MF Global’s bankruptcy highlights perilous faults in UK finance rules

An abridged version of an article Mark has written on MF Global appeared in today’s City AM –… The full piece is below:

‘Lessons have been learned’ – the contemporary platitude of choice for repentant organisations and governments alike in their communications strategy.

All too frequently was it employed when bankers and politicians accounted for the gross regulatory and commercial failings that precipitated the collapse of Lehman Brothers.

Lehman was meant to be the event that changed everything. The lesson of all lessons. So it was with disbelief that I heard a blow-by-blow account of the travails of an articulate group of MF Global clients who came to see me in parliament recently.

As the City’s MP, I have the privilege of regular contact with a range of professionals who act as an early warning system when it comes to any clouds gathering on the financial horizon. The sorry tale of MF Global’s demise seems to suggest that almost four years on, we have failed to heed the warnings of Lehman’s collapse.

MF Global was a major international financial derivatives broker until it filed America’s eighth largest bankruptcy in October last year. A primary dealer in US Treasury Securities and provider of exchange-traded derivatives, it made an ill-fated $6.3bn trade on the bonds of some of Europe’s most indebted nations that contributed to an internal liquidity crisis. In the chaotic days before bankruptcy was declared, MF seemingly dipped into segregated US customer funds to cover margin calls through its UK operation (MFGUK) as a result of the escalating European sovereign debt crisis. The UK provided a convenient cover for such trades in comparison to the US, where the reuse of clients’ collateral on such a scale would not be allowed. Debate continues to rage over whether the misuse of customers’ money was intentional, US lawsuits and congressional hearings failing yet to uncover a smoking gun.

As soon as the ship hit the rocks, regulatory authorities from leading financial jurisdictions such as Singapore and Canada acted quickly to get MF clients their money back. Seven months later, Canadian clients have had their investment returned in full, Singaporeans 90% and in the United States 72% of funds have been returned. By contrast, in the UK, the figure stands at 26% (and even the returned funds of those lucky clients come with strings attached).

The MF Global case is important as it highlights two significant shortcomings in the British financial landscape. The first is that of re-hypothecation, a process whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients. In return the client may be rewarded with a rebate on fees or lower borrowing costs (but often clients are not even aware that their money is being used in such a way). The second is the efficacy of the UK’s regulatory system and its impact on the City of London’s vital reputation as a safe place in which to do business.

Re-hypothecation usually involves a right of a bank or broker to transfer assets held in custody and over which they will usually have a charge to their own account. This “right of use” allows them to get an enhanced return on the assets and the client is left with a claim to return of the equivalent amount of money but crucially no claim on the assets if the bank or broker becomes insolvent. This is really a form of churning of collateral and typically sees organisations such as banks or brokers using the collateral to back their own trade and borrowing. Crucially, since collateral is not cash, it does not show up on balance sheets, making any re-hypothecation activity opaque. Before Lehman’s collapse in 2008, the IMF calculated that US banks were receiving over $4 trillion funding on the back of $1 trillion of original collateral – a churn factor of four. This significantly affected the overall volume of leverage in the system, but only came to light after the collapse.

Frighteningly, this is and remains largely a British problem. In Canada, re-hypothecation is forbidden. In the US, a defined set of client protection rules exists alongside a cap of 140% on the amount a client’s debit balance can be re-hypothecated. In the UK, there is no limit unless a client has specifically negotiated one with their broker. Such are the implications of this that Edith O’Brien, Assistant Treasurer of MF Global Inc., has claimed ‘Lehman happened in the UK; it did not happen in America’.

Which brings us to the efficacy of the UK’s system of regulation. Amongst the Financial Services Authority’s myriad edicts sits COBS, the Conduct of Business Sourcebook, which explains how banks and other financial institutions should classify their clients. They can be labelled either Retail, Professional or Eligible Counterparty. Clients classified as Retail have their funds held in a segregated account. But the money of clients labelled Professional or Eligible Counterparty – a precondition for having access to a more comprehensive suite of financial products – can effectively be lent to the business where the client has agreed to the so called ”title transfer” of the cash. Clients have little control over their classification and in practice would often be under pressure to agree a title transfer structure in order to obtain financing on their positions, particularly in relation to derivatives products. In spite of the conflict of interest, this is decided by their financial adviser. This has huge implications for this latter grouping in the event that a broker goes bust. They are considered unsecured creditors and therefore on liquidation find themselves far down the pecking order as the carcass of the insolvent company is picked over.

