The Federal Reserve is supposed to be on the front lines fighting systemic failure. If the latest concerns raised about MF Global are true, however, the Fed and its rules, albeit indirectly, could have made matters worse for MF Global customers. In the long run, it also could have negative repercussions for the central bank’s reputation, not to mention its independence.
As noted in this Zero Hedge article, the Fed’s Regulation T makes it legal for banking and trading firms to hypothecate customers’ margin securities to other institutions. Most of us know that. We also know that, in turn, those other institutions are permitted to rehypothecate the securities to other institutions down the line.
But Reg T has other pernicious elements to it, particularly if you have the poor fortune of being either a customer or a taxpayer. First, the rule also allows firms to rehypothecate customer funds for the benefit of the firm, not the customer. And if the firm fails before the hypothecation is unwound, the client is considered an unsecured creditor at the back of the line.
The most destructive effect of the rule, says Bruce Krasting, the Zero Hedge author, comes when customers of the firms second or third down the line of hypothecation start to withdraw their funds. At that point, it becomes harder and harder for firms up the line to meet their clients’ liquidity demands. All of a sudden we would be back in October 2008.
It is a disturbing picture and the implications laid out by Krasting are not pleasant. Do read the whole article.