On Tuesday, the SEC announced that Morgan Stanley will be fined $7.5 million to settle civil charges that it violated customer protection rules, when it used trades involving customer cash to lower its borrowing costs. The SEC said MS will settle the case without admitting or denying the charges, effectively letting slide a violation which, in an exaggerated format, was exposed as a quasi-criminal offense engaged in by Jon Corzine's now defunct MF Global.

Ok so, Morgan Stanley engaged in some creative "commingling" - what's the big deal, most banks do it. What makes this particular case curious is the basis of the commingling: it involves some of the more interesting, and abstract, concepts of modern finance, including Morgan Stanley's "Delta One" trading desk, as well as the rehypothecation of collateral, all of which participated in a complicated violation of customer protection.

While we present more details below, here is a quick primer on the Customer Protection Rule:

"it is intended to safeguard customers’ cash and securities so that they can be promptly returned should the broker-dealer fail. The SEC order finds that from March 2013 to May 2015, Morgan Stanley’s U.S. broker-dealer used transactions with an affiliate to reduce the amount it was required to deposit in its customer reserve account."

According to the SEC order, Morgan Stanley's transactions violated the Customer Protection Rule, which prohibits broker-dealers from using affiliates to reduce their customer reserve account deposit requirements.

In the SEC’s order, the regulator says that Morgan Stanley had its affiliate, Morgan Stanley Equity Financing Ltd., serve as a customer of its U.S. broker-dealer, a relationship that allowed the affiliate to use margin loans from the U.S. broker-dealer to finance the costs of hedging swap trades with customers. The margin loans lowered the borrowing costs incurred to hedge these swap trades and reduced the U.S. broker-dealer’s customer reserve account deposit requirements by tens to hundreds of millions of dollars per day.

The SEC found that Morgan Stanley’s affiliated transactions violated the Customer Protection Rule and that as a result of inaccurately calculating its customer reserve account requirements, it submitted inaccurate reports to the SEC. Morgan Stanley provided substantial cooperation during the SEC’s investigation and has agreed to review its compliance with the Customer Protection Rule and to take remedial steps to improve its calculation processes. Morgan Stanley also significantly increased the amount of excess funds it maintains in its customer reserve account. Without admitting or denying the findings, Morgan Stanley agreed to pay a $7.5 million civil penalty, to cease and desist from committing or causing any similar violations in the future, and to be censured.

So how did MS' Delta One desk and rehypothecated customer collateral get involved? Here is the answer, in all its excruciating detail:

The Issue: Financing Firm Hedges of Customer Swaps

Within MS, there are several subsidiary broker-dealers. Among them are MS&Co, which is a U.S. broker-dealer subsidiary of MS, and MSIP, which is a U.K. broker-dealer subsidiary. Across these broker-dealers, MS offers its customers a prime brokerage platform, including access to Delta One Structured Products (“DSP”) desks that offer customers synthetic exposure to specific securities through derivatives. For example, to meet customer demand for synthetic exposure to equity securities—i.e., exposure to price changes in an equity security without owning that equity security itself—a DSP desk will enter into an equity swap with a customer.

A customer entering into an equity swap with a DSP desk can take a long or short position vis-à-vis the underlying equity. If the customer goes long, then it is exposed to the same performance as if it owned the equity. Conversely, if the customer short sells the underlying equity through an equity swap, it obtains short exposure to that equity.

When entering into an equity swap with a customer, the DSP desk seeks to remain as neutral as possible in terms of its own market exposure. To hedge its exposure to the equity swap customer, the DSP desk generally would purchase the underlying equity for an equity swap where the customer had long exposure and would short sell the underlying equity where the customer had short exposure (“DSP Hedge”).

MS imposed a cost on trading desks for using firm capital to purchase their positions, including DSP Hedges. MS makes capital available to its trading desks but charges an interest rate on this capital, known as a proxy rate, that typically is higher than the interest that external third parties charge for collateralized loans. To avoid being assessed this more expensive internal financing rate, MS can finance its positions externally through a securities lending agreement. For example, MS&Co often rehypothecates customer margin securities in order to generate financing for customer margin loans.

In connection with the Prime Broker’s international synthetics business in particular, a portion of the DSP Hedges were less liquid, emerging markets equities (“EM DSP Hedges”), and as a result, they were more difficult to finance externally.

Although a broker-dealer may rehypothecate liquid securities and use the funds obtained to finance less liquid positions, the equity swaps traded in connection with the international synthetics business were largely booked in MSIP which held only a limited amount of liquid securities. Because the EM DSP Hedges exceeded MSIP’s liquid securities available for rehypothecation, the DSP desks were required to pay MS’s proxy rate to finance the EM DSP Hedges.

MS&Co held a substantial amount of liquid customer margin securities that were eligible for rehypothecation under Rule 15c3-3. Recognizing that MS&Co had a surplus of liquid customer margin securities and MSIP had a deficit for rehypothecation purposes, Prime Broker personnel began to explore whether DSP desks could access external financing that MS&Co could generate through rehypothecation in order to more cheaply finance the EM DSP Hedges.

Within certain limits, the Customer Protection Rule allows a broker-dealer to finance one customer’s margin activity with another customer’s assets, but does not allow one broker-dealer’s customer activity to finance another broker-dealer’s activities. As described below, the Prime Broker conceived of an affiliate that would transact with MS&Co, on one hand, and the DSP desks, on the other hand, for the purpose of providing financing for the EM DSP Hedges that was below the proxy rate.

The Proposed Solution: Affiliated Entity MSEFL

In early 2012, senior personnel from the Prime Broker developed a transaction structure centered on the use of an affiliate of MS&Co to hold the EM DSP Hedges, which it would purchase with funds obtained from margin loans extended by MS&Co. Following some initial meetings with relevant stakeholders regarding the broad contours of this idea, a New Product Approval (“NPA”) process was initiated in April 2012.

The affiliate—which eventually became MSEFL—would be a prime brokerage customer of MS&Co. Through this relationship, MSEFL would receive margin loans from MS&Co. MS&Co would fund these margin loans through the rehypothecation of its other customers’ liquid margin securities.

The EM DSP Hedges would trade in an MS account for global DSP desks, but would settle in MSEFL’s prime brokerage account. Therefore, the funds from the margin loans from MS&Co would be used to purchase or to borrow the EM DSP Hedges. In addition, the DSP desks would transfer the economics of the relevant, underlying equity swaps to MSEFL via a total return swap. The mechanics of the proposed transaction structure were as follows.

The Prime Broker estimated that, by avoiding MS’s proxy rate, MSEFL could achieve cost savings of up to $34 million per year. The Prime Broker’s use of MSEFL was ultimately more limited, and the Prime Broker thus did not realize this amount of savings.

From April to August 2012, the NPA was reviewed by stakeholders, including the Legal and Compliance Division and the Financial Control Group, which is responsible for ensuring MS&Co maintains sufficient funds to safeguard customer cash under Rule 15c3-3.

The Problem with the Proposed Solution: The Customer Protection Rule

Rule 15c3-3 imposes restrictions and responsibilities on a broker-dealer that are designed to safeguard its customers’ cash and securities so that these assets can be promptly returned if the broker-dealer fails. As to customer cash, Rule 15c3-3 requires a broker-dealer to maintain a reserve of funds and/or certain qualified securities in its Reserve Account that is at least equal in value to the net cash owed to customers. 17 CFR 240.15c3-3(e). The amount required to be maintained in the Reserve Account is based upon a computation typically performed on a weekly basis, which is calculated pursuant to a formula contained in Exhibit A to Rule 15c3-3 (“Reserve Formula”).6 See id. 240.15c3-3a. Subject to some adjustments, Rule 15c3-3 requires that a broker-dealer hold an amount equal to at least the excess of “credits” over “debits” in its Reserve Account. Id. 240.15c3-3(e). The term “credits” refers to the amount of cash the broker-dealer owes its customers or cash derived from the use of customer securities, while “debits” refers to amounts the customers owe the broker-dealer, for example due to margin loans extended to customers. See id. 240.15c3-3a.

The proposed transaction structure involving MSEFL was problematic for two reasons. First, the stated intent and objective of Rule 15c3-3 is to “eliminat[e] . . . the use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities as trading and underwriting through the separation of customer related activities from other broker-dealer operations.” Exch. Act Rel. No. 9775, 1972 WL 125434, at *1 (Sept. 14, 1972).7 The EM DSP Hedges were used to hedge the Prime Broker’s risk arising out of equity swaps with the Prime Broker’s customers, which was transferred to MSEFL, an affiliate of MS&Co. As a result, the financing of the EM DSP Hedges was inconsistent with Rule 15c3-3.

Second, as described below, the transaction structure allowed for the impermissible reduction of the Reserve Account through the debits of an affiliate.

The margin loans from MS&Co to MSEFL established a potential debit that MS&Co intended to use to reduce its Reserve Account by the same amount as the margin loans. In mid-August 2012, however, Prime Broker personnel identified a problem with the inclusion of this debit in the Reserve Formula.

Because broker-dealers could potentially seek to reduce their Reserve Account requirement through affiliates, Rule 15c3-3 also limits a broker-dealer’s ability to include debits generated by the activity of affiliates. Note E(4) of the Reserve Formula (“Note E(4)”) provides that the debits of affiliates should be excluded “unless the broker or dealer can demonstrate that such debit balances are directly related to credit items in the formula.” In other words, debits attributable to an affiliate’s positions can be included in a broker-dealer’s Reserve Formula only to the extent that there are directly related credits attributable to those positions. This limitation imposed by Note E(4) is designed to ensure that debits related to affiliate activity, on a net basis, will not reduce a broker-dealer’s Reserve Account requirement.

