You Don’t Actually Own the Securities in Your Account

Back in the old days, before digitalization fundamentally transformed the mechanics of financial transactions, this was not the case. But that was then. This is now.

Most Americans have probably never heard of the Uniform Commercial Code (UCC), which is “a comprehensive set of laws governing all commercial transactions in the United States.” Even fewer Americans are familiar with Article 8 of the UCC, which “provides a modern legal structure for the system of holding securities through intermediaries.”

In the mid-1990s, Article 8 was revised so that “investment securities can be safely used as collateral” by large financial institutions. Essentially, this modification of an obscure set of laws allowed big banks to use their customers’ securities in investment accounts as collateral in the derivatives market.

Eventually, the big banks began using their customers’ securities as collateral to make money in the developing worldwide derivatives markets. Basically, banks like JP Morgan Chase, Citi, Wells Fargo, Bank of America, and others pool these assets in places like the Depository Trust Company (DTC), which “is a member of the U.S. Federal Reserve System, a limited-purpose trust company under New York State banking law and a registered clearing agency with the U.S. Securities and Exchange Commission.”

Incredibly, the DTC retains “custody of more than 1.4 million active securities” valued at more than $87 trillion. Despite the fact that most Americans have no idea about the DTC and what it does, it carries immense power and influence throughout the financial world.

Now, back to derivatives. In 2002, Warren Buffet stated that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal… We view them as time bombs, both for the parties that deal in them and the economic system.”

He is not alone in that view. Many other investment gurus, from Carl Icahn to Michael Burry, agree with Buffet.

Today, the worldwide derivatives market has reached the astronomical figure of more than $1 quadrillion. For those not familiar with that number, one quadrillion = 1,000 trillion.

In the early 2000s, the total derivatives market was a fraction of what it has ballooned into today. However, even then, financial derivative instruments connected to home mortgages like credit default swaps, posed an imminent threat to the worldwide financial system when the housing market collapsed in 2008.

In short, the big banks, like those mentioned above, pooled subprime mortgages with AAA-rated mortgages and used it as collateral to make bets in the derivatives markets. In many cases, these big banks were making bets against the very mortgages that they had bundled and sold as AAA-rated.

Of course, as everyone knows, this led to a huge bubble in the housing market that eventually burst in spectacular fashion. But what most people don’t know is that when the bubble burst, the big banks were insulated from major losses due to changes made decades ago to Article 8 of the UCC.

For instance, consider the example of Lehman Brothers. In September 2008, Lehman Brothers filed for bankruptcy due to its overleveraged derivative positions in the housing market. At the time, Lehman was more than $600 billion in debt. Eventually, the case was dragged through the bankruptcy courts.

Here is where the story gets sinister. When Lehman Brothers filed for bankruptcy, its custodian, JP Morgan Chase, made sure it was at the front of the line when Lehman’s assets were distributed. Ordinary investors who had accounts with Lehman were simply out of luck. They had to wait years to be reimbursed, although many were only awarded a fraction of what they were owed.

The point is that a system like the one that has been created, wherein big banks can use customers’ assets to make risky bets in the derivatives markets and then jump to the front of the line in the event of a financial collapse, is a system that is rotten to the core.

Not only is this a complete conflict of interest, it emboldens “too-big-to-fail” institutions to engage in extremely risky derivatives trades with their customers’ securities. It is also a gross violation of the property rights that Americans have enjoyed since the founding of this country.

Fortunately, there is a solution. The UCC must be amended, again, to close this gaping loophole that allows big banks to use their customers’ securities as collateral. Make no mistake, this is not an easy lift. But the ball is already rolling.

This week, the Tennessee House and Senate held hearings on this very issue. Moreover, a bill was voted out of committee that would revise Section 8 of the UCC and restore property rights by redefining the security entitlement language.

Of course, this is only the first step in a very long journey. But, when the American people come to realize that they don’t actually own the securities they think they do, I strongly believe that this issue will catch fire.

Chris Talgo (ctalgo@heartland.org) is editorial director at The Heartland Institute.

Originally published by American Thinker. Republished with permission.

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