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PFGBest Accounts Frozen (PFG scandal big thread)
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PFGBest Accounts Frozen (PFG scandal big thread)

  #551 (permalink)
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djkiwi View Post
Guys, I've been digging a little deeper into the re-hypothecation rules I mentioned in an earlier post and uncovered some important points on IB that I had missed as part of my earlier due diligence. Here is some background on re-hypothecation from an older article from my files. I've bolded and underlined some key provisions enabling brokers to do this.

Hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

U.S. RULES

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).

This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions.

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.

BEWARE THE BRITS: CIRCUMVENTING U.S. RULES

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.

Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.

LEHMAN LESSONS

In fact this is exactly what Lehman Brothers did 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.

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds 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 (normally conducted under a Global Master Securities Lending Agreement).

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. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.

MF RE-HYPOTHECATION PROVISION

A similar re-hypothecation provision can be seen 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:

“7. Consent To Loan Or PledgeYou 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.”

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these 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 but regulatory filings and letters from MF Global’s administrators contain some clues.

According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited 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”.

CAUSTIC COLLATERAL

Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules.

Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments 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.

Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds.

OFF BALANCE SHEET

As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering.

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link.

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.

The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added):

“Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral. Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged.

We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition.

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion.

HYPER-HYPOTHECATION

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.

Fuelling hyper-hypothecation and joining together daisy chains of liability through the pledging and re-pledging of collateral have been banks around the world. Once in the system collateral is being pledged and re-pledged over and over again either through sale and repurchase agreements or re-hypothecation as demonstrated by a review of SEC filings. For instance, Goldman Sachsdisclosed recently 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 Commercere-pledged $72 billion in client assets, Credit Suissesold or re-pledged CHF 332 billion of assets (received under resale agreements, securities lending and margined broker loans), Royal Bank of Canadare-pledged $53.8 billion of $126.7 billion available for re-pledging, Knight Capital Groupdelivered or re-pledged $1.17 billion of financial instruments received, Interactive Brokers re-pledged or re-sold $7.9 billion of $16.7 billion available to re-sell or re-pledge, Wells Fargo re-pledged $19.6 billion as at September 2011 of collateral received under resale agreements and securities borrowings, JP Morgansold or re-pledged $410 billion of collateral received under customer margin loans, derivative transactions, securities borrowed and reverse repurchase agreements and Morgan Stanley re-pledged $410 billion of securities received.

LIQUIDITY CRISIS

The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up.

Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic.

U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening.

As for MF Global’s clients, the recent adoption of an “MF Global rule” by the Commodity Futures Trading Commission to ban using client funds to purchase foreign sovereign debt, would seem to suggest that it was indeed client money behind its leveraged repo-to-maturity deal - a fact that will likely mean that very few MF Global clients get their money back.

Interactive brokers

I looked at the the IB fully disclosed clearing agreement located here:

https://www.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleV...sedClearingAgreement.jsp

Note Section D4 from this agreement which is basically a mirror image of MF Global:

4. To the extent allowed by the Laws and Regulations, Interactive and its affiliated
companies ("Affiliates") may engage in stock lending activity and the lending of
Customer collateral, securities or other property including, but not limited to, using
Customer collateral, securities or other property for their own accounts or for the
accounts of other Customers, and lending, either to themselves, to their Affiliates, or to
others, any Customer collateral, securities and other property held by Interactive in
Customers' Fully-Disclosed Accounts. Pursuant to applicable Laws and Regulations,
Interactive or its Affiliates may deposit collateral, securities and/or other Customer
property with third parties and may pledge, re-pledge, hypothecate or re-hypothecate
Customer collateral, securities and/or other Customer property,
either separately or
together with other securities and/or other property of other Customers of Interactive
for any amount due to Interactive in any Interactive Fully-Disclosed Account in which
Customer has an interest. Interactive or its Affiliates, may so pledge, re-pledge,
hypothecate or re-hypothecate Customer collateral, securities and/or other property
without retaining in Interactive's or its Affiliate's possession or under its control for
delivery a like amount of similar collateral, securities and/or other property and
Interactive or its Affiliates may return to Customer collateral, securities and/or other
property other than the original, or original type of, collateral, securities and/or
property that Customer deposited with Interactive. Collateral that is registered with a
third party may not be in Customer's name.