The debit resulting from the margin loans to MSEFL had no directly related credit and thus would have improperly reduced MS&Co’s Reserve Account. Initially, MS&Co believed that the credits resulting from the rehypothecation of MS&Co’s other customers’ liquid margin securities could be considered directly related. But, as the Financial Control Group advised, “the credit must arise from the rehypothecating of the affiliates [sic] own collateral to be deemed directly related.” As such, the Prime Broker concluded that it could not achieve the desired cost savings because of the absence of a directly related credit and considered further options to determine whether it could operationalize MSEFL.

The Proposed Fix: Transferring Short Sale Proceeds to MSEFL

In an effort to keep the debit that would be generated by MS&Co’s margin loan to MSEFL in the Reserve Formula, the Prime Broker explored whether they could identify directly related credits to add to the transaction structure. In or about early September 2012, the Prime Broker considered whether the problem might be resolved by having the DSP desk transfer separate short sale positions—the proceeds of which are credits in the Reserve Formula—to MSEFL.

As mentioned above, the DSP desks could trade equity swaps that offered customers either long or short synthetic exposure to underlying equities. When a DSP desk offered short exposure

through an equity swap, the DSP desk would establish the DSP Hedge by shorting the underlying equity and, in doing so, receive short sale proceeds.

To implement this updated transaction structure, MSEFL would sell short to the DSP desk the underlying equities that the DSP desk had shorted to establish the DSP Hedge. The DSP desk would use the proceeds from its own short sales to pay MSEFL for these equities. MS&Co would then borrow the underlying equities and deliver them to the DSP desk to cover MSEFL’s short sales, and MS&Co would credit MSEFL with short sale proceeds. The DSP desk, in turn, could then close out its short sales. The revised transaction structure included the following additional elements:

The Problem with the Proposed Fix: The Customer Protection Rule

Prior to its approval and implementation, MS&Co did not realize that this updated transaction structure achieved a result contrary to Rule 15c3-3 generally and the purpose of Note E(4).

MS&Co intended for MSEFL’s short sale proceeds to serve as the directly related credit for purposes of the debit resulting from the margin loans to MSEFL. Therefore, MS&Co believed that it could now offset that debit in its Reserve Formula.

When MS&Co borrowed the underlying equities to execute the short sale, however, that borrow was included as a debit in its Reserve Formula. Therefore, MS&Co was claiming that a credit (the short sale proceeds) was directly related to MSEFL’s debit (the margin loan from MS&Co) even though that same credit already generated a separate, offsetting debit (the stock borrow).

MS&Co was improperly using the same credit to offset two different debits— specifically, relying on a credit that already offset another debit in order to serve as the directly related credit for purposes of the separate affiliate debit. Further, MS&Co did not comply with Note E(4), which is designed to ensure that net affiliate activity does not decrease a broker-dealer’s Reserve Account requirement.

FINRA’s Interpretations of Financial and Operational Rules includes guidance reflecting advice from Commission staff that specifically speaks to this point: “A short sale credit balance . . . may not be used for netting purposes with a debit balance with the same customer in arriving at the excludable debit balance portion from the reserve formula pursuant to Note[] E(4) . . . .” FINRA Interpretations of Financial and Operational Rules, Rule 15c3-3(Exhibit A – Note E(6))/011 (NYSE Interpretation Memo No. 04-3 (June 2004)) (describing advice from SEC Staff).

Although they consulted with an external subject matter expert, MS&Co personnel did not appreciate that the updated transaction structure ran contrary to Note E(4). The Financial Control Group ultimately concluded during the NPA process that “including shorts was ‘benign’ and wouldn’t require additional explanation or ‘proving.’” Consequently, on September 17, 2012, the Prime Broker “mov[ed] forward with expanding the structure to include shorts equal to the debit.”

MS&Co Used MSEFL to Finance Firm Hedges for Over Two Years

The NPA received final approval on March 6, 2013, and MSEFL financed EM DSP Hedges until May 2015, when Commission staff contacted MS&Co regarding its use of MSEFL. MS&Co had controls in place intended to ensure that affiliate debits would be excluded from the Reserve Formula. Because MS&Co’s practice was first to net all account debits against credits and then to exclude any affiliate net debit balance, however, MS&Co’s controls did not exclude the affiliate debits offset by credits arising from short sale proceeds in MSEFL’s account.

Consequently, MS&Co reduced the amount that it calculated it was required to deposit in its Reserve Account through its use of MSEFL by over $305 million on average and as much as approximately $752 million on a single day. Because MS&Co’s improper use of credits to offset affiliate debits was not limited to MSEFL, MS&Co further reduced the amount it calculated it was required to deposit in the Reserve Account by nearly $78 million on average and as much as about $417 million on a single day.

MS&Co Incorrectly Calculated and Reported Reserve Formula

MS&Co is required to submit monthly reports, known as Financial and Operational Combined Uniform Single (“FOCUS”) Reports, and annual audited financial statements. These FOCUS Reports and annual audited financial statements include, among other things, a broker-dealer’s Reserve Formula calculation. By improperly including debits from affiliates, MS&Co’s Reserve Formula calculations were inaccurate until it corrected this error in May 2015. Consequently, information in MS&Co’s FOCUS Reports and annual audited financial statements on its Reserve Formula calculations was inaccurate.