As I read the daily travails of the imploding MF Global and the quest by at least 33,000 account holders to “find my MFing money”, I am biting my tongue about the proselytising I have done over the past four years about what I got so scathingly chastised for calling “the Persian hordes of Wall Street” when I and my Spartan comrades were fighting off the repo lenders at BSAM.

The secret underground world of securities finance is at the centre of the MF Global affair and I feel for the clients who are rightly wondering how on earth this could have happened. The answer lies in the Impossible Mission Force files of Jon Corzine, a veteran of the securities finance underground and a guy well versed in the arcane worlds that are being laid bare in the press as the carcass of MF Global is being autopsied (wait a minute....that is CSI).

I am currently involved as an expert witness in some litigation that surrounds the re-hypothecation of securities by Lehman Brothers International Europe. It has served to reawaken many thoughts about the back-room work of securities finance, securities lending and the great big financial bugaboo of financial COO’s counterparty credit risk. It has also clarified some thinking about “whose money is it after all” once it’s in a prime brokerage account.

Prime brokerage came into existence in 1994 when the SEC defined prime brokerage as “a system developed by full-service firms to facilitate the clearance and settlement of securities trades for substantial retail and institutional investors who are active market participants”. The industry went international, following the hedge fund trend, primarily to the UK with the role of the prime broker more or less remaining the same.

The central prime brokerage services that exist in addition to the normal custody and clearing/settlement activities are that prime brokers provide financing (usually collateralised by securities) and agent the borrowing of securities to cover short positions. The advantage of using a prime broker is that the client can custody all of its positions and the associated margin deposits at the single prime broker and trade with any executing broker. The ability to have all of its positions and associated margin deposits in one location is generally a cost saving and reduces operational complexity for the client.

A necessary evil of this arrangement is re-hypothecation, which is a fundamental and well known component of the brokerage industry and provides the financing to support indebtedness of the client. Yes, re-hypothecation is generally a less expensive form of financing, and yes, re-hypothecation is capital efficient for the prime broker and the associated benefits are partially shared with customers, but that means that the prime broker can...and does...use a portion of the funds for its own funding purposes.

In the US, the Securities Exchange Act of 1934 allows US prime brokers to re-hypothecate assets to the value of 140% of the client's liability to the prime broker. This is quite different in places like the UK where there are no statutory limits on the value of assets that the prime broker can re-hypothecate or how much money it can raise from using those assets. How many clients who do business with a US prime broker and innocently allow their assets to get handled in the prime broker's overseas affiliate.....say, like LBIE.....have a clue about these regulations or lack thereof? Well, probably all those frozen in the Lehman bankruptcy at least, right?

The really pernicious thing is that it is not the custom and practice of the industry to generate prime broker customer reports which track or disclose when or where customers’ assets were re-hypothecated. Assets available for re-hypothecation (as much as 100% of a client's assets in places like the UK) can be pooled and used as necessary by the prime broker. Ownership of those assets is supposed to be maintained on the books and records of the prime broker.

In current litigation on these issues with regard to LBIE, it is being argued that no one knew or suspected that this was a concern (as though that has ever been a valid defense).
Granted, in the securities industry, the focus on counterparty risk was generally one-sided; the concern was to protect the prime broker from the failure of its customers. But no one REALLY was ignorant of prime broker counterparty risk.....otherwise why would all securities lending agency agreements indemnify clients against it?

The failure of Lehman Brothers was clearly unprecedented. But surely big lessons were learned. Prime custody and moving cash to BNY Mellon is all the rage, right?

When LBIE filed for bankruptcy: 5,000 ISDA Master Agreements for OTC derivatives; 1,000 Global Master Repurchase Agreements for Repos; and hundreds of thousands of open trades under the ISDA Master Agreements were in place, not to mention that LBIE had custody of assets for 1,300 prime brokerage accounts.

So, certainly, when MF Global went down unceremoniously only three years later, this would not happen all over with such surprise. Not so. In fact, I feel like I'm watching a bad rerun of Mission Impossible as I see reports that there is $600 million lost, then found, then lost again. The culprits are those nasty derivative contracts on European sovereign debt....oops, no, actually it was repo on that debt. So, where did the cash from that re-hypothecation go? I have no inside knowledge and I am no forensic accountant, but I shall lay odds that, just like with LBIE, the money was used to fund a losing brokerage operation and it is now gone, gone, gone.

Lawsuits will ensue. Expert witnesses will say for the defense that this was a freak event that no prudent man could foresee and that market practice did not provide a means of protection. And if you or any of your IM Force is caught, the CFO will disavow any knowledge of your activities.

At this point in the show the Impossible Mission Force Global (aka MF Global) team, led by Jon Corzine, walks off with a swagger and the clients and viewers are left to wonder, "what happened.......again?"