Re-hypothecation of Brokerage Accounts and What it Means to You

Update: The Wall Street Journal has picked up this topic and today posted an article entitled, “Is Your Brokerage Account Safe?”  Some of the advice contained: look for SPIC insurance and opt for “cash” accounts which restrict what the brokerage can do.

Last year, Jon Corzine (former Democratic governor and major contributor to the Obama reelection campaign) ran MF Global into the grown at light speed and blew a hole in the commodities markets.  Clients suddenly found that $1.2 billion of their cash simply disappeared.  A later investigation showed that customer’s money and assets were re-hypothecated, through an entity in England.

I won’t be discussing Jon Corzine’s admission under oath that he didn’t know anything (a felony under the Oxley Sarbanes law), or how he was caught committing perjury under oath by a CME representative, or how Jon Corzine has been able to avoid being thrown in jail.

No, I’m going to discuss what this means to the little guys—you and me.

In basic layman’s terms: Your broker can use your assets (cash and securities) as collateral for loans or bets.  If you broker bets a bad bet and goes under, your money disappears. And there isn’t anything to do. Worse yet, the counter parties (like J.P. Morgan are fighting to claw your money back, even if you transferred the cash or assets to another brokerage.

MF Global customers also quickly found out that SPIC insurance only covers theft of securities or illegal actions of the brokerage, and this scenario isn’t covered.  Oops.

Unfortunately, ALL brokers have discovered the magic of re-hypothecation, where they can use your assets and use them as collateral, sometimes many times over.  You have $1,000 in a margin account, the brokerage can use that $1,000 as collateral.  Re-hypothecation rules in England are lax, allowing the brokerage to lever up many times over.

Basically, wall street has figured out that you can have your cake and eat it too… and sell it, and eat it again, and sell it again:

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.

All of the commonly used online brokerage firms: TD-Ameritrade, Scottrade, FirsTrade, Interactive Brokers, WellsTrade, etc.,  ALL of them spelled out that they have the RIGHT to re-hypothecate (or re-pledge) any of your assets in your margin brokerage accounts.

What does that mean for little guys like us?

Read the fine print and learn the magic words: cash account.

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