Early Warning Signs and the Reuters Report
A recent report out of Reuters caused a bit of a stir. It claimed that several prime brokers were engaged in hyper-hypothecation – meaning the hypothecating of client assets to a degree that could threaten the broker’s viability and pose liquidity challenges. Among the cited brokers was Interactive Brokers.
As Interactive Brokers is one of our recommended brokers, it is time to bring them into the story, albeit in a fairly bit part and only long enough to address whether we suffered an error in judgment. Or – more to the point – is it now time to dump them?
For an answer, let’s compare the histories of MF Global and Interactive Brokers. This will also highlight the early signals that were visible well before October 2011 that MF Global might be headed for trouble.
MF Global was spun off from Man Group in an IPO in 2007. From the get-go the new company had problems. In 2008, it had to set aside a bad debt provision to cover losses from unauthorized trading by in-house brokers. Following the incident, the company paid a $10 million fine to the CFTC and $500,000 to the CME. Also in 2008, the liquidity of MF Global was questioned, causing its shares to crash. It took an investigation and announcement by the CME, CFTC, and other regulators that MF Global was in financial compliance to calm investor fears.
As a result of the two incidents in 2008, a new CEO was brought in, who promised to better manage MF Global’s risk. Then in 2010, he was replaced by Jon Corzine, making it three CEOs in as many years, all following on the heels of internal bumps in the road.
So, we have a new company struggling with obvious risk management and oversight problems, regulatory issues, and a high turnover in company leadership. That should have been a red flag for customers paying attention.
In contrast, Interactive Brokers has not had problems with rogue traders losing millions, liquidity concerns, nor issues with regulatory agencies. The company was founded by Thomas Peterffy 34 years ago, and he serves as its chairman today. The company had a great year in 2010, and 2011 looks to be another winner.
This is a well-established company with a long history of growth, headed by a respected leader in the brokerage and market making industry for 34 years, and no liquidity, oversight, or compliance issues.
It also seems relevant that in Interactive Brokers’ denial of the Reuters claim that it was actively hyper-hypothecating, they quote figures from their first-half 2011 financial report – a document in the public domain and available on its website. The figures reported in the document appear to refute the Reuters accusation, suggesting that Reuters did not do sufficient due diligence when researching the article.
It is also important to consider the difference in company structure: 10% of Interactive Brokers is held by the public and 90% privately; MF Global was a public company. Mr. Peterffy and the other principles and “members” (as they are referred in company literature) have large personal stakes in Interactive Brokers and lots to lose if the company fails. In MF Global’s case, it was shareholders and clients Corzine and crowd had at risk, and ultimately it was they who got shafted.
Unfortunately, due to today’s lack of transparency and the extraordinary complexity of structured investments, it is impossible to know exactly how safe any brokerage company is. The best we can do is dig into the data and make our own judgments. It looks reasonably prudent to determine that Interactive Brokers is a sound choice, but diversifying accounts between brokerage firms and even jurisdictions is always a good idea. As always, we continue to monitor our brokers for any signs of potential trouble.
So, Was MF Global Re-hypothecating Gold Bullion?
This accusation has gone viral within the gold community. It is based on a court filing by HSBC and surrounds the ownership of gold bullion held by a trustee for a client of MF Global. The speculation is that the gold had been re-hypothecated, resulting in a question of who is entitled to ownership.
But after digging into this story, reality is not quite as provocative as many have claimed. Here is a link to the actual Interpleader Complaint filed with the New York court.
Scroll down to section four where the sequence of events is spelled out. It is really straightforward stuff.
Bottom line: No gold has been hypothecated, re-hypothecated, or hyper-hypothecated. The dispute is between the trustee of the gold and the claimed owner of the gold. As is not uncommon in this sort of situation, as custodian of the bullion HSBC is stuck in the middle and is asking the court to decide to whom to release the gold so that it – HSBC – is not held liable by either party.
That MF Global is in bankruptcy and the case is filed with the bankruptcy court seems to be the bigger issue here. When a company enters bankruptcy protection, all decisions concerning how money or assets will be released or disposed of are made by the court, and it can be a lengthy procedure. That seems to be the case here, and in time the gold will make its way into the legally sanctioned hands.
Parting Thought
The downfall of MF Global has exposed yet another patch of the underbelly of the brokerage industry. Practices that are routine and legal – and hitherto largely unknown to most investors – can leave a company vulnerable when abused.
And don’t expect the regulators to come to the rescue with strict oversight and public warnings. This rarely happens. When it does, it is usually too late or after the fact.
This report is an attempt to filter through the noise and tune into the signal. With so much misinformation floating about on the Internet, an investor must remain vigilant in the world of finance and investments… a difficult task at best.
[Kevin Brekke is a contributing editor The Casey Report.]
