April 05, 13
The November 2011 bankruptcy of MF Global and the subsequent global search for the million $1+ billion in customer deposits is looking increasingly like the tip of the iceberg. There is a much larger risk scenario that is beginning to unfold. Pay attention now or suffer the consequences later.
Hypothecation is far more prevalent than you might think
At first blush, you might think that the bankruptcy of MF Global was an isolated situation where a rogue company acted outside of the boundaries of their contracted fiduciary duties to customers. And you would be wrong. The reason why Corzine will almost certainly not get the Madoff treatment — at least in the judicial sense — is because his customer agreements have authorized the company to hypothecate and re-hypothecate anything on deposit.
So, earlier today I took a look at my TD Ameritrade account agreement and low and behold we have the following on page 6 of the customer agreement, apparently last modified in November 2011:
In other words, property on deposit — including cash — is not required to be segregated. It can be pledged, re-pledged, hypothecated and re-hypothecated at their sole description, without notice and without recourse. If those hypothecated trades go great, the house keeps 100% of the upside. If those house trades fail catastrophically, the depositors have been exposed to the potential risk that they will suffer without recourse if the company were to become insolvent or bankrupt. This is counter-party risk. Is it legal? Apparently yes. Is it ethical? Personally, I don’t think so. Will it end happily? I fear possibly not. That is why I don’t invest in hedge funds, fund of funds, or derivatives. The opportunity of obfuscation of ownership just too great. I would rather own something outright — like investment-grade domain names.
For more perspective on the issue of hypothecation of custodial assets, I strongly encourage you to read the excellent piece from earlier today on Zerohedge, which you can find here. It was one of the most useful things I read during 2011. If nothing else, it should serve to make any investor more highly conscious of the true counter-party risk for any investment. Otherwise you just might end up with the proverbial: