Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Boris Johnson Hits Coronavirus Panic Button Again, UK Accelertoing Covid-19 Second Wave - 25th Sep 20
Precious Metals Trading Range Doing It’s Job to Confound Bulls and Bears Alike - 25th Sep 20
Gold and Silver Are Still Locked and Loaded… Don't be Out of Ammo - 25th Sep 20
Throwing the golden baby out with the covid bath water - Gold Wins - 25th Sep 20
A Look at the Perilous Psychology of Financial Market Bubbles - 25th Sep 20
Corona Strikes Back In Europe. Will It Boost Gold? - 25th Sep 20
How to Boost the Value of Your Home - 25th Sep 20
Key Time For Stock Markets: Bears Step Up or V-Shaped Bounce - 24th Sep 20
Five ways to recover the day after a good workout - 24th Sep 20
Global Stock Markets Break Hard To The Downside – Watch Support Levels - 23rd Sep 20
Beware of These Faulty “Inflation Protected” Investments - 23rd Sep 20
What’s Behind Dollar USDX Breakout? - 23rd Sep 20
Still More Room To Stock Market Downside In The Coming Weeks - 23rd Sep 20
Platinum And Palladium Set To Surge As Gold Breaks Higher - 23rd Sep 20
Key Gold Ratios to Other Markets - 23rd Sep 20
Watch Before Upgrading / Buying RTX 3000, RDNA2 - CPU vs GPU Bottlenecks - 23rd Sep 20
Online Elliott Wave Markets Trading Course Worth $129 for FREE! - 22nd Sep 20
Gold Price Overboughtness Risk - 22nd Sep 20
Central Banking Cartel Promises ZIRP Until at Least 2023 - 22nd Sep 20
Stock Market Correction Approaching Initial Objective - 22nd Sep 20
Silver Bulls Will Be Handsomely Rewarded - 21st Sep 20
Fed Will Not Hike Rates For Years. Gold Should Like It - 21st Sep 20
US Financial Market Forecasts and Elliott Wave Analysis Resources - 21st Sep 20
How to Avoid Currency Exchange Risk during COVID - 21st Sep 20
Crude Oil – A Slight Move Higher Has Not Reversed The Bearish Trend - 20th Sep 20
Do This Instead Of Trying To Find The “Next Amazon” - 20th Sep 20
5 Significant Benefits of the MT4 Trading Platform for Forex Traders - 20th Sep 20
A Warning of Economic Collapse - 20th Sep 20
The Connection Between Stocks and the Economy is not What Most Investors Think - 19th Sep 20
A Virus So Deadly, The Government Has to Test You to See If You Have It - 19th Sep 20
Will Lagarde and Mnuchin Push Gold Higher? - 19th Sep 20
RTX 3080 Mania, Ebay Scalpers Crazy Prices £62,000 Trollers Insane Bids for a £649 GPU! - 19th Sep 20
A Greater Economic Depression For The 21st Century - 19th Sep 20
The United Floor in Stocks - 19th Sep 20
Mobile Gaming Market Trends And The Expected Future Developments - 19th Sep 20
The S&P 500 appears ready to correct, and that is a good thing - 18th Sep 20
It’s Go Time for Gold Price! Next Stop $2,250 - 18th Sep 20
Forget AMD RDNA2 and Buy Nvidia RTX 3080 FE GPU's NOW Before Price - 18th Sep 20
Best Back to School / University Black Face Masks Quick and Easy from Amazon - 18th Sep 20
3 Types of Loans to Buy an Existing Business - 18th Sep 20
How to tell Budgie Gender, Male or Female Sex for Young and Mature Parakeets - 18th Sep 20
Fasten Your Seatbelts Stock Market Make Or Break – Big Trends Ahead - 17th Sep 20
Peak Financialism And Post-Capitalist Economics - 17th Sep 20
Challenges of Working from Home - 17th Sep 20
Sheffield Heading for Coronavirus Lockdown as Covid Deaths Pass 432 - 17th Sep 20
What Does this Valuable Gold Miners Indicator Say Now? - 16th Sep 20
President Trump and Crimes Against Humanity - 16th Sep 20
Slow Economic Recovery from CoronaVirus Unlikely to Impede Strong Demand for Metals - 16th Sep 20
Why the Knives Are Out for Trump’s Fed Critic Judy Shelton - 16th Sep 20
Operation Moonshot: Get Ready for Millions of New COVAIDS Positives in the UK! - 16th Sep 20
Stock Market Approaching Correction Objective - 15th Sep 20
Look at This Big Reminder of Dot.com Stock Market Mania - 15th Sep 20
Three Key Principles for Successful Disruption Investors - 15th Sep 20
Billionaire Hedge Fund Manager Warns of 10% Inflation - 15th Sep 20
Gold Price Reaches $2,000 Amid Dollar Depreciation - 15th Sep 20
GLD, IAU Big Gold ETF Buying MIA - 14th Sep 20
Why Bill Gates Is Betting Millions on Synthetic Biology - 14th Sep 20
Stock Market SPY Expectations For The Rest Of September - 14th Sep 20
Gold Price Gann Angle Update - 14th Sep 20
Stock Market Recovery from the Sharp Correction Goes On - 14th Sep 20
Is this the End of Capitalism? - 13th Sep 20
The Silver Big Prize - 13th Sep 20
U.S. Shares Plunged. Is Gold Next? - 13th Sep 20
Why Are 7,500 Oil Barrels Floating on this London Lake? - 13th Sep 20
Sheffield 432 Covid-19 Deaths, Last City Centre Shop Before Next Lockdown - 13th Sep 20
Biden or Trump Will Keep The Money Spigots Open - 13th Sep 20
Gold And Silver Up, Down, Sideways, Up - 13th Sep 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Re-Hypothecation ABC in Gold and Securities Markets: What You Need to Know

