Analysis: Loss of £374m raises worries over use of client money

This month, clients of MF Global suffered an unpleasant double surprise. Not only did the American brokerage go bankrupt after it took large bets on eurozone debt, but many of its customers suffered a second hit when regulators disclosed that some $600m (£374m) had gone missing from their accounts.

The case raises a serious question for investors everywhere: how carefully are prime brokers looking after the money that clients have entrusted to them?

The money’s disappearance has baffled the market. Suspicions were raised that MF Global used clients’ money to fund some of its trading operations. If this is the case, the episode will do nothing to improve the wider public’s already fractured view of the probity of financial companies. Investment banks and asset managers are expected to implement policies that prevent the money they manage getting mixed with their own pots. For that, segregated accounts are set up to keep investors’ assets isolated from risks taken by their brokers without their consent.

But reports have indicated that MF Global may have failed in its duty to keep client assets out of harm’s way. CME Clearing, a clearing house, has stated that the evidence points to a “significant shortfall in the US segregated accounts at MF Global”.

The case is under investigation. If suspicions are confirmed, investors and other stakeholders will have reason to be seriously concerned, as America’s Futures Ind­us­try Association (FIA) has acknowledged. “Segregation of customer funds is the cornerstone that assures the financial integrity of our markets and any violation of these segregation requirements cannot be tolerated,” the FIA said in a statement last week. (Analysis continues below)

Using clients’ assets to make money is standard, legal practice at many asset managers and brokerages. Brokers and managers can, for instance, take a commission when they lend out clients’ securities to investors so that the investors can short-sell them. The broker or manager simply has to agree with clients a provision that allows it to transfer the title for the assets to itself or a third party. This is called re­hypothecation, and it is deployed in Britain as well as America, including by exchange traded funds.

Ashurst, a law office, has noted that re-hypothecation can bring cheaper financing for brokerage clients, but can also have a downside. “There is a greater risk that the assets may not be recovered on an insolvency of the prime broker, because re-hypothecated assets are no longer held in trust,” the company noted in a report.

In Britain, client assets have long been ring-fenced. After the collapse of Lehman Brothers in September 2008, however, many investors still had to fight court battles to have their assets returned.
In the case of prime brokers, the level of protection is agreed with clients, and some may find it preferable to skip the extra costs implied by having a segregated account.

An expert in asset protection law, who spoke to Fund Strategy on condition of anonymity, says that agreements signed by clients of retail investment funds will usually provide asset protection similar to that enjoyed by bank account holders.

The FSA says not all brokers’ clients get enough information to make informed decisions and has promoted rule changes that have been gradually implemented this year. Among the most important are stricter reporting requirements to help investors keep track of their money. For instance, large brokers were expected this year to start providing clients with detailed daily statements about their assets.

To help investors spot eventual traps, the FSA has determined that, when contracts include a right for the broker to use safe-custody assets in its own trading, they must also include a detailed explanation of the risks that such assets will be exposed to. Last year the FSA group that monitors clients’ assets also voiced its intention to be more intrusive in its audits on companies. According to Matt Shaw, a member of the team, “we are generally finding compliance with CASS (the client asset sourcebook) falls short of our expectations.”

The legal expert points out, however, that the changes are still in progress, and only mean that investors will have a better chance of recovering their assets, which is often after a lengthy judicial procedure. The ideal outcome for the eventual solvency of their brokers is for the clients to have the money back in their hands in a short time so that they can invest it elsewhere, the expert adds.

“It is probably ironic that the MF Global case came to light at the same time that the Supreme Court is trying to decide which clients of Lehman Brothers’ UK unit will recover their ring-fenced funds,” the expert says.

The $2 billion case has been in the courts for over three years while claimants discuss whether investors who had money in segregated accounts at Lehmans have the same rights as those who did not.

The dimensions and the nature of the MF Global case may not be the same, but many investors could well endure similar woes before they once again see the colour of their money.