It may seem strange to say that we might have seen the JP Morgan fine concerning client money coming. Following the collapse of Lehman Brother's, the FSA fired a warning shot off it's bow in a Dear Compliance Officer letter in March 2009 in which it stated, "Recent firm visits suggest that many firms do not have the appropriate trust acknowledgements in place. Where these are placed on file, we found instances where the documentation had not been executed in the name of the relevant bank or with appropriate authority on behalf of the relevant bank. Creating and operating these accounts are of paramount importance in establishing trust status for the benefit of the underlying client, the purpose of which again is only apparent on insolvency. . . In periods of market turbulence, we would anticipate that firms would conduct due diligence more frequently. We are reminding firms to document their due diligence."

The reason that the FSA has become so exercized about a so-called “administrative error” is that this particular error has been implicated in global economic crisis; namely, poor trust documentation surrounding the process of rehypothecation – the process by which a dealer lends out collateral posted by a client to another counterparty. Rehypothecation of client assets was one of the “dominant drivers of contagion” during the financial crisis, amplifying the market turmoil in the wake of the Lehman Brothers collapse according to the the Senior Supervisors’ Group (SSG). The body, consisting of financial regulators from the US, Japan, Germany, France, the UK, Canada and Switzerland, made the assertion in its Risk Management Lessons from the Global Banking Crisis of 2008 report. The authors noted that, following the bankruptcy of Lehman Brothers International Europe, clients that had elected to allow the dealer to rehypothecate their assets found themselves caught in the bankruptcy as mere unsecured creditors to the estate, rather than having their assets preserved in segregated customer accounts.

As a result, counterparties that should not have been significantly affected by the collapse of the dealer found their assets trapped in the insolvency, shrinking their funding base and dragging a host of additional institutions into a precarious fiscal position, further deepening the crisis. Lehman Brother’s administrators PricewaterhouseCoopers confirmed that more than $40 billion in hedge fund collateral had been swallowed in the collapse. Custody of assets and rehypothecation practices were dominant drivers of contagion, transmitting liquidity risks to other firms. The loss of rehypothecated assets and the “freezing” of custody assets created alarm in the hedge fund community and led to an outflow of positions from similar accounts at other firms. Some firms’ use of liquidity from rehypothecated assets to finance proprietary positions also exacerbated funding stresses, the authors concluded. At the heart of the problem lay a failure to keep accurate and complete trust documentation. Given this latest move by the FSA, risk managers are warned to establish regular checks on the quality of this type of documentation.

Dr. Victoria Lemieux, CiFER