Econintersect: Revisiting an article nearly a year old from Thompson Reuters, reminds us that the question of regulation of cross-border finance is a very important issue that is little mentioned in the news of the day. In December last year Christopher Elias described how cross border collateral pledges were determined by his analysis to account for the $1.6 billion missing client funds after the collapse of MF Global. Two primary areas of activity were identified by Elias: straight repos and rehypothecation involving client account assets. More recent reports indicate that there is not likely to be any criminal prosecution in this case.
Let's examine the two financial processes identified as those at the heart of this case.
Wikipedia defines a repo as follows:
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.
A repo is equivalent to a spot sale combined with a forward contract. The spot sale results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan, while the settlement date of the forward contract is the maturity date of the loan.
A repo can be thought of as a secured loan. The security pledged is held by the lender and ownership legally assumed in case of default. Many repos are simply overnight transactions between banks to assure liquidity is maintained by the borrower. This author will point out that with repo arrangements around a "circle" of banks the process creates liquidity out of nothing. Each bank has a loan form the next to obtain their liquidity but with fractional reserve banking each bank in the circle can show a balance sheet that shows artificially and temporaily inflated liquidity.
The overnight repo between banks carries less financial risk than term or open (no closing date specified) repo. Term or open repos may have been involved in the MF Global balance sheet. Elias says that MF Global held $16.5 billion in European sovereign debt that was used in repo to maturity deals which enabled the firm to treat the entire transaction like a sale and remove the risky assets from its books.
The problem arose when the sovereign debt was downgraded and lost value. Then additional assets of the firm became securities for the repos. And to the extent that client funds were mixed with assets of the firm in repo transactions, client interests would legally disappear from client accounts when the firm went bankrupt. The only criminal act would derive from the mixing of client and firm assets and it appears that, based on the reporting by Thompson Reuters that is not a criminal activity.
Investopedia defines re-hypothecation:
The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees.
In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades. While rehypothecation was a common practice until 2007, hedge funds became much more wary about it in the wake of the Lehman Brothers collapse and subsequent credit crunch in 2008-09.
In the United States, rehypothecation of collateral by broker-dealers is limited to 140% of the loan amount to a client, under Rule 15c3-3 of the SEC.
"Rehypothecation" is derived from "hypothecation", which is the right of a lender to seize collateral pledged to secure a loan in the event of default. Rehypothecation interposes another party in the process between the holder of the pledged security and the lender to the interposed party. In this case the holder of the collateral is the client and the borrower is the custodian of the client's funds, MF Global.
Think of the process as similar to a parent guaranteeing the loan of a child with the pledge of the parent's property as security. It is unlikely that MF Global clients were thinking that they were signing adoption papers and loan guarantees when they signed the paperwork that apparently made it legal fro MF Global to pledge the client's assets as was done.
Nine months later (September 2012) the money was still missing and it became apparent that there were unlikely to be any criminal charges connected with the disappearance, according to another article published by Thompson Reuters. The possibility was mentioned that civil cases could still be filed because it still appears that improper mixing of client and company funds occurred.
Here is the introduction to Christopher Elias' article from last December:
A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.
MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet.
Apparently theft of funds by "improper" actions are distinguished in the laws of the land from criminal activity.
What still is open is the possibility of regulatory action (civil proceedings) by the CFTC (Commodity Futures Trading Commission). Here is what Aruna Viswanatha and Alexandra Alper wrote at Thompson Reuters:
It is not uncommon for a regulatory agency to hold off on bringing charges while a criminal investigation is underway. Often if prosecutors are involved, they "don't want the civil enforcement agencies mucking around" said Daniel Waldman, a former general counsel of the CFTC who is now in private practice at Arnold & Porter. "That is pretty standard."
This story continues to unfold a year after the bankruptcy occurred. What appears to be more and more clear is that client's money will have simply disappeared into an international black hole and the process will have been completely legal. Perhaps Dodd-Frank, or something stronger, needs to become international in scope (suggested to Econintersect by Steve Suppan).
The following video from last December covers some of the popular opinions about MF Global at the time. The picture emerging now appears to be much simpler, but with the same end effect.
Hat tips for directing our attention to the December 2011 article by Christopher Elias go to Steve Suppan (Institute for Agriculture and Trade Policy) and to Roger Erickson.
- MF Global and the great Wall St re-hypothecation scandal (Christopher Elias, Thompson Reuters News & Insight, Securities Law, 07 December 2011)
- As MF Global criminal probe nears end, civil cases become likely (Aruna Viswanatha and Alexandra Alper, Thompson Reuters News & Insight, Legal, 12 September 2012)
- Wikipedia and Investopedia references embedded links in the article.