Such has been the hapless fate of the vast majority of MFGUK clients who took for granted that ‘client money was client money’ which would be returned in the event of bankruptcy. They now find themselves in a much more complicated situation, jostling with all the other claimants on the client money pool for a share of all the property via a Primary Pooling Event (PPE). PPE entails appointing a trustee, in this case KPMG, whose job it is to determine who is owed what. It is set to be a long, protracted and enormously expensive process. All the while, money is tied up that might otherwise be reinvested by clients in other areas of the economy.

It did not need to be this way. The FSA put MFGUK into special administration at a time when it was technically solvent with sufficient resources at its disposal to give regulators scope for an alternative strategy least disruptive to clients and counterparties. Nevertheless, in the face of FSA failings, the role of the Financial Services Compensation Scheme (FSCS) becomes all the more important. Yet the FSCS is only obliged to compensate clients once an amount is agreed with KPMG and then is granted six months to pay out. In addition, the sum that the UK insures – up to £50 000 – is trivial in the context of a large broker insolvency. To contrast it with some of our international competitors, the US insures up to $250,000 USD for equities, Canada $1 million CAD. After nearly seven months since MF Global was declared bankrupt, the FSCS has paid MFGUK clients a pitiful £130,000 from the $2.5bn funds owed.

What is at stake here is more than just the return of client funds. The handling of MF threatens the very vitality of the UK economy. International brokerage firms have exploited regulatory arbitrage to transfer an unknown amount of client funds to the UK to be re-hypothecated many times over. That has the potential seriously to compromise the stability of the entire UK financial system. While it may ensure large sums of money come into the UK, clients and taxpayers potentially bear all the cost and none of the benefit.

Second, the speed at which clients’ money is returned in the event of bankruptcy is seen as a litmus test when it comes to the attractiveness of the City of London to investors. Not only have clients suddenly realised that their money may not be as safe as they had assumed but re-hypothecation makes sorting out trading positions and who gets what out of an estate very messy. Many of Lehman’s clients are still stuck in the courts several years down the line and I have no doubt that the same fate awaits MFGUK’s. When our competitor jurisdictions are returning funds to clients in double quick time, it will be no surprise if investors start to turn their backs on the City of London.

Ironically if the Vickers reforms are enacted later this year we shall institute a ‘ring fence’ yet even now we fail successfully to safeguard segregated funds. The FSA’s remit is to protect clients and maintain confidence in the financial system in the UK. The bungled handling of the MFGUK administration singularly highlights the FSA’s inability to fulfil its duties and learn the lessons from the Lehman collapse.

To shore up London’s reputation before investor confidence drains away, the MFGUK case now requires the immediate involvement of the wider UK financial establishment. We also need an urgent review of client protection rules and the effectiveness of the FSCS as a backstop. Until very recently, the UK could boast that no material client money losses had resulted from broker failures. This is the standard that a leading global financial centre must surely strive to uphold.

Standing aloft these priorities has to be an examination of re-hypothecation. I appreciate that the ability for London-based financial firms to manipulate collateral via this mechanism is an attractive means of promoting liquidity to the City of London. Nevertheless, surely this benefit must now be balanced against the opportunity costs of investors overlooking the UK and the potential burden on the taxpayer in the event of systemic failure. I reckon we need either to dispense with re-hypothecation entirely or at least limit the percentage of client funds that can be used in such a way.

The handling by the FSA of the MFGUK bankruptcy could have been rationalised had its demise been a complete market surprise. Yet the FSA’s full awareness of client segregation problems following Lehman’s collapse debunks the myth that ‘lessons have been learned’. This latest episode of regulatory incompetence risks doing real and lasting damage to the international competitiveness of London as a financial centre.