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MF Global and the great Wall St re-hypothecation scandal

12/7/2011 COMMENTS (15)
MORE SECURITIES LAW
By Christopher Elias (UK) INSIGHT

Business Law Research Note: This version of the article has been modified from the original to make it clear that re- Court’s rejection of
Citigroup settlement
pledged collateral may come from straight repos and not just re-hypothecation. Some of the financial figures from raises questions for both
banks' disclosures have been adjusted accordingly. SEC and defendants
We can do better than
(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF this, can't we Mr.
Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global Khuzami?
and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at Implications of the SEC’s
landmark §304 ‘no fault’
the expense (quite literally) of their clients.
clawback settlement
MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently SEC seeks tougher
misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of enforcement options as it
stumbles on settlements
brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A
Citigroup settlement
loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous rejected, SEC’s rubber-
$6.2 billion Eurozone repo bet. stamp meets the road
It's cognitive dissonance
MORE MF GLOBAL COVERAGE time at the SEC
If anyone thought that you couldn’t have your cake and
Off balance sheet repo
* Corzine denies knowledge of any European loan eat it too in the world of finance, MF Global shows how you risks come back to bite
* A persistent MF Global won NY Fed dealer status can have your cake, eat it, eat someone else’s cake and Exchange sanctions lifted
then let your clients pick up the bill. Hard cheese for many for failure to prove service
* Exclusive: Regulators know what happened to funds
as their dough goes missing. 11th Circuit finds
actionable ‘confirmatory
* James Giddens: member of small trustees club statements’ that prolong
FINDING FUNDS
stock-price inflation
* Judge approves cash for MF Global bankruptcy
Current estimates for the shortfall in MF Global customer SEC likely to continue
* MF Global drew up survival manual in final days funds have now reached $1.2 billion as revelations break improving its enforcement
track record
that the use of client money appears widespread. Up until
* Full coverage of MF Global from Reuters Legal
now the assumption has been that the funds missing had
been misappropriated by MF Global as it desperately sought to avoid bankruptcy.

Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that
allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF
Global clients never get their money back.

REPO RECAP

First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-
sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and
putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate
money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules.

MF Global used a version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved
borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time
as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the
transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it
debt from Italy, Spain, Belgium, Portugal and Ireland.

Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain
Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be
MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more
information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo?

Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’
money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or
net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use
of clients funds known as “re-hypothecation”.

RE-HYPOTHECATION

By way of background, 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 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.

Written with contributions from Nanette Brynes.

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and
news on governance, transactions and legal risk. Visit Business Law Currents online
at http://currents.westlawbusiness.com.

Comments (15)

12/13/2011 6:09:28 AM by andrewtanner

@mfarimani Thanks for your valuable inputs. I think the key question remains. If we assume that the reported
shortage of 1.2 billion dollars in client funds is correct, the moot question is where did these funds go? Common
sense suggests two things-either they were co-mingled with MFG funds and used as margin to hold on to positions or
they were lost. If they were used as margin, on liquidation of positions they should have been returned. Maybe the
picture will be clear when all MFG Holdings and MFG Inc. proprietary positions have been reversed. However its more
difficult to digest the money to be lost in MF Global proprietary trading. There was an article in WSJ today stating that
Italian sovereign bonds were sold at 89cents to the dollar around 2nd week of November by LCH Clearing. Assuming
MFG bought them for a 100 cents, the loss would be 11% of 6.4 billion dollars or 700 million dollars. If MGF had not
provided 11% margin to the repo financier, and say only provided 5%, the repo financier would have an unsecured
claim on MFG for the balance 6%. Therefore the cash outflow from MFG would be just the margin he had provided to
the financier i.e.5% of 6.4 billion i.e. 320 million dollars (with the balance 380 million being a claim by the financier
for the loss). Considering that MFG had a consolidated capital of 1 billion dollars as well as about 1.2 billion dollars of
unsecured loans, I just dont see how they could have lost 1+1.2+1.2(presumably segregated client funds)
i.e.3.4billion dollars in the last 3 days of operation. Money is there somewhere.

12/13/2011 4:34:51 AM by mfarimani

A shortfall has been reported by CME as MFG's DSRO. One possibility is as follows. The UK entity would have an
omnibus client account with the US entity through which UK customers' trades on US exchanges are channeled to
the US entity as the executing broker. This account has to be treated as a segregated client account by the US entity
with the client being the UK entity. However, US entity has to declare the account as a client ominbus account to US
exchanges and thus get margined gross across the customers of the UK entity. If the account was not declared as
omnibus by the US entity and was margined by the exchanges net across customers' positions, there will be excess
client margin sitting with the UK entity. The upshot is that the DSRO, upon adjusting for this account to be omnibus,
will declare a shortfall in customer margins held in US while the excess margin is sitting in the UK entity and
continues to be under FSA Client Money Rules. In the meantime, the UK entity will not be showing any excess client
margins. It could very well be that, barring willful misconduct, once the books of the two entities are reconciled, the
disappeared funds re-emerge.