Stock-Markets / Credit Crisis 2011 Dec 15, 2011 - 08:18 AM GMT

By: Casey_Research

Stock-Markets

Diamond Rated - Best Financial Markets Analysis ArticleKevin Brekke, Casey Research writes: A new polysyllabic term has entered the Wall Street lexicon and is sweeping through the investing world like a brush fire through a dry canyon: "hypothecation." With its connection to the MF Global bankruptcy and aftermath, it engenders the kind of fear a homeowner might feel while monitoring the approaching flames.

The rise of hypothecation as the lead suspect in the MF Global tragedy has caused a fair bit of confusion about what, exactly, it is – and is not. Proving the idiom that nature abhors a vacuum, the blogosphere has weighed in with all manner of explanations, many of which have been less than accurate.


In an attempt to help our readers get to the heart of the matter, we will briefly review hypothecation – what it is and how it is used – and do so in plain English.

There is considerable ground to cover here, so we will get right into it, starting by defining the term, then discussing the role hypothecation played in the demise of MF Global before turning our attention to the question in the minds of many gold investors – was MF Global re-hypothecating gold bullion? Finally, we'll have some closing thoughts on the potential implications for us as individual and institutional investors going forward.

The Two Faces of Hypothecation

At its most basic level, anyone who has traded on margin (borrowing money from a broker to purchase stock) or shorted a stock (borrowing shares through a broker that are sold today in the hope of replacing them with shares purchased at a lower price tomorrow and pocketing the difference) has participated in hypothecation.

Hypothecation is a legal term that means "to pledge something as collateral." In the financial world of stockbroking, to hypothecate shares of stock means they are pledged against a loan from a broker for money to complete a transaction. For the investor, hypothecation necessitates a margin account.

Opening a margin account requires that a broker obtain a signed agreement from the investor. The margin agreement can be part of a standard account-opening agreement, or it might be a completely separate document. It is this agreement that opens the door for the assets in your account to be used for re-hypothecation purposes. Without such an agreement, you will not be able to open a margin account. In other words, if you have a margin account, you are in the game. If you don't have a margin account, you are strictly an innocent bystander with no legal skin in the game.

