I was shocked how quickly MF Global fell. Was no one else so surprised?
While the dramatic circumstances surrounding the violent death of MF Global may appear rapid in retrospect, there was plenty of time for alert buy-side counterparts to avoid the carnage.
From the time MF Global’s US$6.3 billion bet on European debt was made explicit in its Q2 2012 statement to its bankruptcy filing, six days had elapsed – time enough to close out positions and head for the hills.
One US broker dealer explained it thus: “If you know your bank is going under, not only do you hightail it down to your local branch and withdraw your entire savings, but you also rack up as much credit card debt as you can. You don’t need more than a couple of hours to accomplish all that.”
Even over the summer months, many brokers had stopped dealing with MF Global when word on the Street was the broker was having difficulties.
But man cannot live on rumours alone. After all the CME Group audited MF Global’s books barely a week before it went bust and found nothing wrong. And now lots of clients are left with their accounts frozen.
True enough. However, some suspicious minds believe MF Global moved the funds after the audit. In any case, it was hard to see this one coming unless you knew where to look. In fact, the US$6.3 billion was included in a regulatory filing ahead of the results statement.
There were even signs beforehand. Even in June, the Financial Industry Regulatory Authority had noticed the exposure and made the broker increase its capital. MF Global disclosed the increase of capital on 1 September.
Were there any more useful market signals that could have helped the buy-side assess risk?
Monitoring credit default swap (CDS) spreads and interbank lending rates can give institutional investors pause for thought on the long-term financial health of counterparties. CDSs are essentially insurance against holding bonds. If the CDS spreads of a particular counterparty are out of whack with peers, this could be a sign you should reconsider your exposure to the counterparty. Certainly in Q2/Q3 2008, ahead of Lehman Brother’s bankruptcy, CDS screens were almost permanently on display in trading rooms around the world.
The same applies with interbank borrowing costs. If you see interbank borrowing costs rising for a specific counterparty and you think your counterparty’s funding model is highly geared to short-term funding, this could also be cause for alarm. Only last week in the UK, the key three-month inter-bank lending rate passed the 1% mark as banks fearful of the implications for counterparties of Greek and Italian debt default started charging each other more than double the Bank of England’s 0.5 per cent base rate.
It seems there’s a lot to look out for when assessing counterparty risk!
This is why you have to be stringent with your counterparty risk processes. Good, experienced traders should always listen to their gut instinct but hunches and market insight need to be backed up by risk management systems that can quickly and automatically give you a consolidated view of your counterparty risk.
Different counterparties require different exposure limits, taking into consideration: how long it would take to recover lost assets; how complex are your positions; what is the basis of settlement; the extent to which positions are collateralised. And don’t forget that the parameters need to change with the times. There was much market speculation about MF Global over the summer and buy-side risk management systems should have taken account of these rumours. When real data on MF Global started trickling in, systems should have indicated much higher risk levels.