When a sweet bet turns sour

Counterparty risk has shot back up the buy-side agenda in recent months as investment institutions grow more concerned about their brokers' exposure to the crosswinds of an uncertain macro-economic climate.
By None

So it seems a risky wager on European debt has caused the downfall of a broker.

Indeed. And institutional clients are now left wondering which – if any – counterparties they can truly trust anymore. While no Lehman Brothers, futures broker MF Global is worldwide business with a wide range of clients that can trace its roots back 230 years to a sugar trading firm started in England by James Man and until 2007 was a division of hedge fund giant Man Group.

And this bad bet on sovereign debt wasn’t for a few measly pennies. Early last week, MF Global revealed a net long position of US$6.3 billion in a short-duration European sovereign debt portfolio financed to maturity, including government bonds from Belgium, Italy, Spain, Portugal and Ireland.

In the present climate, that gamble did not pan out the way the broker’s chief exec, former New Jersey governor and ex-Goldman Sachs CEO Jon Corzine, expected. The US-based equity and derivatives broker filed for bankruptcy last Monday and had its primary dealer status removed by the New York Federal Reserve.

So were there any warning signs? Anything counterparties could have done to protect themselves?

That’s the US$6.3 billion question. Clearly the futures exchanges on which MF Global trade had more than an inkling. The broker’s failure came after a number of exchanges, including the CME Group, Singapore Exchange and NYSE Liffe, prohibited MF Global from opening new derivatives positions, allowing the broker only to liquidate its existing positions.

As a futures broker, 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 everything kosher. Subsequent events have thrown a harsh spotlight on the self-regulatory model futures brokers enjoy.

Auditor KPMG is currently in the process of trying to unwind MF Global trades and transfer positions held by clients but this has raised added complexities. While CME Group has permitted MF Global clients to transfer accounts to other brokers, Deutsche Börse’s clearing arm, Eurex Clearing, for instance, has already liquidated MF Global positions, with clients not given the option to transfer them to other clearers.

Billions of dollars have been pulled from Man Group because of its former connection with the broker even though Man insists it has no counterparty exposure.

Other than checking the spreads on counterparties’ credit default swaps and maintaining a wide range of deep broker relationships, which is expensive and time-consuming, it’s hard for buy-side firms to protect themselves in volatile times like these.

Could this get any worse?

Actually it could. Late last week came the revelation institutional clients were dreading. The ultimate sin appears to have been committed: MF Global may have been funding prop trading with client cash. Now the hunt goes on for more than $630 million in customer money that was supposed to be segregated from the firm’s own piggy bank. No one can guess how long the unwinding of trades could take, or if the ‘living wills’ supposedly set up post-Lehmans will make the situation any easier for counterparties to clear up after a bankruptcy.

For some, the MF Global episode bolsters the cry for new regulation to protect counterparties. Initiated to prevent big deposit-taking US institutions from engaging in high-risk, high-reward activities, such as proprietary trading, the Volcker rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and is designed to protect counterparties from the troublesome experience of finding out that their bank has used their money to fund its own wagers.

But MF Global was not big enough to have come under Volcker, which is scheduled to become law in 2012. Gary Gensler, chairman of the Commodity Futures Trading Commission, insists segregation of customer funds is already a core principle of counterparty protection in the commodity futures and swaps markets. But with the consultation process on the Volcker rule only just starting, there will be strong calls for its reach to be extended before it hits the statute books.

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