The worldwide financial contagion spreading through subprime markets may now be hitting the futures industry in a serious fashion. Sentinel Management Group has frozen assets largely composed of margin excesses belonging to futures market participants – including hedge funds, brokers and commodity trading advisors – meaning that these clients could find themselves unable to meet margin calls.

Futures industry executives told FO Week that this could pose a major financial shock to the futures industry, although there have been ongoing meetings to resolve the issue between Sentinel and the National Futures Association, the designated self-regulatory organisation of the firm and exchanges.

One senior executive of an FCM, whose firm has often done business with Sentinel, estimates that 80% to 90% of Sentinel’s assets are tied to the futures industry with clearing FCMs, non-clearing FCMs, hedge funds and CTAs. Sentinel, a registered FCM and cash management firm, reported it held $1.52bn in US customer segregated funds and another $3.8m for non-US futures customers on 30 June, according to CFTC reports.

“This is a huge deal,” the executive said. “If it gets to the point where Sentinel says they can’t do anything and sells their portfolio at 50 cents on the dollar, there are clearing firms that would no longer be able to meet segregated fund requirements. And that’s where this becomes a big problem for the Merc. There is the potential for this to become very ugly, but I think that’s unlikely at this point.”

The Chicago money manager blamed liquidity risk in credit markets for its fund freeze – as its portfolio appears to be mired in immobile commercial credit markets. This puts the firm in a situation in which it is effectively stymied – the only way to allow customers access to funds is to trade inefficiently.

“We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients,” Sentinel said in a letter to clients.

 “Credit markets have experienced a liquidity crisis in the past several weeks. Investor fear has overtaken reason and has induced a period in which most securities have ceased to trade. This fear, while warranted in some cases, has spilled over into the rest of the credit market and liquidity has dried up all over the street,” the firm said.

“This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to price securities or to trade them. High grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices,” it added.

This means that the company has chosen to protect customer investment in the long term in the hope that those same customers will not require any of their margin excess during the normal course of trading in the short term.

Sentinel, which could not be reached for comment, raised further confusion in the market when a letter to customers leaked to the media stated that the firm asked the Commodity Futures Trading Commission (CFTC) to freeze the redemptions to customers. A CFTC spokesperson said the regulator is “aware of the situation and is monitoring it.” However, sources close to CFTC said the agency does not have jurisdiction to intervene in what is considered a business matter between a firm and its customers, not a market issue.

Sentinel has since retracted the statement regarding the CFTC. However, the firm said in its letter that it would make redemptions to customers until it can honour them “in an orderly fashion”.

“We will continue to monitor the markets and we will raise cash as opportunities present themselves. We understand that this will obviously cause inconveniences on your part, however, at present, we do not see an alternative,” Sentinel said. “We don't believe it is in anyone's best interest if a run on Sentinel took place and we were in a forced liquidation mode.”

CME Group released a statement saying that Sentinel had told CFTC the firm would stop accepting redemptions. The exchange clarified that any futures risk is not directly related to it, in that Sentinel is not a CME Group clearing firm. It added that all of its clearing members, some of which use Sentinel for “investment advisory and investment services,” remain in good standing with the exchange.

“The Merc is recognising Sentinel’s funds as good funds because they think this thing will resolve itself without real loss to those Sentinel investors who are their clearing members,” said one executive.

That could change however if the commercial paper held by Sentinel continues to decline in value. If so, sources said CME Group clearing members, as well as clearing members of other exchanges, could be asked to provide more margin to CME Group.

And this is where it could hit the futures industry hard. Industry sources have said for weeks that credit lines have been shrinking or drying up for months now. Those firms would then have to go back to customers for more margin, which then could have a ripple affect on their firm if nervous customers close out accounts. The situation also could be exacerbated if other big funds and cash management firms are hit like Sentinel.

“You have to start asking yourself, “Is everyone in this going to come out okay?”

And if there are firms that won’t be okay that I’m doing business with, they may owe us money,” one executive said. “There could well be a domino effect.”