The Tooth Fairy is a wonderful myth of childhood. Children would place their tooth under their pillow and wake up excitedly the following morning to find a shiny coin under their pillow; this is a childhood joy many of us experienced. Alas, the sad reality is there is no Tooth Fairy; the money came from mom and pop’s pockets.
There is no free money in life.
Blocked funds and administrative hold reside in the same mythical village as the Tooth Fairy, Santa and the Easter Bunny. Let’s imagine you wish to buy a rare automobile. You are lucky enough find a 1967 Ferrari P4, you are indeed very fortunate, and the seller tells you there are two other wealthy potential buyers. He
wants a deposit of 10 percent to hold the car for you. You tell him that’s not a problem; I have been searching worldwide for years for such a car here is my check.The dealer deposits your check in his account only to be told by his bank it is not good funds. What! It was written on funds in a blocked account. But not a problem
for the dealer, he simply sells the car to one of the other buyers with real money.Your blocked funds could not facilitate a transaction and your P4 belongs to a buyer operating in the real world.
The trading of real financial instruments in Private Placement Memorandums, such as CMO’s, Treasury Bonds, Securities, MTN’s, CD’s, Commodities and Currencies, is no different than the example of the rare car purchase. Sellers of securities want to be paid in cash. Platform trading relies on the ebb and flow of billions of dollars every day.
Trading platforms also rely on heavy utilization of leverage to generate high returns. Leverage in turn is dependent on margin utilization. To see how margin works let’s take an example most people are familiar with, buying real estate. If you buy a house for $100, 000 and you pay a down payment, let’s say 10 %, you
pay $10,000 cash and a bank lends you the balance. You are controlling a $100,000 investment with $10, 000. This is leverage. You have significantly leveraged your $10,000. In fact your leverage is 10 to 1 or 10x. If the house was to double in price, you have made a $100,000 on your investment. Of course you have to deduct expenses,although still a nice return. The $10,000 you put down on the house was a cash payment.
Think about it. When have you made a down payment, paid a utility bill, paid taxes or paid for anything with blocked funds? When a trade platform places a trade, they use a deposit called margin. Let’s say a trader wants to buy 1,000,000 shares of stock and that stock, XYZ stock, is trading at $50 a share. He is going to utilize leverage by buying on margin. Margin in the U.S. is set by the Federal Reserve at 50% under
Regulation T.The trader draws $25,000,000 from the customer’s segregated funds account at the broker dealer through which he is executing and the broker/dealer pays the seller through an exchange such as the New York Stock Exchange, the Chicago mercantile Exchange the London Stock Exchange or an Over the Counter Exchange. The broker/dealer lends him the other $25,000,000 and charges him an interest rate called the broker loan rate.
Now let’s say the investors in this particular trade platform have all invested with blocked funds or funds on administrative hold. The institution that sold your trader $50,000,000 of XYZ stock wants to be paid. If they don’t get paid in cash your trader gets no stock !!!
Perhaps the single most widely misunderstood term in the world of High-Performance Private Placement Programs and Trade Platforms is “Blocked Funds”.The nomenclature was incorrectly renamed by brokers and intermediaries as a spinoff,derived from the phrase “Segregated Account”. There are many myths about blocked funds and its aliases, “Reserved Funds” and “Administrative Holds”, which this white paper will clarify.
First let’s understand the origin of segregated accounts. The Segregated Account is unique to the trading industry. It is a third party fiduciary account structure established at a highly regulated clearing institution, bank or broker/dealer which acts much like a custodian. The segregated account is designed to prevent the trader from being able to directly manipulate or liquidate the client’s capital and it also protects investors from fraud.
Speaking of fraud, let’s disclaim a common misconception about Blocked Funds,Reserved Funds, and Administrative Holds. Investments involving Segregated Accounts, Blocked Funds, Reserved Funds or Administrative Holds are commonly claimed by uninformed parties to be entirely free from risk; in other words a client cannot lose their money in the investment. This could not be any further from the truth. Investments using segregated accounts are not exempt from investment or market related risk. Segregated accounts minimize risk of misappropriation by the traders and should be considered more like a system of checks and balances.Segregated Accounts are a function of government-mandated account segregation and regulatory necessity and for various types of trading; however they are also carried out in different manners.
Individual Trader Strategies
The client that invests directly with an individual trader is traditionally participating in amanaged account, an investment on retail side of the market normally done at less than institutional levels. The client opens their segregated account at a regulated clearing institution,bank or broker/dealer; it is advisable that the segregated accounts are opened with a larger clearing institution, bank or broker/dealer who does not
have significant conflicts of interest with the traders. When investing directly in an individual managed account with a trader, the trader has the ability to make trades, buy or sell on behalf of the client’s account with a LPOA (“Limited Power of Attorney”). The applicable clearing institution, bank or broker/dealer clears
and executes the transactions; profits and losses are booked, marked to market, on a daily basis. It is true an investor could allocate some or all of their capital to an individual trader and open up a direct segregated account with a clearing institution, bank or broker/dealer that can clear and execute the trades. However, investors who concentrate their entire investment with a single trader should only use risk capital with which they can easily part. While allocating to individual traders is quite commonplace in retail investment industry practice, this could be the riskiest of strategies in an already risky investment, in this author’s opinion.
A more balanced option for qualified investors might be an Institutional Private Placement Program or Multi-Strategy Trade Platform and its associated limited liability investor protection. Investors in highly-regulated Institutional Private Placement Programs and Trade Platforms can typically allocate capital at a minimum ranging between Two Hundred Fifty Thousand Dollars ($250,000.00) and Five Hundred Thousand Dollars
($500,000.00) to obtain trader diversification that would be equal to a direct investment of several million. However, just like in all investing, there are risk rewards and payoffs. Allocating capital to Private Placement Programs or Trade Platforms allows managers to diversify the client’s allocations, on a weighted basis, to a number of traders which are trading in a spectrum of markets to maximize the potential for high performance and minimize downside deviation. The primary structural difference in a Private Placement Program over an Individually Managed Account, outside of the diversification and potential performance, is that instead of the client, the Trade Platform or Private Placement Program opens the segregated accounts at a regulated clearing institution, bank or broker/dealer. In Institutional Private Placement Programs and Multi-Strategy Trade Platforms, the trader has the ability to make trades on behalf of the Private Placement Program’s or Trade Platform’s account with a LPOA (“Limited Power of Attorney”). The applicable clearing institution, bank or broker/dealer clears and executes the transactions; profits and losses are booked, marked to market, on a daily basis.
The bottom line is that the definition of “Blocked Funds” in this industry is actually referring to a “Segregated Account”; all managed accounts, Private Placement Trading Programs and Trade Platforms use Segregated Accounts” as they are a government required structure. The “Blocked Funds” in this “Segregated Account” are actually at full risk in the investment. The funds are actually and simply being blocked for the use of the investment and cannot remain in a personal account for such use. They must be placed into a “Segregated Account” specifically for the use of the investment and the entire amount is at risk in that investment.