Sheila Keefe, CFE, CPA
Principal, BDR Advisors LLC
Customers of MF Global have suffered losses in excess of an estimated $1.2 billion since MF Global declared bankruptcy at the end of October. Many of the victims are farmers who used commodities futures in segregated accounts at MF Global as a hedge against price volatility. These farmers may not recover their funds on deposit and, at the very least, have had their accounts frozen while MF Global works through bankruptcy, tying up necessary capital for farmers to invest for the coming growing season.
At the center of the current investigation of the MF Global bankruptcy is the trading practice known as rehypothecation. To start with, simple hypothecation is the practice of pledging assets as collateral, something common to many loans that can also occur when investors trade securities on margin. Rehypothecation occurs when brokers re-use customer’s pledged assets as collateral for house trading purposes. The practice of rehypothecation allows for the same asset to be applied against two separate risks. Additionally, the repeated use of the same asset by many parties in the market gives rise to concerns of a shadow banking system and off-balance-sheet financing, because while the pledged assets appear only once on a balance sheet, on the books of the investor the value of the pledged assets flow through the market as the pledged assets of others.
The ability of brokers to re-use pledged assets as collateral varies by country. Canadian laws prohibit all rehypothecation, while British laws place no limits on the level of rehypothecation allowed by brokers with investors and brokers determining allowable rehypothecation levels by mutual agreement. American trading standards allow brokers to rehypothecate up to 140 percent of an investor’s pledged assets. So if a customer pledges $1,000 to trade on margin, the broker can count $1,400 as pledged assets for their own trades.
While most trading agreements allow for rehypothecation, $1.2 billion missing from the segregated accounts at the center of the MF Global controversy should have been specifically excluded from such practices. MF Global lost a bundle betting on the European sovereign debt crisis. In recent Congressional testimony, CEO Jon Corzine stated that segregated accounts were not co-mingled with other MF Global funds, and the $1.2 billion missing from the segregated accounts were not used to cover the Euro-sovereign debt trading losses. With so much money missing from segregated customer accounts, it seems unlikely that the facts will support Corzine’s assertions. These are early days in the investigation, and Corzine’s statements will be put to the test.
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