The investigation of the MF Global scandal is still ongoing. A lot of details concerning the missing customer funds haven't been revealed. At this stage there is no definitive answer as to whether MF Global blatantly transferred segregated customer funds to cover its own liquidity shortfall, or it merely used the often frowned-upon, but completely allowable practice of rehypothecation. In this blog post, I explain what rehypothecation is, as well as the controversy around it.
Rehypothecation refers to the practice of primary brokers of re-using collateral posted by their customers, mostly hedge funds, in their own borrowings and tradings. Different countries have implemented various levels of regulatory control over this practice: in Canada rehypothecation is not allowed at all; in the US a prime broker may pledge up to 140% of the client's liability to the prime broker; in the UK, there is no upper limit on how much re-pledging is allowed, making the UK a hotbed of collateral recycling. Indeed, many banks --including the pre-crisis Lehman Brothers and the current MF Global -- used their UK subsidiaries to create funding for their US operations by taking advantage of the regulatory asymmetry.
Two researchers at IMF, Manmohan Singh and James Aitken, have carefully studied the role of rehypothecation in their 2010 research paper. According to the paper, after the collapse of Lehman Brothers in the fall of 2008, certain assets posted by Lehman's investors were "rehypothecated and no longer held for the customer on a segregated basis and as a result the client may no longer have a proprietary interest in the assets."
Unlike the Lehman Brothers' case, details of the lost customer funds at MF Global are still scarce, and some may never be revealed. Whether it is rehypothecation, or upfront stealing, hopefully time will give us a clear answer.
