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05-11-2011, 10:50 PM
Business Times - 05 Nov 2011
A game of chance?
Risk may be an inherent part of any investment, but counterparty risk may not always be apparent to investors. By Genevieve Cua
THE prospect of losing some money in an investment doesn't faze most people. It's par for the course. Counterparty risk, however, is a different matter altogether. It's an issue that investors are increasingly aware of particularly after the infamous unwinding of structured products linked to the failed Lehman Brothers in 2008. But it is also an issue that investors would find fairly difficult to get visibility on.
MF Global's shock bankruptcy is causing distress among clients anxious to withdraw their funds. Could this event have been anticipated? It is likely that most investors were not even aware that MF Global ran a sizeable proprietary trading desk and was looking to expand this. Or that as of its latest filing for its quarterly results, it reported a gross leverage ratio of 30 times.
The firm's US$6.3 billion proprietary bet on the short term debt of Italy, Spain, Belgium, Portugal and Ireland was revealed in a recent regulatory filing and by last week, the firm was under severe pressure to raise cash to support its positions. This exposure and the subsequent plunge in the firm's share price caused ratings agencies to downgrade its credit rating - Fitch to junk level and Moody's to one notch above junk.
As if that was not bad enough, the final straw that pushed it into bankruptcy was that more than US$630 million of client funds remain unaccounted for. This caused a potential buyer to walk away, and raises serious questions about the firm's internal controls and whether it broke a sacrosanct rule in futures broking - that of segregating client accounts from house funds.
MF Global in Singapore provided brokerage services in the trading of derivatives contracts or contracts for difference (CFDs). As these are over-the-counter contracts, the broker acts as the sole counterparty to execute and close out a trade. Hence the financial strength of a broker is paramount.
Investors are often told to keep themselves abreast of their broker's financial strength and credit rating. But financial strength deteriorates quickly under the onslaught of market stress and excessive leverage.
Credit rating
And, how much assurance can you take from a credit rating? News articles now say that US regulators were concerned about MF Global's proprietary positions as early as June. Negative rating actions came late in the game - just last week - and predictably exacerbated MF's decline.
A Reuters report also says that before the past week's developments, GovernanceMetrics Inc gave MF Global a 'D' grade for corporate governance. It ranked the firm's risk management profile among the bottom 20 per cent of US companies.
It quoted GMI corporate governance specialist Neil Minow: 'We had concerns over conflicted directors and directors who were not expert in the field, and executive compensation that had perverse incentives.'
GMI said that the firm's risk management worsened with MF chief Jon Corzine on board.
Here, in any case, is a checklist of issues to look out for, particularly if you trade over-the-counter contracts:
Deal with a regulated entity. In today's fluid and connected world, many Singapore investors deal with offshore brokers who may offer varying degrees of commitment to the principle of segregated accounts, depending on their jurisdiction. Those licensed by the Monetary Authority of Singapore (MAS) must keep client funds segregated.
The principle of segregation is stated in MF Global's document on client asset protection for US clients. But it states that CFTC (Commodity Futures Trading Commission) rules do not require that the money and property of non-US customers trading non-US futures or options be held in separate secured accounts.
It adds, however: 'At this time, MF Global does maintain funds of its foreign customers trading foreign futures or options in a separate secured account in the same manner and employing the same risk-based analysis used for US customers. Such funds are segregated from the funds of the FCM (futures clearing merchant) and may not be used to secure or guarantee the obligations of the FCM.' This of course sounds good on paper, but now rings hollow.
IG Markets Singapore managing director Peter McDermott says: ' . . . as per MAS rules, we segregate client money including unrealised profits, so if IG or any of our counterparties go bust, then client money is safe - notwithstanding the inconvenience of having to wait for monies to be returned or having to realise any losses.'
He adds: 'In a general context, the more information investors are given by providers the better, so investors can reach their own conclusions on the likelihood and consequences of counterparty failure.'
Proprietary activity. Ask your broker-dealer if it engages in proprietary trading and if such trading constitutes a substantial part of its business. Among Singapore investors, prop trading has always raised alarm bells and the suspicion that the house may be trading against its clients.
A number of futures brokers here say that they do not engage in prop trading. Says CMC Markets director of Asia, Gavin Ward: 'Our business model is built as a brokerage, not as an investment bank . . . Investors should be aware that counterparty risks can increase significantly if the firm they are trading with engages in proprietary trading activities. The greater the risk taken on the firm's balance sheet, the greater the firm's exposure to market risk and volatility; which can in turn result in large capital losses if their positions go against them.'
Phillip Futures does run a 'small' prop desk. But this is not run as a business unit and its prop positions are 'negligible', says Grace Chan, the firm's marketing and sales channel director. She suggests that investors should choose a reliable financial institution to deal with, governed by an established regulator.
She adds: 'It would be good for investors to monitor the financial institution for consistently stable performance and keep themselves updated with news regarding the financial institution, (such as) management structural changes. If the counterparty is listed, following the share prices may help too, as huge change in share price could be a cause of concern.'
Spread your assets. In terms of risk management, investors may be prudent to use more than one broker. They should also take the extra step of ascertaining which counterparties their brokers are exposed to. Brokers Kim Eng and CIMB Securities, for instance, used MF Global as a counterparty for their CFD business.
gen@sph.com.sg
A game of chance?
