For the second time in less than a year the futures industry has been rocked by the implosion of yet another well-known FCM, Peregrine Financial Group, Inc. This time the collapse took place against a backdrop of formal CFTC allegations, from the start, of the misappropriation of customer funds. While PFG was nowhere near MF Global in the size and scope of its business, the firm enjoyed added industry prominence as a “thought leader” and promoter of ”best practices” growing out of its special efforts to instruct large numbers of individual traders by means of the periodicals and books it published over many years.
Once again, the market is teaching a hard and unwelcome lesson. Once again, the end-user, irrespective of size, must ask difficult yet fundamental questions: How well do I know, or can I know, the intermediaries on whom I rely for my futures executions, for protection of my funds, and – worst case – for my own continuation in business?
The CFTC will have the opportunity to reveal its findings on PFG as the investigation it is conducting and as the suit it filed in federal court on July 10th both progress. The Commission and the National Futures Association (NFA) had access to PFG’s financial statements, however incomplete, over decades. The vast majority, if not all, of PFG’s own clients had no such access and therefore no context whatsoever in which to consider the financial and operating stress under which the firm conducted its business.
It remains to be seen how restive end users become regarding financial opaqueness in non-public FCMs as a group. Among our clients in the energy space are companies with a longstanding insistence on transparency – clients for whom we have rated some of PFG’s major private competitors on a confidential basis for years. The rating exercise will always be less revealing when the rated company falsifies its financials, as the CFTC alleges Peregrine did. However, in our decade of experience measuring financial health among both financial and non-financial companies, we have found that our singularly quantitative and non-discretionary approach has, in fact, suggested promiscuity by the likes of Enron, Parmalat and Worldcom, ahead of their cataclysms. Our approach has most certainly exposed plain vulnerability on the part of weak, publicly held FCM-parents like MF Global and Penson.
Indeed, the stark truth in the futures market, for those with the fortitude to face it, is that there remains a very wide diversity of Financial Health Ratings among the 70-odd FCM parent companies that report publicly and that Rapid Ratings tracks monthly. On a scale of zero/worst to 100/best, MF Global was at 23 when it filed for bankruptcy in October and Penson was at 22 when it announced the sale of its futures business to Knight Capital Group in May. These companies carried alarming but also long-standing High Risk ratings. There are still 11 remaining FCM parents that we presently consider to be High Risk (below 40) or Very High Risk (below 20); indeed, one of them appears to be in free fall. They stand in sharp contrast to the 17 FCM parents that we rate in the 60s-70s (Moderate Risk) and 80s (Low Risk).
The range of these ratings forces the attentive end user to judge the risk position he/she assumes in his/her choices among these FCMs, along with any incentives in price or quality of service that he/she may have to overlook lesser ratings. In the case of privately held clearers, assessing the end user’s risk position requires extra effort on both the end user’s part and our part and this effort is an excellent use of time. Private firms have long been able to hide behind their corporate status and deny requests for financial transparency. In some cases a balance sheet is offered and heralded as disclosure, notwithstanding its telling only a point-in-time and incomplete picture of financial strength. Peregrine underscores the MF Global lesson that counterparty risk management is necessary in the futures industry. Transparency by private FCMs is critical to enabling their counterparties to perform adequate due diligence and is also essential for third party analysis. We are accustomed to performing this analysis on behalf of our customers on their private counterparties. End users must be prepared to terminate their business relationships with any and all unresponsive counterparties, though, before the market will adapt to these greater disclosure demands. And, where necessary, end users should press for independently audited financial reporting from the counterparties who are responsive.
The lessons of MF Global and now Peregrine are straightforward for all end users: there is no substitute for clear-eyed due diligence in the selection and maintenance of all trading relationships in the futures industry – and no excuse any longer for the lethargy and obfuscation of days gone by.