When the sponsor fails: does the asset survive

Graduate · enrolled learners

This lesson opens with Sentinel Management Group, 2007.

What happened

Sentinel Management Group was a firm that managed cash for futures brokers and hedge funds, holding their money and short-term securities, and it was supposed to keep those client assets segregated, separate from its own, so that if Sentinel failed the clients' assets were safe. Sentinel did not. It commingled client securities with its own and pledged them as collateral to borrow money for its own leveraged trading, so the assets its clients believed were segregated were in fact encumbered by Sentinel's lender. When Sentinel's trading went wrong in 2007, it froze client redemptions and filed for bankruptcy, and its clients discovered their segregated assets had been pledged. In the bankruptcy, the courts ultimately held that the lender's security interest had priority over the clients, so the clients did not get their assets back ahead of the bank, and they lost on the order of 600 million dollars. Segregation had existed on paper and in the clients' understanding, and it did not survive Sentinel's failure, because the assets had been pledged away, so when the sponsor fell the assets fell with it.

The decision point

Whether an asset survives its sponsor's failure depends on one thing: whether it was genuinely segregated and placed beyond the reach of the sponsor's creditors, or whether, despite the label of segregation, it had been pledged, commingled, or otherwise encumbered so that the sponsor's creditors could reach it. Sentinel is the case that shows the label is not the protection: client assets described and believed to be segregated had been pledged to Sentinel's lender, so when Sentinel failed the lender had priority and the clients lost about 600 million dollars. For a tokenized real-world asset, this is the final test of the SPV structure the course has built: the token is worth the underlying only if the underlying genuinely survives the sponsor's failure, and it survives only if it is really held apart and beyond the sponsor's creditors, not merely called segregated. So the decision when structuring or holding a tokenized asset is to verify that the underlying is actually beyond the sponsor's creditors, not pledged, not commingled, not encumbered, and to confirm who would have priority to it if the sponsor failed, because segregation that exists only on paper collapses in the sponsor's bankruptcy, and a token backed by an underlying the sponsor has pledged away is a token whose asset does not survive the sponsor, as Sentinel's clients discovered.

Recorded loss

$600,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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