=C
learingOrganizations (last visited January 8, 2022); 7 U.S.C. § 1a(15) (defining derivatives clearing organization); CME Group, What is
Clearing, https://www.cmegroup.com/education/courses/clearing/what-is-clearing.html (last visited January 8, 2022).
7 See 7 U.S.C. § 7a-1(c)(2).
8 See CME Group, Clearing Firms, https://www.cmegroup.com/clearing/financial-and-regulatory-surveillance/clearing-firms.html (last
visited January 10, 2022).
9 See CME Group, CME Clearing’s Financial Safeguards, https://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html
(last visited January 8, 2022); CME Clearing Risk Management and Financial Safeguards, available at https://www.cmegroup.com/clearing/files/financialsafeguards.pdf.
10 See U.S. Department of the Treasury, Financial Stability Oversight Council, Designations, https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/fsoc/designations (last visited January 8, 2022); Appendix A, Designation of Systemically Important Financial Market Utilities, available at https://home.treasury.gov/system/files/261/here.pdf.
11 See 17 CFR § 39.30 et seq.

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