Misappropriation of Clients' Security Deposits by Securities Firms and the Industry-wide Crisis

Generally, modern securities trading is subject to multilevel clearing and settlement. A depository and clearinghouse offers corporate clearing services (also known as primary clearing) to securities firms and other clearinghouse participants as to capital and securities. Securities firms complete secondary clearing with their customers (i.e., investors). Multilateral netting is applied to the primary settlement where the clearinghouse, as the central counterparty to both buyers and sellers, offsets receivables against payables in all transactions of each clearinghouse participant and settles with participants at the net figures. This method greatly reduces the workloads and the need for funds in the clearing and settlement, thereby reducing the need for collateral.

The secondary clearing is on a transaction-by-transaction basis. Securities firms complete, instead of netting, full-amount clearing and settlement with investors in every transaction. Before any transaction, an investor must make a security deposit available to the full amount of transaction. After the transaction, the balances of capital account and securities account change accordingly to reflect the deal. This multilevel clearing and settlement system may result in a considerable amount of clients' money staying in a securities company's account. If left unsupervised, that money (i.e., funds available in client clearing accounts) could be easy-to-access ideal funds for misappropriation should the securities company face financial strain.

In the prereform custody mode, securities firms accessed those funds in client clearing accounts by setting up money ledgers and asset ledgers. Securities firms were prohibited from misappropriating client security deposits. However, regulators and custodian banks had no access to the information of a client's asset portfolio. Therefore, they could not check the client's security deposits by cross-referencing general and subsidiary ledgers. This undermined the enforcement of such a prohibition and resulted in uncontrollable breaches. Banks were also less motivated to supervise detail records maintained by securities firms concerning funds in client clearing accounts, which gave securities firms free rein for misappropriating such money.

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