Risk may be an inherent part of any investment, but counterparty risk may not always be apparent to investors. By Genevieve Cua
THE prospect of losing some money in an investment doesn't faze most people. It's par for the course. Counterparty risk, however, is a different matter altogether. It's an issue that investors are increasingly aware of particularly after the infamous unwinding of structured products linked to the failed Lehman Brothers in 2008. But it is also an issue that investors would find fairly difficult to get visibility on.
MF Global's shock bankruptcy is causing distress among clients anxious to withdraw their funds. Could this event have been anticipated? It is likely that most investors were not even aware that MF Global ran a sizeable proprietary trading desk and was looking to expand this. Or that as of its latest filing for its quarterly results, it reported a gross leverage ratio of 30 times.
The firm's US$6.3 billion proprietary bet on the short term debt of Italy, Spain, Belgium, Portugal and Ireland was revealed in a recent regulatory filing and by last week, the firm was under severe pressure to raise cash to support its positions. This exposure and the subsequent plunge in the firm's share price caused ratings agencies to downgrade its credit rating - Fitch to junk level and Moody's to one notch above junk.
As if that was not bad enough, the final straw that pushed it into bankruptcy was that more than US$630 million of client funds remain unaccounted for. This caused a potential buyer to walk away, and raises serious questions about the firm's internal controls and whether it broke a sacrosanct rule in futures broking - that of segregating client accounts from house funds.
MF Global in Singapore provided brokerage services in the trading of derivatives contracts or contracts for difference (CFDs). As these are over-the-counter contracts, the broker acts as the sole counterparty to execute and close out a trade. Hence the financial strength of a broker is paramount.
Investors are often told to keep themselves abreast of their broker's financial strength and credit rating. But financial strength deteriorates quickly under the onslaught of market stress and excessive leverage.
Credit rating
And, how much assurance can you take from a credit rating? News articles now say that US regulators were concerned about MF Global's proprietary positions as early as June. Negative rating actions came late in the game - just last week - and predictably exacerbated MF's decline.
A Reuters report also says that before the past week's developments, GovernanceMetrics Inc gave MF Global a 'D' grade for corporate governance. It ranked the firm's risk management profile among the bottom 20 per cent of US companies.
It quoted GMI corporate governance specialist Neil Minow: 'We had concerns over conflicted directors and directors who were not expert in the field, and executive compensation that had perverse incentives.'
GMI said that the firm's risk management worsened with MF chief Jon Corzine on board.
Here, in any case, is a checklist of issues to look out for, particularly if you trade over-the-counter contracts:
Deal with a regulated entity. In today's fluid and connected world, many Singapore investors deal with offshore brokers who may offer varying degrees of commitment to the principle of segregated accounts, depending on their jurisdiction. Those licensed by the Monetary Authority of Singapore (MAS) must keep client funds segregated.
The principle of segregation is stated in MF Global's document on client asset protection for US clients. But it states that CFTC (Commodity Futures Trading Commission) rules do not require that the money and property of non-US customers trading non-US futures or options be held in separate secured accounts.
It adds, however: 'At this time, MF Global does maintain funds of its foreign customers trading foreign futures or options in a separate secured account in the same manner and employing the same risk-based analysis used for US customers. Such funds are segregated from the funds of the FCM (futures clearing merchant) and may not be used to secure or guarantee the obligations of the FCM.' This of course sounds good on paper, but now rings hollow.
IG Markets Singapore managing director Peter McDermott says: ' . . . as per MAS rules, we segregate client money including unrealised profits, so if IG or any of our counterparties go bust, then client money is safe - notwithstanding the inconvenience of having to wait for monies to be returned or having to realise any losses.'
He adds: 'In a general context, the more information investors are given by providers the better, so investors can reach their own conclusions on the likelihood and consequences of counterparty failure.'
Proprietary activity. Ask your broker-dealer if it engages in proprietary trading and if such trading constitutes a substantial part of its business. Among Singapore investors, prop trading has always raised alarm bells and the suspicion that the house may be trading against its clients.
A number of futures brokers here say that they do not engage in prop trading. Says CMC Markets director of Asia, Gavin Ward: 'Our business model is built as a brokerage, not as an investment bank . . . Investors should be aware that counterparty risks can increase significantly if the firm they are trading with engages in proprietary trading activities. The greater the risk taken on the firm's balance sheet, the greater the firm's exposure to market risk and volatility; which can in turn result in large capital losses if their positions go against them.'
Phillip Futures does run a 'small' prop desk. But this is not run as a business unit and its prop positions are 'negligible', says Grace Chan, the firm's marketing and sales channel director. She suggests that investors should choose a reliable financial institution to deal with, governed by an established regulator.
She adds: 'It would be good for investors to monitor the financial institution for consistently stable performance and keep themselves updated with news regarding the financial institution, (such as) management structural changes. If the counterparty is listed, following the share prices may help too, as huge change in share price could be a cause of concern.'
Spread your assets. In terms of risk management, investors may be prudent to use more than one broker. They should also take the extra step of ascertaining which counterparties their brokers are exposed to. Brokers Kim Eng and CIMB Securities, for instance, used MF Global as a counterparty for their CFD business.
gen@sph.com.sg
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