12/13/2011 3:42:01 AM by andrewtanner

@mfarimini Tks. You are extremely knowledgeable! Any take on how money could have been rerouted back to MFGI
or MF Global Holdings from MF Global UK and whether this happened?

12/13/2011 3:16:53 AM by mfarimani

@andrewtanner. The part of Reg T you have referred to relates to OTC derivatives which are bilateral arrangements
whereby each party accepts the credit risk of the other. OTC agreements contain title transfer provisions unless
negotiated and altered by the customer. ETDs are governed by CFTC regs. I am not familiar with MFG's document but
the FIA/FOA sites have boiler-plate FCM agreements that ar followed very closely by the FCM community.

12/13/2011 2:46:36 AM by andrewtanner

@mfarimini Also read the last part of MF Global rehypothecation clause reproduced below “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.” The question is-Was this a clause in all client agreements?
in our possession and control.” The question is-Was this a clause in all client agreements?

12/13/2011 2:41:37 AM by andrewtanner

@mfarimani I read this in business insider. Link is below. The rules on broker's ability to A) Hypothecate and B) Re-
hypothecate in the USA are spelled out in Reg T. This set of rules has been established by our good friends at the
Federal Reserve Bank. Let me provide some telling words on this re Reg. T rule 15c3-3: Except as otherwise agreed in
writing by the OTC derivatives dealer and the counterparty, the dealer may repledge or otherwise use the collateral in
its business; In the event of the OTC derivatives dealer's failure, the counterparty will likely be considered an
unsecured creditor of the dealer as to that collateral; The Securities Investor Protection Act of 1970 (15 U.S.C. 78aaa
et seq.) does not protect the counterparty. Well there you have it. Reg. T does permit the broker to “repledge” (AKA
re-hypothecate). In the event of default by the broker, the counterparty will be considered an unsecured creditor.
(AKA customers lose money). And SIPC provides zero protection to account holders in the event of a broker default.
Am still unclear in light of above. 2) Also if collateral was sent to MF Global UK for rehypothecation, how did MF Global
UK remit funds back to MFGI? The court affidavit filed by CME last week shows that MFGlobal UK owes 600 million
dollars to MFGI held in segregated client omnibus accounts (and in turn MFGI is holding 250 million dollars of
MFGlobal UK in an omnibus account). This seems to be in ordinary course of business. If there were a transfer made
by MFGlobal UK to MFGI as a loan, it would have found mention in the court affidavit. Or could it be that MFGlobal UK
sent the funds to MF Global Holdings (the parent company?). Read more: http://articles.businessinsider.com/2011-
12-12/wall_street/30506937_1_otc-derivatives-link-royal-bank#ixzz1gOx0HyyA

12/13/2011 2:22:24 AM by mfarimani

@andrewtanner: Rehype right allows for the FCM's to accept collateral from customers and post to the
exchange/CCP. It is an essential clause in any futures clearing agreement. Under CFTC, FCMs who are broker/dealers
are allowed to repo out cusotmer's collateral but proceeds of repo have to be put back into customer's seg account.
The broker remains responsible for return of "equivalent"collateral to the customer under the FCM agreement. Under
SFA customer asset protection cease at the point of rehypothecation and customer becomes unsecured creditor to
the broker. The numbers I have seen for MFGI customer collateral rehyp are too small to explain the $1.2B missing
funds.

12/13/2011 1:32:10 AM by andrewtanner

Christopher, would appreciate your insights

12/13/2011 1:30:48 AM by andrewtanner

1) correction..in my previous comment, the fourth last line should read "..secured through an off balance sheet repo
to maturity"..not "reverse repo. 2) @mfarimani As i understand it the moment the client allows his asset to be re-
hypotheticated it loses its identity and hence is not considered a segregated asset but rather an asset of the firm and
the client is deemed an unsecured creditor in the event of bankruptcy. This would apply under CFTC also. The reason
why FCMs prefer UK is simply due to the extra limit they enjoy in rehypothecation in the UK. Secondly, only clients
who had permitted rehypothecation in their client agreements would be affected and I am sure if it were a large
proportion of the 5.8 Billion dollars of segregated funds, the Trustee would have reported the same to the Court and
this would be a quick and comprehensive answer to the missing funds. I think rehypothecation did happen but not on
scale large enough to explain the missing funds.

12/13/2011 12:36:37 AM by mfarimani

CFTC rules require the proceeds of rehypothecation to be deposited into customer account, i.e. customer asset
protection remains post re-hyp. Any collateral transferred from US to UK entity must have been under a title transfer
agreement. Unlike the US regime, under the FSA regime Client Asset Rules cease to operate once the broker
exercises the right to re-hyp. i.e. the broker can treat proceeds of the re-hyp as house money/asset. This is a
regulatory defect well known to FSA as evidenced by Lord Turners referrals to the issue in a few of his
writings/speeches. If it turns out that re-hyp of UK held collateral was indeed behind the missing custoer funds, FSA's
foot dragging in closing the loop hole will be to blame.

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