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Heed the 'Transparent' Lessons From MF Global

Gillian Tett, Financial Times
Watch Berkshire

What exactly sparked the dramatic demise of MF Global? That question has sparked feverish speculation, with the words “hubris”, “funding crisis”, “poor risk controls” or “bad sovereign debt bets” being tossed around.

MF Global
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But as the debate heats up, there is another word which can be tossed into the mix: “transparency”. Right now, it might seem bizarre to say “transparency” in the same sentence as MF Global. After all, this is a brokerage which may have “lost” $1.2 billion of customer money in opaque circumstances.

Nevertheless, if you leave aside the micro-mysteries surrounding the broker’s back office, in a macro, market sense, the issue of “transparency” is important. In particular, this debacle shows that investors are becoming savvier about some of the macro risks stalking financial institutions – and willing to react. Call it a new form of market discipline; one that is, crucially, speeded up.

To understand this, think back for a moment to how Wall Street operated in the halcyon – complacent – era before 2007. Back then, most investors were willing to leave money with hedge funds, brokers and banks without bothering to read the fine print of custody rules. Hedge funds, too, deposited assets with banks on the basis of trust; there was a belief that banks’ audited accounts and hedge fund reports provided a good guide to their “strength”.

But the last four years have punctured this innocence and trust. During the collapse of Bear Stearns, for example, hedge funds suddenly discovered, to their cost, how much power the brokers can wield when they hold customer assets, particularly when there are margin calls. Then, when Lehman Brothers collapsed, hedge funds realised the hard way that British bankruptcy law does not ring-fence customer assets during liquidation.

Investors have also made the painful discovery that credit risk and asset price swings are not the only thing which can damage portfolios; counterparty and liquidity risks matter too. And they have realised that published, audited accounts do not reveal those subtle, secondary counterparty and liquidity risks; nor do the reports that hedge funds have traditionally given their clients.

These lessons are having tangible consequences. One is that the audit profession is now, belatedly, engaging in new soul searching. In the coming months, for example, American auditors will hold a series of round-tables to discuss whether their time-honoured system for auditing banks, say, needs to be updated for the new internet, Twitter age.

A second consequence is that hedge funds face growing pressure from their own clients to get better custody services in place, with improved forms of transparency too. No longer are investors content with just monthly reports. They want spreadsheets with detailed, up-to-date information on funds’ assets, strategies and exposures, including counterparty, liquidity and other risks that used to be obscured.

Entrepreneurs are scrambling to respond. Take the case of Northern Trust, the Chicago-based group. In recent months, it has found a niche selling new custodial services that offer higher forms of oversight and transparency. These are being bought by funds. Investors are responding: Northern Trust executives say that one big sovereign wealth fund recently acquired this monitoring system – to keep detailed, real-time tabs on hedge funds and brokers.

Now, I would not pretend that this shift towards more transparency is complete, far less perfect; there is more to be done. It is hard for investors to work out where the collateral backing deals is “really” sitting, or what “really” lies inside any structured asset deal. The back offices remain dangerously opaque, as that $1.2 billion stain shows.

But nobody should ignore the impact of the changes that have already occurred, as Northern Trust, and others, flog quietly their monitoring services. Take MF Global. The chain of events that sparked the broker’s demise appears to have started when it published its last set of quarterly accounts. As financial players perused that statement, using their flashy new monitoring systems, they spotted the brokers’ sovereign exposure – and started to worry about counterparty and liquidity risk. Five years ago, it might have taken weeks – or months – for anybody to react; however, this time, lines were cut extraordinarily fast. Hence that “out of the blue” crunch-cum-run that killed MF Global.

Now, MF Global executives might argue that this shows that too much transparency can be dangerous; or at least it can, when it sparks a self-fulfilling panic. MF Global investors would no doubt disagree. Either way the key point is this: even before regulators impose new rules, the rhythm of financial markets has changed. Investors are getting savvier; reactions are speeding up. In that sense, then, the tale of MF Global might almost be cheering; were it not, of course, for that $1.2 billion hole that highlights how much change is still needed in brokers’ back offices too.

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