MF Global fallout highlights myriad counterparty risks

The unwinding of client positions at failed futures broker MF Global is being complicated by the different liquidation policies of futures clearing houses, but institutions are also re-examining their own counterparty risk procedures.
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The unwinding of client positions at failed futures broker MF Global is being complicated by the different liquidation policies of futures clearing houses, but institutions are also re-examining their own counterparty risk procedures.

Compared to the collapse of Lehman Brothers in 2008, which was confirmed only after months of very clear warning signs to market participants, MF Global clients had little time to reduce their exposure to the US-based equity and derivatives broker before it filed for bankruptcy on 31 October.

Less than a week before, its interim results statement revealed losses of US$191.57 million and a net long position of US$6.3 billion in a short-duration European sovereign debt portfolio. But the warning signs of counterparty risk were there for those industrious enough to seek them out.

The Financial Industry Regulatory Authority, a US watchdog, noticed MF Global’s massive exposure as early as June and demanded the broker increase its capital. By 1 September, the broker had disclosed the capital increase.

“Why didn’t counterparties see this coming?” asked one New York broker-dealer who wished to remain nameless. “Because they simply weren’t looking. There was plenty of time to react if you knew what to look for and what to do when the situation was heading south.”

Associated risk exposures

In the aftermath of the bankruptcy, issues of oversight and procedure are being raised. MF Global was ‘regulated’ by CME Group – the largest futures exchange operator in the US and a ‘self-regulatory’ organisation for the sector. It was up to CME to make sure MF Global’s accounts were in order. The week before the collapse, CME had audited MF Global’s customer accounts and found nothing untoward on the books.

As a result, too few clients were able to react in time. In the US, independent trustee and liquidator James W. Giddens froze 150,000 MF Global customer accounts last week, including 50,000 futures trading accounts within days of the broker filing in the Bankruptcy Court for the Southern District of New York. Some 17,000 positions have been moved to various futures brokers, with the liquidator retaining $1.5 billion in funds to pay potential claims. When former clients will see any of this money is now a matter for the liquidator and the courts and could take months, if not years.

The situation highlights the buy-side’s need to understand their associated risk exposures and maintain appropriate levels of collateralisation to mitigate risk, said Martin Loxley, director of collateral management at post-trade processing solutions provider Omgeo.

“Risk measurement systems need to be in place which quickly and automatically provide a consolidated view and accurate appraisal of your counterparty risk,” Loxley said. “With greater insight into risk comes more timely responses.”

But the counterparty risk has now moved beyond the insolvency of MF Global, albeit one of the ten largest bankruptcies in US history. Those institutional investors and other clients who had positions open with the broker are now trying to ascertain what various derivatives clearing houses have done with those positions.

On 4 November, as part of a bulk transfer of MF Global customer accounts and collateral held at US derivatives clearing houses – including CME Clearing, ICE Clear US, The Clearing Corporation, CBOT Clearing, MGEX, NYSE Liffe US and The Options Clearing Corporation – the seven coordinated to provide clients with further information on the status of their account transfers. Most accounts at central counterparties (CCPs) have been frozen until clearing houses determine that accounts have been transferred to other brokers. This has led to confusion over the status of client positions and the location of their funds.

“Every clearing house has a different policy and system for freezing, liquidating or transferring positions when a broker goes bankrupt,” said one broker. “You need to be aware ahead of time what these systems are so that you can react accordingly. Just trying to close your position when something goes awry may not be enough.”

To assist clients to transfer out of positions held through MF Global, CME Clearing – which held about 15,000 accounts and approximately $1.45 billion in collateral – has for the short term set its initial margin upcharge to zero. The margin upcharge is normally applied to customer accounts when they are receiving a margin call. CME’s intention is to decrease the size of any margin calls resulting from the bulk transfer of MF Global customers to new clearing members.

“This is a short-term accommodation to maintain market integrity and provide temporary relief to customers whose accounts have been disrupted by this event,” the company said in a statement.

Effective mechanisms

The speed and detail of activity by CME Group around the recovery of brokerage assets suggests effective mechanisms are in place to transfer assets from a failed broker to a viable alternative, said Sarah-Jane Dennis, principal at investment management consultancy Investit. But additional challenges have been introduced by the apparent non-compliant movement of segregated assets by MF Global following the CME audit.

“Possibly these assets were used in internal repurchase agreements (repos), which are currently permitted by the regulations, which would explain why the threads of ownership have become confused,” she said.

Across the Atlantic, 1.6 million positions were in play with at MF Global’s UK unit when the broker went into receivership. Administrators KPMG said as of Monday, over 650,000 MF Global open positions had been closed.

In a statement, KPMG said the process of default and close-out had been difficult because of the many markets in which MF Global operated. Defaults happened at different times for different markets, making it problematic for the auditor to provide information and unwind the trades.

More than 20 CCPs outside the US closed or terminated positions across a five-day period from 31 October to 4 November, ranging from Kuala Lumpur Commodities Exchange, the Tokyo Grain Exchange and New Zealand Futures Exchange in Asia Pacific, to the Warsaw Stock Exchange, Athens Derivatives Exchange and Eurex Clearing in Europe. The latter, Deutsche Börse’s clearing arm, liquidated MF Global positions within days of the bankruptcy. Clients were not given the option to transfer them to other clearers.

“In a perfect world, all clearing houses would quickly transfer positions to other members of the clearing house. But what we’re seeing with MF Global is an example of the rules not working for the investor,” said a broker-dealer following the case.

Investit’s Dennis said institutional investors must establish a risk-aware culture to ensure risk is instinctively considered in their day-to day-operations.

“Firms should apply exposure limits to different counterparties,” said Dennis. “These limits need to take into account a combination of factors including, time to recover lost assets, complexity of positions, basis of settlement, and the extent to which positions are collateralised.”

For many who got out in time, it wasn’t so much a case of risk management systems sending out alarm bells but gut feel and experience.

“We stopped trading with them a while back, when it became apparent that they were having difficulties,” said Tony Whalley, head of dealing and derivatives at Scottish Widows Investment Partnership. “There was market rumour floating around concerning their ongoing viability and when you hear that, you tend to take a cautious approach. If there are adverse stories about a firm in the market, the upside of using them is pretty minimal but the downside can be catastrophic.”

Limits of regulation

More troubling for some, is not the status of positions with clearing houses but a perceived shortfall of some US$600 million from client accounts held by MF Global, suggesting a failure to segregate client funds from prop trading funds.

“If this is true, it’s a case of outright theft and that’s counterparty risk which is difficult to guard against,” said a New York broker-dealer. “Regulation mitigates risk but it is no substitute for your own risk management.”

Commodity Futures Trading Commission rules dictate client funds and the funds of broker-dealers must be segregated and “may not be used to meet any obligations of the futures commission merchant/broker-dealer”, while the Securities and Exchange Commission’s customer protection rule outlines similar protective measures.

“There are plenty of laws and regulations to safeguard client funds. This isn’t a case of needing more regulation. It’s a case of properly using what we already have,” said one broker-dealer.

But Investit’s Dennis expects tougher measures to be included in both the US Dodd-Frank banking reform act and the European market infrastructure regulation to address controls around movement of segregated assets and internal repos.

“Although, as we can see from MF Global’s behaviour after their successful passing of the CME audit, if a firm decides to break the rules, there is not enough regulation in the world to stop them,” Dennis said.

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