Sunday, November 13, 2022

FTX and an old blog post

A long time ago I wrote a blog post about rehypothecation with brokers. It is - unsurprisingly - relevant again.

In some sense crypto provides fast-track learning as to why we have banking and broker regulation in the first place.

The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.


John Hempton (originally in 2008 - but repeated in 2022 because history rhymes)

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