Did MF Global clients forget Lehman’s lessons?

December 16, 2011

By Margaret Doyle
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Have MF Global’s clients suffered an action replay of the collapse of Lehman Brothers? That’s the intriguing question posed by the broker’s demise, which has left executives facing accusations of misusing client funds. One theory is that MF Global was able to use a legal process called rehypothecation to use customers’ money to back its own trades.

When investors enter into a trade with a broker, they typically secure the deal by posting collateral, which is deposited in a ring-fenced account. Rehypothecation is the practice whereby brokers ask clients for the right to use the collateral to back the broker’s own trades or borrowing. In return for allowing their assets to be reused in this way, clients get cheaper funding and services.

In the United States, regulators have limited the practice. Brokers are only allowed to rehypothecate assets worth up to 140 percent of the client’s liability. So if a client has borrowed $100 secured by collateral worth $300, the broker can rehypothecate assets worth up to $140. The remaining $160 of collateral remains untouched. But in the UK there is no limit to rehypothecation, so the broker can use the full $300 as collateral for another trade.

MF Global appears to have taken advantage of this transatlantic difference. According to accounts filed by MF Global in the UK, the broker’s London-based subsidiary had sold or repledged $16.1 billion in customer collateral as of March 31, 2011.

There’s no way of knowing how MF Global used these funds. Jon Corzine, the former New Jersey governor who ran the broker and masterminded its failed $6.3 billion bet on euro zone debt, has denied misusing client funds. KPMG, the administrator for MF Global’s UK arm, says it has no evidence that contractual terms were breached. But as rehypothecation was explicitly permitted in MF’s client agreements, this wouldn’t constitute a misuse.

Nevertheless, the apparent scale of MF Global’s use of rehypothecation is surprising given that many hedge funds were burned by the practice when Lehman collapsed in 2008. Many of the client assets in the Wall Street broker’s UK arm had been rehypothecated, leaving customers to fight for their cash as unsecured creditors.

The UK responded by bringing in new rules. But these mainly focus on informing clients that their assets are being used by brokers, rather than banning or even limiting the practice. If rehypothecation ends up to blame for huge client losses at MF Global, the UK may have to do more to protect customers.

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