The Customer Protection Rule and Too Big to Fail

I wrote a long post about the Customer Protection Rule (formally, Rule 15c3-3 under the Securities Exchange Act of 1934), and I realized no one would want to read it, so here's a slightly shorter post.

The key thing to recognize is that the Customer Protection Rule, which applies to U.S. broker-dealers, prevents the broker-dealers from using customer funds to finance themselves. To oversimplify a little, when a customer holds cash in a brokerage account, the broker-dealer can only do two things with it: (A) make margin loans to other customers, or (B) hold the cash in segregation. By "hold the cash in segregation" I mean hold it in a special account that is reserved for customer property and that can't be subject to a security interest in favor of the bank maintaining the account. (The broker-dealer can also invest the cash in U.S. Treasury securities, which must also be held in segregation.) The broker-dealer can't use the cash for any other purpose, and certainly it can't use the cash to pay its own creditors.

The purpose of the rule is to prevent broker-dealers from putting their customers at risk. A broker-dealer that is in compliance with the Customer Protection Rule should always be able to return customer cash and securities reasonably quickly without risk of loss. Of course nothing is perfect, and I don't want to exaggerate the degree of protection, but it's pretty good. (As an added layer of protection, insurance provided by the Securities Investor Protection Corporation automatically protects the first $500,000 of customer assets, except that it only protects up to $250,000 of cash.)

Two observations here. First, hedge funds generally want to borrow money to finance their trading activity. Some funds operate without leverage, but that's pretty rare. So typically a hedge fund, far from having cash in its brokerage account, will actually have a large debit in its account (that is, it will have a large margin loan payable to the broker).

Second, a broker-dealer should be largely indifferent to customer withdrawals, at least in terms of its own liquidity. Since the cash is segregated anyway, it's not as though it was ever available to the broker-dealer in a meaningful way. Sure, it can be a cheap way to finance margin loans, and it earns a modicum of interest in the special reserve account (or, if it is invested in Treasuries, it earns a small return that way), but to a close approximation a broker-dealer shouldn't care about customer withdrawals as such. (One little nuance here is that the broker-dealer generally run their computations for segregation once a week, so when customers withdraw cash it briefly reduces the broker-dealer's liquidity. But within a week its liquidity is restored as it draws a corresponding amount out of segregation, and I'm pretty sure a broker-dealer could always run the computation more frequently if it wanted. Not 100% sure about that.) Of course customer withdrawals of cash might signal a loss of confidence, which is quite serious, but by themselves they are not a big deal.

That's why I found the following passage from Too Big to Fail puzzling:

Apart from the new anxiety about money market funds and general nervousness about investment banks, he [John Mack, CEO of Morgan Stanley] was facing a more serious problem than anyone on the outside realized: At the beginning of the week, Morgan Stanley had had $178 billion in the tank—money available to fund operations and to lend to their major hedge fund clients. But in the past twenty-four hours, more than $20 billion of it had been withdrawn, as hedge fund clients demanded it back, in some cases closing their prime brokerage accounts entirely.

"The money's walking out the door," Chammah [co-president of Morgan Stanley] told Mack.

"Nobody gives a shit about loyalty," Mack railed. He had wanted to cut off the flow of funds, but up until now had been persuaded by Chammah to keep wiring the balances.

"To put the gates up," Chammah warned, "would be a sign of weakness."

The question was, how much more could they afford to let go? "We can't do this forever," Chammah said.

I really can't tell what's going on here. "Money available to fund operations and to lend to their major hedge fund clients" is only half right. Sure, you can use customer cash to fund margin loans, but you emphatically cannot use it to fund operations. That would be grossly illegal.

Also, hedge funds really shouldn't be holding that much cash at their brokerage. It's weird. Hedge funds usually want leverage, and sitting on cash is the last thing they want to do. (Admittedly the markets were weird at that point, and if you're net short you might be holding cash in your account as collateral for your short positions.)

But the big point here is the one I made earlier. This is presented as a loss of liquidity for Morgan Stanley. But the money was coming out of segregation, it was never a source of liquidity to begin with. Don't get me wrong, you never want to lose customers, but the last thing to worry about is returning their cash.

Also, it's true that Morgan Stanley can use customer cash to fund margin loans, but (A) at the margin most broker-dealers have lots of cash sitting in segregation, so they don't need to reduce their margin lending, and (B) anyway when a broker-dealer has to use alternative funding to finance a margin loan, it can take the borrower's securities out of segregation to obtain the financing on a secured basis.

As I said, it's puzzling. Maybe its customer reserve account was empty somehow and so a dollar of customer withdrawals meant a dollar of financing that it had to obtain in the market? And maybe Morgan Stanley was having trouble obtaining financing even on a secured basis? But that all seems very unlikely. I don't really get it.

[Oh, also, you can't refuse to give customers their cash! I guess you can slow-walk them, maybe, but the regulators would flip their shit if they knew you were intentionally holding on to customer cash when customers were trying to get it out.]

[Updated slightly for clarity.]