Hypothecation and Investment of Customer Funds and Securities

Regarding the issues raised in [URL="http://www.effectivevolume.com/content.php?1058-Comments-for-December-8-2011"]Pascal's Comment of the Day[/URL] and follow up comments, I'm opening this thread to discuss the ultimate trade: keeping our cash and securities safe in the event of another global meltdown. The ZeroHedge link is here:

[URL="http://www.zerohedge.com/news/why-uk-trail-mf-global-collapse-may-have-apocalyptic-consequences-eurozone-canadian-banks-jeffe"]http://www.zerohedge.com/news/why-uk-trail-mf-global-collapse-may-have-apocalyptic-consequences-eurozone-canadian-banks-jeffe[/URL]

On the hypothecation issue, my understanding is it relates only to securities pledged by customers as margin, not cash. That being said, it is still legal for futures brokers (I don't know about securities brokers) to invest customer cash in any number of ways, including sovereign debt, or repo it, both internally and externally. The so-called MF Global Rule that was passed a few days ago gives firms six months to comply.

The bottom line in relation to all the articles that are being published about possible abuses of customer funds and securities is that we really don't know all the exact technical questions to ask and probably cannot rely on the statements that are being released, as they might be simply cleverly worded to mask risks.

My preferred method for broker hunting is now very simple: identify futures commission merchant (FCM) clearing firms where the owners have significant skin the game. That is, will their personal fortunes go down with the ship? These are likely to be smaller operations, but they should also be better run with more of an eye toward risk management. The importance of being a clearing firm is to reduce reliance on third parties. I suppose the flip side is you can hold your nose and go with one of the true too-big-to fail brokers.

In any case, I've written in this forum before that one of the benefits of leverage in futures is the ability to maintain low cash balances, especially with the eMinis and currencies, where it is possible to post as little as $500/contract during the day. I suspect that's the shell game all customers are trying to play now...keeping as little cash as possible in their accounts.

Also, even with insurance, such as SIPC (which does not cover futures accounts), it can be months before funds are returned. The FDIC, which insures bank accounts (currently unlimited coverage for non-interest bearing checking accounts), is quicker. In all, I would hesitate to put more than 10% of my net worth in any particular entity taking into consideration its affiliates. And, in the worst case scenario whereby we are faced with a bank holiday, it would not hurt to have a month's worth of cash on hand, as ATM withdrawals would likely be limited.

Thank you Bob.

I made this tread "sticky" so that we can refer to it at any time in the future, because this issue will be there for a long time.


Pascal

I'll post this again for "posterity" if not prosperity, no bad luck intended.

TOS claims:

[I]It is important to realize that neither TD Ameritrade nor Penson Futures utilize a business model like MF Global. Unlike MF Global our clearing firm, Penson, does not trade proprietarily, they are only in the business of clearing trades acting solely as a custodian and clearing firm for our customer assets on the Futures side.

Second, all of our accounts are reconciled with Penson Futures daily with the added measure of an Autosweeps process of all Cash and Excess Equity being swept off of the books of Penson Futures to your TD Ameritrade account nightly so as to further reduce our counterparty risk with Penson Futures. The end result of this process is that most if not all of our customer funds that remain at Penson Futures are held at the clearinghouse of the particular exchange to which we route trades, primarily the CME and/or the ICE, for performance/margin purposes.

Additionally your equities account with TD Ameritrade is federally insured through either FDIC or SIPC depending on your Cash Sweep Vehicle (MMDA or Cash), either way they are insured up to $250,000.

Cash is held in your brokerage account, protected by Securities Investor Protection Corporation (SIPC) coverage applicable to the account against brokerage failure (up to $250,000).

Balances reflected in your brokerage account are FDIC-insured and are held by TD Bank N.A and TD Bank USA, N.A., or both (up to $250,000 per depositor, per bank). The IDA balances are not covered by the Securities Investor Protection Corporation (SIPC) protection applicable to your brokerage account.[/I]

Is this a satisfactory answer? Dunno. My instincts say no. But like Deckard, I'm a little person trying to crawl my way out of noodle bars, acid rain, and regular police harassment. He didn't even know he was a robot; and I don't know if my money is safe or that either.