It is important that you as an investor understand the terms of trading on margin. Once you trade on margin, any common stock, cash, or securities in your margin account can be considered as collateral for the money you borrow. And if the terms of the margin agreement allow it – almost universally the case – the broker can borrow or loan shares in the investor's account up to the value of the amount borrowed (the margin).

Here it seems appropriate to mention that hypothecation is sanctioned by the SEC – subject to a host of rules, of course. Yet some of the recent reporting regarding hypothecation makes it sound as though brokers are taking shares from customer accounts for their own use and unbeknown to the customer. Unless the broker is engaging in deliberate fraud, that is not the case.

Most margin account agreements contain language that clearly explains that if a customer trades on margin, one understands that shares or other securities in one's account – up to the amount of margin – can be borrowed or lent to other customers for shorting or to the broker for other uses. If a customer does not agree with this arrangement, one should not trade on margin. This is standard practice in the stockbroking industry.

Those "other uses" lead us to the second face of hypothecation.

Re-hypothecation

Re-hypothecation is when a broker reuses customer-pledged collateral to back the broker's own trades and borrowings. It is 100% legal. However, while the practice may be legal, that does not mean it is prudent. Using the same collateral to support two separate borrowing transactions is obviously a risky tactic.

As background, under US Federal Reserve Board Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate an amount up to 140% of the customer's liability to the broker.

Let's quickly do the math on that one. If a customer has purchased $1,000 of securities, of which $500 is margined (borrowed), the broker is permitted to re-hypothecate up to $700 of the collateral – $500 x 140%.

Echoing the above, the use of re-hypothecated customer collateral is a common practice among broker dealers.

However, MF Global pushed the envelope on re-hypothecation by arbitraging differences in re-hypothecation regulations between jurisdictions and using off-balance-sheet maneuvers to ratchet its leverage to very high levels – referred to as hyper-hypothecation. The many components of this elaborate scheme, when combined, may make it impossible for MF Global's clients to recoup any of their losses.

MF Global Goes Offshore

"Give me a place to stand and a lever long enough and I will move the world." – Archimedes, 220 BCA

Once a leverage junkie, always a leverage junkie. It will help to understand the MF Global collapse if we keep in mind that its leader, Jon Corzine, is an ex-Goldman Sachs (GS) man, and the boys at GS love their leverage. The 140% leverage allowed under the US re-hypothecation regulation just didn't scratch Corzine's itch.

The solution: take it offshore.

Corzine decided to extend the lever a few thousand kilometers east and stand in the UK. In the UK, it turns out, there is no limit to the amount that can be re-hypothecated. It is the responsibility of the customer to negotiate the terms of re-hypothecation. Absent that, the broker is free to re-hypothecate 100% of the securities in a customer's margin account, not just the securities acting as collateral.

The forensic accounting and investigation into the collapse of MF Global and the disappearance of possibly $1 billion or more in client funds is under way, and I do not wish to draw any premature conclusions. But preliminary reports about the investigation suggest that MFG had churned pledged client assets – re-hypothecating collateral several times – and used it to place a massive $6.2 billion bet on European sovereign debt.

It was a bad gamble that sent MFG into history's dustbin.

This is an arcane and complicated topic, and this article does not attempt to cover every detail. The goal is to provide enough information for a reader to have a better sense of the terms that are probably going to be in the media a lot in the days and weeks just ahead.

Early Warning Signs and the Reuters Report

A recent report out of Reuters caused a bit of a stir. It claimed that several prime brokers were engaged in hyper-hypothecation – meaning the hypothecating of client assets to a degree that could threaten the broker's viability and pose liquidity challenges. Among the cited brokers was Interactive Brokers.

As Interactive Brokers is one of our recommended brokers, it is time to bring them into the story, albeit in a fairly bit part and only long enough to address whether we suffered an error in judgment. Or – more to the point – is it now time to dump them?

