The 1934 Securities Exchange Act and all that
Bronte Capital (John Hempton) post originally from 2008 - but repeated in 2022 because history rhymes
Capital Thinking • Issue #1155 • View online
A long time ago I wrote a blog post about rehypothecation with brokers. It is - unsurprisingly - relevant again.
In some sense crypto provides fast-track learning as to why we have banking and broker regulation in the first place.
-John Hempton
FTX and an old blog post
The 1934 Securities Exchange Act and all that
When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge.
The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral.
So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.
There is one word for this. Dumb. They can – on face of it – take your assets and pledge them to finance their risky business.
If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.
It involved organised crime, guys that killed hitmen and all sorts of other colourful characters. There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.
The US had huge problems with broker-dealers in the 1930s. They folded and lots of people lost their entire fortune by not understanding their credit arrangements.
Enter the US Securities Exchange Act of 1934. This is one piece of depression era legislation that survives and thank the Good Lord for that.
What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take.
I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.
So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.
This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses.
Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.
If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account. [If your broker wants to steal from the segregated client account there are precious few defences – but…] You can not contract out of this requirement.
So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails. And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail. Even the Drexel Burnham Broker Dealer did not fail.
Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day. I have no proof of this claim – but in this age of computers that is plausible.
The result. Whilst Lehman brothers went bust Lehman US broker dealer did not. This pretty well saved the US hedge fund industry.
Europe however was a different story.
John Hempton
John Hempton (originally in 2008 - but repeated in 2022 because history rhymes)