Clearly the Federal Reserve Board's Regulation T and SEC Rule 15c3-3 identified above needs to be tightened to protect investors. Although it is unlikely IB will be the next MF Global they certainly have the legal authority to do so.

Cheers
DJ

Thanks for the information. I just added additional criteria to my FCM checklist .

Due diligence is the key. I will never sign another piece of paper from a broker until I have read and understood all of the fine print.

I'm just a simple man trading a simple plan.

My daddy always said, "Every day above ground is a good day!"
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  #552 (permalink)
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Great post. Thanks.

Just one small thing. A mortgage is not an example of hypothecation. I won't go into why, because it is boring and no one would care, but I would not use that example in a conversation with someone in finance.



djkiwi View Post
In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.


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  #553 (permalink)
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Yea, a mortgage is technically a transfer in a majority of jurisdictions. In a minority however its treated as a lien.

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  #554 (permalink)
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djkiwi View Post
.....

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

U.S. RULES

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

Pursuant to applicable Laws and Regulations,
Interactive or its Affiliates may deposit collateral, securities and/or other Customer
property with third parties and may pledge, re-pledge, hypothecate or re-hypothecate
Customer collateral, securities and/or other Customer property,
either separately or
together with other securities and/or other property of other Customers of Interactive
for any amount due to Interactive in any Interactive Fully-Disclosed Account in which
Customer has an interest. Interactive or its Affiliates, may so pledge, re-pledge,
hypothecate or re-hypothecate Customer collateral, securities and/or other property
without retaining in Interactive's or its Affiliate's possession or under its control for
delivery a like amount of similar collateral, securities and/or other property and
Interactive or its Affiliates may return to Customer collateral, securities and/or other
property other than the original, or original type of, collateral, securities and/or
property that Customer deposited with Interactive. Collateral that is registered with a
third party may not be in Customer's name.

Clearly the Federal Reserve Board's Regulation T and SEC Rule 15c3-3 identified above needs to be tightened to protect investors. Although it is unlikely IB will be the next MF Global they certainly have the legal authority to do so.

Cheers
DJ

@djkiwi

Does this literally mean that IB or any brokerage that includes this wording in their agreements can pledge client money that is is segregated accounts as collateral to back their prop trading and therefore the customer money could be lost should the broker be unable to meet their obligations?

I'm just a simple man trading a simple plan.

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  #555 (permalink)
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  #556 (permalink)
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New post on Commodity Customer Coalition


A Primer on Commodity Bankruptcy for #PFGBest
by John Roe
Sir Templeton, we disagree. This time it really is different.

Though I quipped PFGBest was an MF Global redux, Mr. Wasendorf's brokerage firm is unlike MF Global in many ways. These differences will result in a different tack for PFGBest's case, plotting a different course for its customers, though they may end up at the same destination as MF Global's victims.

We wanted to offer our best guess as to how this process will proceed for PFGBest customers. Please note that this is our opinion and we discourage anyone from acting based on the opinions set forth below. This article is for informational purposes only.

What are the differences between PFGBest and MF Global?
PFGBest is a privately held non-clearing FCM which filed a voluntary application for Chapter 7 Bankruptcy. As a non-clearing FCM, PFGBest's designated self-regulatory organization (DSRO) was the National Futures Association (NFA). At this time, we do not know the legal structure of PFGBest, but their corporate timeline mentions an entity called Wasendorf and Sons, Inc. as well as 'wholly owned subsidiaries' like PFG Canada. To our knowledge, all affiliates are owned by Mr. Wasendorf, so that will make things easy on bankruptcy attorneys and customers alike.

MF Global was a public company traded on the NYSE, structured as a holding company--MF Global Holdings Ltd, Inc.(MFGH). MFGH owned many subsidiary operating and finance entities. It's MF Global Inc. subsidiary (MFGI) was a clearing FCM with dual registration with the SEC as a broker dealer. This is the entity which housed MF Global's customer property and brokerage operations. As a clearing firm, MFGI's DSRO was and= exchange, not the NFA--in their case,the Chicago Mercantile Exchange (CME).