For an answer, let's compare the histories of MF Global and Interactive Brokers. This will also highlight the early signals that were visible well before October 2011 that MF Global might be headed for trouble. MF Global was spun off from Man Group in an IPO in 2007. From the get-go the new company had problems. In 2008, it had to set aside a bad debt provision to cover losses from unauthorized trading by in-house brokers. Following the incident, the company paid a $10 million fine to the CFTC and $500,000 to the CME. Also in 2008, the liquidity of MF Global was questioned, causing its shares to crash. It took an investigation and announcement by the CME, CFTC, and other regulators that MF Global was in financial compliance to calm investor fears.

As a result of the two incidents in 2008, a new CEO was brought in, who promised to better manage MF Global's risk. Then in 2010, he was replaced by Jon Corzine, making it three CEOs in as many years, all following on the heels of internal bumps in the road. So, we have a new company struggling with obvious risk management and oversight problems, regulatory issues, and a high turnover in company leadership. That should have been a red flag for customers paying attention. In contrast, Interactive Brokers has not had problems with rogue traders losing millions, liquidity concerns, nor issues with regulatory agencies. The company was founded by Thomas Peterffy 34 years ago, and he serves as its chairman today. The company had a great year in 2010, and 2011 looks to be another winner. This is a well-established company with a long history of growth, headed by a respected leader in the brokerage and market making industry for 34 years, and no liquidity, oversight, or compliance issues.

It also seems relevant that in Interactive Brokers' denial of the Reuters claim that it was actively hyper-hypothecating, they quote figures from their first-half 2011 financial report – a document in the public domain and available on its website. The figures reported in the document appear to refute the Reuters accusation, suggesting that Reuters did not do sufficient due diligence when researching the article. It is also important to consider the difference in company structure: 10% of Interactive Brokers is held by the public and 90% privately; MF Global was a public company. Mr. Peterffy and the other principles and "members" (as they are referred in company literature) have large personal stakes in Interactive Brokers and lots to lose if the company fails. In MF Global's case, it was shareholders and clients Corzine and crowd had at risk, and ultimately it was they who got shafted. Unfortunately, due to today's lack of transparency and the extraordinary complexity of structured investments, it is impossible to know exactly how safe any brokerage company is. The best we can do is dig into the data and make our own judgments. It looks reasonably prudent to determine that Interactive Brokers is a sound choice, but diversifying accounts between brokerage firms and even jurisdictions is always a good idea. As always, we continue to monitor our brokers for any signs of potential trouble. 

So, Was MF Global Re-hypothecating Gold Bullion?

This accusation has gone viral within the gold community. It is based on a court filing by HSBC and surrounds the ownership of gold bullion held by a trustee for a client of MF Global. The speculation is that the gold had been re-hypothecated, resulting in a question of who is entitled to ownership.

But after digging into this story, reality is not quite as provocative as many have claimed. Here is a link to the actual Interpleader Complaint filed with the New York court.

Scroll down to section four where the sequence of events is spelled out. It is really straightforward stuff. Bottom line: No gold has been hypothecated, re-hypothecated, or hyper-hypothecated. The dispute is between the trustee of the gold and the claimed owner of the gold. As is not uncommon in this sort of situation, as custodian of the bullion HSBC is stuck in the middle and is asking the court to decide to whom to release the gold so that it – HSBC – is not held liable by either party. That MF Global is in bankruptcy and the case is filed with the bankruptcy court seems to be the bigger issue here. When a company enters bankruptcy protection, all decisions concerning how money or assets will be released or disposed of are made by the court, and it can be a lengthy procedure. That seems to be the case here, and in time the gold will make its way into the legally sanctioned hands.

Parting Thought

The downfall of MF Global has exposed yet another patch of the underbelly of the brokerage industry. Practices that are routine and legal – and hitherto largely unknown to most investors – can leave a company vulnerable when abused.

And don't expect the regulators to come to the rescue with strict oversight and public warnings. This rarely happens. When it does, it is usually too late or after the fact.

This report is an attempt to filter through the noise and tune into the signal. With so much misinformation floating about on the Internet, an investor must remain vigilant in the world of finance and investments… a difficult task at best.

[Kevin Brekke is a contributing editor for The Casey Report.]

© 2011 Copyright Casey Research - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules