More than eight months after the collapse of Barings PLC, customers of futures exchanges still don't fully understand the credit risks they are taking, say futures market participants.
Some of the lessons from Barings and how futures exchanges can deal with a bankruptcy are not being absorbed by institutional investors that use futures contracts, they said. (Barings was hit last February with more than $1 billion in losses taken by a single trader, Nick Leeson, in its Singapore office. Pensions & Investments, March 6).
While the counterparty risks inherent to futures contracts may be less than those found in over-the-counter transactions, they are greater than is generally understood, even among seasoned investors, industry professionals say.
The counterparty risk comes from both futures brokers, called futures commission merchants, and the exchange clearinghouses. In some instances, the business failure of one customer at an FCM could result in losses to other customers of that FCM, they say.
Verne O. Sedlacek, executive vice president and chief financial officer of Harvard Investment Management Co., Boston, said: "Today, the biggest risk of the (futures) system is lack of understanding (by) customers of the risks they are taking."
Speaking in October at a Futures Industry Association conference in Chicago, Mr. Sedlacek said he is concerned about a widely held perception - even among sophisticated futures investors - that credit risk is absent from the futures markets.
The futures industry itself - including the FIA (of which he's a board member) - should shoulder much of the blame for that, Mr. Sedlacek said.
He said following the Barings' incident, Harvard's executives wanted to find out more information about credit risks at exchanges - Harvard is a heavy user of derivatives - and essentially had to do everything themselves. The lack of information was frightening, he said.
Likewise, T. Eric Kilcollin, managing director at Wells Fargo Nikko Investment Advisors, San Francisco, said at the FIA conference: "I think we've been less than satisfied in getting information we can use to compare" the world's different exchanges. Sometimes it's difficult getting information on the futures broker too, Mr. Kilcollin said.
"I haven't seen a significant change in relations between customers and FCMs" since Barings unfolded, Mr. Sedlacek said. "It tends to keep me awake at night," he said.
Others in the industry acknowledge the risks and the lack of communication of those risks. Lawrence Mollner, chairman of the FIA and an executive vice president of FCM Dean Witter Reynolds, said "the biggest void" in education appears to be at the customer level. He said one thing futures exchanges could do is make it clearer to customers that clearinghouses don't guarantee trades for customers.
Also, he said futures exchanges could better use technology to reduce the risks at futures exchanges. He noted that banks transfer money via automated teller machines worldwide almost instantaneously, while it still takes in some instances much more than 48 hours to clear a futures trade. (The longer it takes for a trade to clear the more risk there is).
But Mr. Sedlacek said FCMs are playing a role. He said there is an unspoken conspiracy among FCMs to keep customers in the dark, as FCMs try to support their business in a highly competitive industry that has excess capacity.
"We in the industry are scared to death of losing volume," he said. And after a very big year in 1994, volume is down in 1995 in the United States for most types of exchange-traded derivatives.
As Eric Bloom, president of futures cash manager The Sentinel Group, Chicago, said, the exchange itself is not the only concern. Another, he said, is other customers of FCMs. If a customer of an FCM fails for whatever reason, other customers may have to pony up some cash to cover losses, he said.
Another major reason for a lack of understanding is the transformation of the futures industry to an institutional focus from a retail one, Mr. Sedlacek of Harvard said. Regulation and disclosure are geared to a retail investor, making it difficult for institutional users to get the information they need.
Mr. Sedlacek said the inherent complexity of futures markets also contributes to muddiness in figuring out where all the risks are.
Some institutions have begun the process of delineating futures exchanges risks, including the differences among exchanges and their clearinghouses.
Debra Parry, managing director with Moody's Investors Services and co-author of a research report on the topic, said: "These institutions are very heterogeneous from country to country. It's a very complicated topic."
The report by New York-based Moody's gives a rundown of how to evaluate credit risks in futures markets. One concern of the Moody's report authors was that a similar incident to Barings could bring down an exchange, exposing customers of the exchange to losses.
"Risk management practices at some (futures exchange) clearinghouses may be insufficient to prevent situations similar to the Barings incident from disrupting their operations in the future," the report said.