MF Global trustee reviewing firm’s practice of repledging collateral

December 21, 2011

By Emmanuel Olaoye and Christopher Elias

NEW YORK/LONDON, Dec. 21 (Thomson Reuters Accelus) – The bankruptcy trustee for collapsed U.S. brokerage firm MF Global Inc. is looking into how the firm re-pledged customer collateral as part of its search for $1.2 billion of missing customer funds.

The practice, called re-hypothecation, has drawn renewed scrutiny after the failure of MF Global and experts said U.S. regulators may face new restrictions as part of efforts to increase protection on customer accounts.

Kent Jarrell, a spokesman for MF Global trustee James Giddens, told Thomson Reuters that Giddens’ team is reviewing MF Global’s practice of re-hypothecation. “That is one of the areas we are looking into in [our] investigation into recovering the missing customer funds.”

The trustee’s investigation was likely to take “a lot more than weeks,” he said.

“What we are doing is we’re going through records and we are tracking transactions. We’re trying to figure out when the transactions were conducted, why they were conducted, and where they are now. If we get in a situation where we believe the transactions were questionable, then we will take appropriate action to try to get it back,” Jarrell said.

Said Nathan Powell, managing partner at Montanus Group, an independent research firm, “I think you’re going to see a clear discussion by the Fed, CFTC, and SEC about the use of client collateral. Both commingling as well as the ability to re-hypothecate. On the accounting rules side they are probably going to focus more on the way that repurchase transactions are accounted for.”


A report by Thomson Reuters Business Law Currents last week suggested that MF Global and other firms exploited an international gap in collateral rules and may have made highly leveraged investments secured by customer collateral that had been re-hypothecated, or re-pledged as collateral for the brokerage’s own investments. It said the funds may have been available to help finance a $6.3 billion bet on euro sovereign debt.

The European debt trades pushed MF Global into bankruptcy, after regulators pressed MF Global to increase its capital and investors became spooked.

U.S. regulators allow prime brokers to re-hypothecate customer collateral up to the value of 140% of a customer’s borrowing.

In the United Kingdom, however, firms have no set limits on the re-pledging of collateral, although individual limits can be negotiated by an investor, such as a hedge fund.


The practice of re-pledging collateral across the Atlantic was spotlighted after the 2008 collapse of Lehman Brothers. A paper by the International Monetary Fund in 2009 said rehypothecation had declined since then, but at a potential cost of reduced market liquidity.

Lehman acted through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK- based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.

In Lehman’s case many funds had signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK. These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law, the accounts had stricter protections.


A similar re-hypothecation provision was in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause:


You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.”

MF Global’s British subsidiary, MF Global UK, said in its annual report that it had sold or repledged $16.1 billion out of $17.3 billion in customer collateral as of March 31, 2011.

It is unknown exactly how much if any of the missing customer money could be attributed to the practice. With the transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money.

Regulatory filings and letters from MF Global’s administrators contain some clues. A letter from MF Global UK’s administrator KPMG to MF Global clients said that when MF Global collapsed, the UK affiliate had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients.”


Successive U.S. governments in recent years have softened the requirements for what can back a re-hypothecation transaction.

Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities.


The problems in locating the $1.2 billion of missing customer money have increased concern over how firms invest customer’s collateral, experts told Thomson Reuters.

Nathan Powell, managing partner at Montanus Group, an independent research firm, said weak rules will always encourage firms to shuttle customer funds to lightly regulated jurisdictions.

He said had Lehman conducted toxic transactions in Britain “simply to take advantage on the lack of limits on re-hypothecation.”

“It looks like a lot of the off-balance sheet activity done by MF Global was being done in the UK. That is where there is a clear parallel there,” Powell said.


Representative Michael Capuano, a Massachusetts Democrat, told a House hearing last week that the Financial Stability Oversight Council should review the practice of re-hypothecation “to make sure that there’s no systemic risk.”

The International Monetary Fund has estimated that banks re-hypothecate collateral to a factor of four, meaning the actual capital backing banks’ re-hypothecation transactions may be as little as 25 percent. It said the practice played a significant role in the “shadow banking” system.

Although U.S. firms disclose repurchase transactions in the footnotes of their financial statements, Powell said there was no requirement to say how often the customer’s collateral was used.

Banks around the world have made extensive use of tools such as re-hypothecation. Once in the system, collateral is being pledged and re-pledged over and over again either through re-hypothecation or sale and repurchase agreements, as demonstrated by a review of U.S. Securities and Exchange Commission filings.

Goldman Sachs disclosed that it had re-pledged $18.03 billion of collateral received as at September 2011, Oppenheimer Holdings re-pledged approximately $255.4 million of its own customers’ securities in the same period. Canadian Imperial Bank of Commerce, Credit Suisse, Royal Bank of Canada and many others similarly reported repledging billions of dollars of capital.

Nor is lending limited to between banks. Intra-bank re-hypothecation is also possible as evidenced by filings from Wells Fargo.

The furor over the missing MF Global money has forced the U.S. Commodities Futures Trading Commission to approve a rule that would impose tighter limits on how brokerage firms can invest customer funds.

The rule, which takes effect in February 2012, prevents Futures Commission Merchants like MF Global from engaging in “in-house” repo transactions. It also bans firms from investing customer funds in foreign sovereign debt. The firms often use repurchase transactions to bolster returns from money sitting in customer accounts.

Terrence F. Martell, a professor of finance at Baruch College and chairman of ICE Clear U.S, said he was against the misuse of customer funds, but a rash of new rules on the use of customer funds could lead to unintended consequences for the futures brokerage industry.

“I’m just hoping that [in the attempt] to solve an immediate problem we don’t inadvertently create other problems for the industry.”

“The FCM business is not a growth industry. How are they going to attract the capital and justify the use of capital if you can’t use customer funds in repos,” Martell said.

Dan Driscoll, executive vice president at the National Futures Association, also warned the futures industry to brace itself for more regulations around customer funds.

“My guess is there may well be other changes to the rules of CFTC and other (self regulatory organizations) that have to do with [the] segregation of customer funds,” Driscoll said.


(Previous versions of this article originally appeared in Thomson Reuters publications <a href=”” target=”_blank”>Business Law Currents</a> and <a href =”target=”_blank”> Compliance Complete</a>. Emmanuel Olaoye is a New York-based correspondent for Compliance Complete. Christopher Elias is a London-based Legal Editor for Business Law Currents.)

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