Who holds your securities

There are two cases that are on-going at present which are interesting to follow.  The first is the MF global lost margin collateral and the second is the Madoff Victims vs JP Morgan debacle. What both these cases have in common is a lack of understanding from investors on where their assets actually reside.

Madoff Victims vs JP Morgan

Two investors caught out by the Madoff Ponzi scheme have decided to file against JP Morgan on the grounds that the bank assisted Madoff with his crimes. In this case, they claim that by offering specific banking facilities to the Madoff fund directly, JP Morgan had enabled the conduit required by Madoff to engage in his fraudulent trading activity.

The investors, Stephen and Leyla Hill, filed a $19 billion lawsuit against the bank, accusing it, as did trustee Irving Picard before them, of ignoring red flags that pointed to Madoff's $65 billion Ponzi scheme. "JPMC chose to enable Madoff's fraud, not just through the various ways it participated in his activity, but by helping cover Madoff's naked theft with the imprimatur of a globally-recognized financial institution" Fin Alternatives | November 8, 2011

Strong ties exist between hedge funds and investment banks but this is nothing new and nearly all hedge funds use banks to provide specific services for them. Whether that service is the primary function of the bank trading market positions under instruction or lending securities to the asset manager so that they can short, connecting the hedge fund to the bank is a necessity. The investment bank may also provide custodial services, collateralized futures and margining facilities, master account management, consolidated reporting, OTC hedging and the list goes on.

So given the number of services offered by investment banks, surely it would be plausible to believe that the bank could have insight into the funds operation and draw presumptuous, even conclusions on the hedge fund itself and its trading strategies --- This is unlikely to be the case, why?

Firstly the fund can have multiple prime brokerage accounts, where it is purchasing bonds through one facility and commodities through another and, the bank may have no knowledge of these other vendors and facilitators. Secondly, investment money may not be held with the bank and the bank is likely to have little insight into the number of investment programs the fund may have sold and how they have been structured.

In most cases not always, banks are just acting on an instruction like a post office sending contraband in the mail system, the postman actually doesn't know what is in the envelope. From the banks perspective it is probably more worried about its own direct risk with the hedge fund rather than trying to be a police officer for the market.

The interesting point to conclude from this case then is the lack of oversight investors seem to have when it comes to understanding the relationships between funds, banks and markets, the accountability and obligations between these entities and, in the case of MF Global, a direct knowledge on where the investor's assets are actually being held.

MF Global
The MF Global disaster really was that for a lot of investors and more than 630 million dollars went missing from customer accounts and over 1.6 billion worth of collateral was tangled up in liquidation proceedings.

The MF Global Inc.’s commodity customers may be required to share some of their cash with other clients unless money missing from some accounts is found, said the head of the group overseeing the liquidation of the broker-dealer. “Distribution of the assets will be pro rata, if there’s insufficient there to fulfil all obligations,” Stephen Harbeck | Investor Protection Corp.

Open positions investors had with MF Global also needed management and were transferred to other market brokers. All this aside, these rapid en-mass transfers are relatively non-standard transactions and nearly always result in errors. In the MF global case, investors were left cornered unable to trade in or out of their position and to add salt to their wounds, they also had to front up more cash for deteriorating margins.

CME Group and Intercontinental Exchange Inc moved over the weekend to limit the fallout from the MF Global bankruptcy on futures markets by lowering margin requirements on some accounts. "The exchanges have lowered the margins to help the transition until the cash arrives," said Jonathan Barratt, managing director at Commodity Broking Services in Sydney. "While it's a prudent thing that the exchanges are allowing people to transfer the positions away from MF Global, funds should also be transferred as well, instead of having people pay the margins twice." Chicago Business | 7th November 2011

What we can learn from both these cases is that investors need to gain a better understanding on where their funds, collateral and assets are actually being held. At point of bankruptcy, being returned what is rightly yours as an investor might be a long winded process and while time passes, it seems to be Murphy's-law that market forces will work against you.

From the perspective of banks, brokers, exchange houses and regulators, it might also be prudent to create a streamlined process for transference and novation of commitments between one market player and another. Certainly what has carried on in the MF Global wind-down has in some respect put the entire financial brokerage system under a lot of stress, this needs addressing.