Finance's newest dirty word

When learning a language, one of the most memorable and enjoyable parts is learning a whole new set of dirty words.

Last week, many of us learning the language of finance were taught a new dirty word: re-hypothecation.

What does it mean? Well, it doesn't have any thing to do with your mother, unless she invests through a brokerage account. Re-hypothecation is the process of lending out assets that don't really belong to you in exchange for new assets that do belong to you, or at least ones you can use.

As the MF Global debacle continues to unfold, we are learning about more serpeptitous plays from the high finance play book. These allegedly include taking and re-loaning assets like stocks and currency that are supposed to be locked away in segregated client accounts, and using the money received on these loans to pay off the firm's own bills.  

While none of this has yet been proven in court, it leaves investors with a sick feeling, knowing that the assests they were supposed to have in their account have been replaced by their broker with an IOU. It also appears that the situation is even more dire than that, with client assets, like physical gold, held in their account may also have been re-hypothecated, loaned short-term to some third party in exchange for cash to be used by the broker to pay its own bills. Now that MF Global has gone bankrupt, investors are trying to get their gold or other assets back from these third parties but are not having much luck.

While there were clearly unique elements about the way MF conducted business, it can't possibly the only the only firm pushing the legal boundaries on hypothecation, which technically is legal, and calls into doubt the practices throughout th industry. Applying the principle of caveat emptor (buyer beware), investors everywhere should be asking themselves the following questions:

  • What is my broker's stated policy on hypothecation of assets (especially if you buy on margin)? 
  • If I'm not comfortable with this policy, what are my alternatives?  
  • What kind of business risks are my brokers taking in their other business and does it put my faith in them as a going concern at risk (are they a safe place to keep money and assets)? 
  • Are my funds insured in the event my broker goes bankrupt? (There is increasing evidence that they are not fully insured in many cases for MF clients.)

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