MF Global was a derivatives broker that filed for bankruptcy last October. It bet $6.3bn on the bonds of Europe’s most indebted nations, contributing to an internal liquidity crisis. Before bankruptcy, it seemed to dip into segregated US customer funds to cover margin calls through MFGUK, its UK operation. The UK was a convenient cover for such trades compared to the US, where the reuse of client collateral on this scale is forbidden.
Regulators from other jurisdictions acted quickly to get client money back. Canadians had their funds fully returned, Singaporeans got 90 per cent and US clients 72 per cent. In the UK the figure is just 26 per cent.
The case highlights two shortcomings in British finance. The first is re-hypothecation, a process whereby brokers use, for their own purposes, assets posted as collateral by clients. The second is the failure of UK regulation and its impact on the City’s reputation as a safe place to do business.
Re-hypothecation usually involves a right of brokers to transfer assets held in custody. They can use collateral to back their own trades and borrowing.
This is largely a UK practice. In Canada, re-hypothecation is banned. In the US, client protection rules exist alongside a cap of 140 per cent on the amount a client’s balance can be re-hypothecated. In the UK, there is no limit unless specifically negotiated.
This links us back to UK regulation. Among the edicts of the Financial Services Authority (FSA) is the Conduct of Business Sourcebook, which explains how institutions should classify clients – as retail, professional or eligible counterparty. Retail funds are held in segregated accounts. But the money of professional or eligible counterparty clients can be lent to the broker when the client agrees to a title transfer. Clients have little control over their classification and can be pressured to agree to a title transfer structure to obtain financing – with huge implications if the broker goes bust. Non-retail clients are unsecured creditors and are left far down the pecking order come bankruptcy.
This is the hapless fate of most MFGUK clients, who thought that “client money was client money.” They are now jostling with others for a share of the property. It will be a long and expensive process.
It didn’t need to be this way. The FSA put MFGUK into special administration when it was technically solvent, with sufficient resources to give regulators scope for a less disruptive strategy to clients and counterparties.
But there’s more at stake than the return of client funds. Brokers have exploited UK regulation to transfer an unknown amount of client funds to the UK to be re-hypothecated many times. This could compromise the stability of the entire UK financial system. While money does come into the UK, clients and taxpayers potentially bear all the cost and none of the benefit in the event of systemic failure.
There is a second shotcoming in British finance. The speed at which clients’ money is returned on bankruptcy is a litmus test of the attractiveness of the City. Clients will have realised that their money may not be as safe as assumed, and re-hypothecation also makes sorting out who gets what from an estate very messy. When the City’s competitor jurisdictions return funds quickly, it will be no surprise if investors turn away from us. The FSA’s remit is to protect clients and maintain confidence in our financial system. Its bungled handling of the MFGUK administration highlights the FSA’s inability to fulfil its duties. To shore up London’s reputation before confidence drains away, the MFGUK case needs immediate attention from the wider UK financial establishment.
We must examine re-hypothecation. The ability to manipulate collateral is a good way to promote liquidity. But this benefit must be balanced against the cost of investors overlooking the UK, and any taxpayer burden if there is systemic failure. We must dispense with re-hypothecation or limit the percentage of client funds that can be used for this purpose.
The FSA’s awareness of client segregation problems after Lehmans debunks the myth that “lessons have been learned”. This latest episode of regulatory incompetence risks damaging London’s international competitiveness as a financial centre.
Mark Field is Conservative MP for the Cities of London and Westminster.