Hypothetically Speaking

The game is rigged.

That’s one lesson from MF Global. Because brokerage accounts are designed by and for the broker, customers agree to all kinds of things without knowing what they’re signing up for. One of these is margin—by borrowing against your securities, you give the broker the right to use your securities for other purposes. Another is securities-lending, where the brokerage can lend out the customer’s stocks or bonds to a short-seller, in exchange for cash which can earn a small spread.

The thing is, many brokerage customers agree to these provisions without knowing it. Lots of accounts are in an “opt-out” form, like Facebook privacy settings. So unless clients tell the firm otherwise, their own securities can be used to “hypothecate” the broker’s own positions. And dealers who receive those securities can re-hypothecate them to cover their own borrowing.

Thus is violated one of the primary principles of fiduciary conduct: the customer’s assets must remain dedicated to the customer’s purposes. The same assets are pledged against multiple loans, and if the firm fails before the loans are unwound, the customer goes to the back of the line as a senior unsecured creditor.

This is all disclosed—in 6-point type at the back of a brokerage agreement that you need a microscope to read. It’s another reason why all our accounts are cash accounts—no borrowing is done, and no one borrows against our client funds. Because when it comes to customer cash, the rule is simple: it’s their money.

Douglas R. Tengdin, CFA
Chief Investment Officer
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By | 2017-07-17T12:34:58+00:00 December 29th, 2011|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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