[ATTACH=CONFIG]11793[/ATTACH]

[I]I contacted Interactive Brokers, here is their answer:[/I]

Recently, much has been written about the safety of customer assets held by brokers and we believe that customers are justified in their concerns. And so, we are writing to help clarify your understanding of how brokers are permitted to operate and, in particular, how Interactive Brokers protects its customers assets while servicing their needs to trade on margin.

To start, and so as not to leave any confusion as to the position of IB vis-à-vis the Thomson Reuters news article, IB DOES NOT, in any way:

1. Circumvent U.S. securities or commodities rules at the expense of our customers;

2. Invest customers’ segregated funds in foreign sovereign debt or utilize in-house repurchase agreements;

3. Commingle or utilize customer segregated assets for proprietary operations;

4. Enter into agreements which are designed to take advantage of supposedly unrestricted U.K. re-hypothecation rules; or

5. Engage in transactions deemed as “hyper-hypothecation”.

More specifically, regarding hypothecation and the level of such activity at IB: - The hypothecation and re-hypothecation of customer assets is a standard and essential practice, which U.S. brokers employ in the course of financing customer activity. The rights to do so are longstanding, have been explicitly provided by regulation and one should not be surprised to see boilerplate consent language in each broker’s customer agreement acknowledging this.

For example, a customer who incurs a margin debit by virtue of the fact that they have purchased securities with only partly their own money, thereby relying upon the broker to lend them the funds to pay the balance at settlement, subjects a portion (up to 140% of the amount borrowed, also referred to as the margin debit) of those securities to a lien on behalf of the broker. The lien is also known as hypothecation. The broker, in turn, may pledge or re-hypothecate the securities upon which they have a lien to replace the cash.

In the case of IB, this re-hypothecation typically takes place in the form of a stock loan. In simple terms, IB borrows money from a third party, using the customer’s margin stock as collateral, and it lends those funds to the customer to finance the customer’s purchase. -

Similarly, a customer who carries a futures position must place a margin deposit with IB. IB may pledge the customer’s cash deposit to a futures clearing house in support of the margin required on that position.

While IB is not in a position to comment on the practices of others and whether they comply or fail to comply with these regulations, or do so in a manner which introduces unwarranted risk to the firm and its customers, we can state that we comply with all regulations and utilize investment policies that tend to be more conservative than those permitted under the regulations.

The Thomson Reuters news article alleged that IB, among other brokers, engaged in a practice that the author categorizes as “hyper-hypothecation” (apparently a term used to describe a process in which a broker alters the risk of one financial
instrument into the exposure of multiple other instruments and perhaps multiple counterparties through a daisy-chain series of pledges) at an amount of $14.5 billion.

While we are not sure of the author’s source for this number, we would refer interested parties to footnote 10 (“Collateral”) on page 17 of our June 30, 2011 financial statement, which is posted on the IB website ([url]http://www.interactivebrokers.com/d...Unaud_Finls.pdf[/url]) and reads as follows:

“At June 30, 2011, the fair value of securities received as collateral, where the Company is permitted to sell or repledge the securities was $16,817,859,287, consisting of $13,022,386,422 from customers, $2,886,934,605 from securities purchased under agreements to resell and $908,538,260 from securities borrowed. The fair value of these securities that had been sold or repledged was $4,526,153,369, consisting of $2,583,920,633 deposited in a bank account for the exclusive benefit of customers in accordance with SEC Rule 15c3-3, $761,740,278 securities loaned, $877,478,486 securities borrowed that had been pledged to cover customer short sales and $303,013,972 securities that had been pledged as collateral with clearing organizations.”

A closer examination of this $16.8 billion balance reveals the following:

1. $13.0 billion represents the amount IB is authorized to pledge (largely based upon 140% of customer debit balances), of which only $0.8 billion has been repledged, largely through stock lending.

2. $2.9 billion represents the investment of customer’s cash balances in reverse repurchase agreements where the underlying collateral is U.S. treasury securities. These transactions are conducted with third parties and guaranteed through a central counterparty clearing house (FICC). $2.6 billion of this collateral, technically a repledge (i.e., part of the $4.5 billion “sold or repledged”), is not re-hypothecated and it remains in the possession of IB and held at a custody bank in a segregated Reserve Safekeeping Account for the exclusive benefit of customers. The remaining $0.3 billion represents collateral pledged to clearing organizations.

3. $0.9 billion represents short sale transactions whereby the sales proceeds have been pledged as collateral to fully secure the borrowed securities. These transactions are classified as securities sold (i.e., part of the $4.5 billion “sold or repledged”).

Based upon this information, which reflects prudently risk-managed broker financing transactions, we believe a fair-minded author would have drawn a different conclusion regarding IB and hyper-hypothecation given a minimum level of investigation and contact.

[QUOTE=Sandy;19572]In high volatile market, when you are not trading, what would be the better option to keep cash? The reason for asking this question is trying to protect my cash from events like MF global crisis.

1. Keep cash in FDIC insured accounts in large bank, such as Chase.
2. Keep cash in FDIC insured attounts at brokerage firm itself. TD ameritrade has option to move money in FDIC insured accounts.
3. Buy relatively stable bond ETFs (SHY, SHV). In this option you have cash invested in some physical assets.

Thanks.
Sandy[/QUOTE]

I'm requoting the above from another thread because it pertains to this one (which has sticky status).

With respect to #2, I believe Sandy is referring to the nightly sweeps that the brokerage unit makes into the bank. Consider, though, what would happen in an MF Global-type situation, where there is a run on the brokerage house and someone decides not to make that sweep on a Friday afternoon. Yes, that would probably be fraud and a crime, but it's within the realm of possibilities. Not to malign TD--just to illustrate a point.

With respect to #3, those two ETFs do indeed list nearly 100% of their holdings as US Treasury securities. However, read this excerpt from the SHY prospectus:

[QUOTE]Securities Lending Risk. The Fund may engage in securities lending. Securities lending involves the risk that the Fund may lose money because the borrower of the Fund's securities fails to return the securities in a timely manner or at all. The Fund could also lose money in the event of a decline in the value of the collateral provided for the loaned securities or a decline in the value of any investments made with cash collateral. These eents could also trigger adverse tax consequences for the Fund.[/QUOTE]

and:

[QUOTE]Pursuant to a securities lending program approved by the Board, the Fund has retained an Affiliate of BFA [BlackRock Fund Advisors] to serve as the securities lending agent for the Fund to the extent that the Fund participates in the securities lending program. For these services, the lending agent may receive a fee from the Fund, including a fee based on the returns earned on the Fund's investment of the cash received as collateral for any loaned securities. In addition, one or more Affiliates may be among the entities to which the Fund may lend its portfolio securities under the securities lending program.[/QUOTE]

This is from the MF Global Inc. broker unit annual financial report as of March 31, 2011:

[QUOTE]The Company entered into repurchase agreements with an affiliate that are collateralized with European Sovereign debt. The affiliate identified the market opportunity and manages the collateral associated with these transaction, although the Company retains the Issuer default and liquidity risk. For these services, the Company is paid a management fee to the affiliate. The management fee represents approximately 80% of the trade date gain recognized by the Company from entering into these repurchase agreements.[/QUOTE]

The similarities are in the business model: a loss leader to obtain cash and securities with which an affiliate manager uses to trade and retain the profits. For MFGI, the loss leader was the brokerage business. Any excess cash or securities that MFGI did not have to post to CME to back positions could be used to invest otherwise. For iShares, and probably most other ETFs, the loss leader is the operation of the funds themselves at very low fees (0.15% for SHY).