MF Global's bankrutcy is much more complicated. The MFGH parent filed filed a voluntary petition for Chapter 11 Bankruptcy, more commonly known as reorganization bankruptcy. The Securities Investor Protection Corporation (SIPC) filed for a liquidation of the MFGI subsidiary under the Securities Investor Protection Act of 1973 (SIPA), as MFGI was a SIPC member firm. This means MFGH creditors have a Chapter 11 Trustee working on their behalf, while customers at MFGI have a SIPA Trustee working on their behalf. As an aside, that is a very charitable way to express the activities of these Trustees.

The SIPC statute does not apply to PFGBest and, as such, PFGBest's bankruptcy will be administered according to the Chapter 7 code and relevant portions of the Commodity Exchange Act (CEA). Chapter 7 means liquidation, not reorganization. As such, PFGBest will not survive to do business in its current form or as a new entity. Its assets will be sold for the benefit of its customers and creditors. A Chapter 7 Trustee has been appointed and has begun work on PFGBest's estate. So what does this process mean for PFGBest's customers?

How will customer property be treated?
PFGBest's assets will be split into two funds, a fund of customer property and a fund of estate property. Customer property of consists of all cash, securities and specifically identifiable property tendered to PFGBest by its customers. The assets of PFGBest will go into its fund of estate property.

If there was no shortfall in customer property, the NFA would seek to bulk transfer customer accounts with positions in tact to a new receiving FCM. The bankruptcy's administrative costs--fees of attorneys for the Trustee, forensic accounting, staff, etc--would be paid for from the fund of estate property. The Trustee would commence a claims process, marshall assets and distribute funds to legitimate claims according to priorites in the bankruptcy code. Generally this would be to cover administrative fees first, secured creditors second (lein holders) and then unsecured creditors.

PFGBest has a shortfall in customer property, which the NFA has pegged at more than $200 million. As a result, instead of an immediate bulk transfer, customer assets were frozen and their positions were liquidated. The Trustee has received approval for PFGBest to continue operations for 60 days, so he can prepare final statements for customers and determine what assets are available for customers. The Trustee will see what amount of property he can safely return to customers at once via a bulk transfer and will initiate that process if it is possible. However, most likely a claims process will be required to return at least some property to customers.

Customer property does have priority over all other classes in bankruptcy except one: administrative fees. If the fund of estate property held $0, the Trustee would pay adiminstrative expenses from the fund of customer property.

What Does PFGBest Have in Assets?
In their bankruptcy filing, PFGBest stated that it held between $500M and $1b in assets and $100M and $500M in liabilities. Hopefully this is true. Given Mr. Wasendorf's attempted suicide and confession, it is likely based on false or flawed assesment of PFGBest's financial condition.

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ThatManFromTexas View Post
But if all the FCM's were required to submit to electronic bank monitoring .... where the segregated account bank balance had to match the reports submitted by the FCM ... wouldn't that resolve a lot of these issues... or am I missing something?

@ThatManFromTexas

There are a couple of potential issues with this:

Firstly, confirming bank balances is an improvement but to be accurate you need to reconcile and audit to the Broker's client ledger. For example if the regulator sees a $5m reduction in the bank balance in one day then this is meaningless without being able to see the Broker's client ledger as this could merely be a large client withdrawing $5m which is no issue. The broker could falsify the ledger and invent a client withdrawal so you are back to square one where you rely on the broker for data.

Secondly what is stopping the broker setting up a second bank account and second set of books for say new clients?

The regulator would have no clue as he would just be looking at the bank statement for the one set of clients. Maybe another broker has been doing this already, only reporting half the client funds to the regulator. Small businesses have been doing this since the beginning of man. They have a set of books for the tax department and another set for themselves.

Bear in mind, we know the regulator is not the sharpest tool in the shed so it doesn't appear that difficult to pull another fast one. Even when electronic monitoring is in place I'd like to see more details on how the process will work in practice.


Cheers
DJ

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In light of what djkiwi wrote. Does anyone know why there isn't, or if it would be possible with a separate bank account for each client with the FCM's? It would be a lot of bank accounts, but I am thinking this would be the most ideal situation. In this way every client would have opportunity to check his or her own balance.

Laurus

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Scariest thing in all this, is that all the brokers applications have you agree to terms that essentially give the broker the right to pledge your funds even if they are "segregated".

Starts to appear the only really way to protect yourself is to just keep the minimum in the account to trade what you want, and keep it at that level.

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Peregrine Founder Says He Spent Most of Missing Money - WSJ.com

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