Big problems can occur when collateral calls are made to but one entity in the daisy chain of hypothecated/lent securities. For instance, if BlackRock has lent Treasury securities held by SHY to an affiliate, it would post collateral to SHY in return. However, it's almost certain that this collateral will be of a lower rating and probably less liquid, such that if there were a fail-to-deliver somewhere in the hypothecation upstream of the Treasurys, SHY would be left holding the collateral and would eventually have to mark down its NAV, with the share price following. It could be forced to liquidate the collateral at fire sale prices to meet redemptions. There's no guarantee that would protect owners of SHY securities from this. To the contrary, this risk has been disclosed to and implicitly accepted by all SHY investors. The $250,000 SIPC guarantee only kicks in when investor cash or the stock itself goes missing from an investor's account.

To be sure, BlackRock and the other large ETF managers have incredible resources and are incentivised not to let the system break. So, it would likely take a deflationary systemic shock greater than anything heretofore experienced to implode a large ETF manager and would be concurrent with shockwaves throughout the entire derivatives markets. As a corollary, the failure of a smaller ETF manager might be a canary in the coal mine event.

If you want the perceived security of US Treasurys without counterparty risk, it's easy to set up a Treasury Direct account, whereby the US Treasury is the custodian of Treasury securities held in your name. The issue is liquidity, as it takes about a week to achieve a transfer to a broker and sale. If you need daily liquidity or check writing capabilities, there are 100% Treasury money market funds (they will have "100% Treasury" in their name). Most do not lend or hypothecate, but as always, read the prospectus, and there still other risks inherent to money market funds.

On another related issue, last week, Pascal mentioned holding gold miner stocks as a hedge to systemic risk by securing the underlying cash flow of the miners. I have no knowledge of Pascal's particular situation, but almost no one holds securities in their own name anymore. Rather, almost all securities are held in street name, whereby they are nominated to the customer's broker, who in turn nominates them to the DTC, where they are finally held by Cede & Co., the partnership nominee of the [URL="http://en.wikipedia.org/wiki/Depository_Trust_%26_Clearing_Corporation"]DTC[/URL].

So, if your broker goes under and there are not the underlying shares to deliver or transfer, the SIPC insurance scheme (as I understand it), will simply cash you out as of the share price on the day of the failure. This is just speculation on my part, but I suspect that gold miner shares are a material part of the paper gold system, which includes ETFs, futures and other derivatives. Thus, I would expect this class of stocks in particular to be over-pledged and more likely to suffer a delivery fail upon a systemic risk event.

The bottom line is that if you don't hold your stocks by direct registration with the transfer agent (and ideally by holding a physical certificate), then your shares can be lent or hypothecated, subjecting them to the same musical chairs risk we see elsewhere. If your stocks are listed on your online account statement, they are not in your name. To accomplish direct registration and/or stock certificate delivery, many brokers will still do this, but the fee is often large. [URL="http://www.usatoday.com/money/perfi/columnist/krantz/2010-05-25-paper-stock-certificates_N.htm"]This article[/URL] explains how to do it on the cheap (or for free), though as a disclaimer, I cannot vouch for its current accuracy as I have not done it and the article might be dated. Also, this is probably only advisable for buy and hold positions, as it is difficult to trade once the stock is held in your name.

If anyone finds an error in what I've described, please correct me. Also, please feel free to post any first hand experience with direct registration.

Best of luck for 2012.

Reading EB post - which I think is pretty accurate -- I have just one reaction.

I am soooo happy that I live in period were we experiment with the concepts of regulation lite financial markets. I can truly see how this working out for all market participants. Dark pools, hidden volume, use of customer money, T+6 on ETF delivery etc etc.

I think it is time to have these same principals govern our Health care and social security sector. I can't wait to see their successful effects in hospitals and Old-Age homes.

Sorry for the Dutch humor,

Ernst

Thank you very much Bob for explaining in detail.