Bushel-whacked

It wasn't too long ago that wheat was considered a sleepy corner of the commodity derivatives markets - a space occupied by farmers and food producers, and a far cry from the relatively exciting world of oil and gold. Times have changed. Tighter supply, soaring demand and growing speculative interest from a wide variety of investors have resulted in billions of dollars of new capital pouring into soft commodity markets, propelling wheat prices to record highs. The shift in market dynamics has created lucrative opportunities for investors, investment banks and brokers - but it has also presented a new array of challenges and risks.

This was starkly illustrated in February, with the revelation that MF Global, a New York-based interdealer broker, had chalked up $141.5 million in losses from a single rogue trade. In a conference call on February 29, Kevin Davis, chief executive of the firm, admitted the trader - identified as Evan Dooley, a broker in the company's Memphis office - had been able to put on a gigantic directional short trade on wheat futures without triggering internal alarm bells because MF Global had elected to disable controls on its US internal trading terminals to speed up processing of voice orders.

The incident marked the second rogue-trading scandal in little over a month, following the EUR4.9 billion loss at Societe Generale (SG), revealed on January 24 (Risk March 2008, pages 23-26). However, observers point out the root causes behind the two events are vastly different.

"It's not like SG, which was a case where the controls broke down - MF Global shut them down deliberately," comments Joseph Weiss, a senior partner at New York law firm Weiss & Lurie, one of several firms preparing class-action lawsuits against MF Global on behalf of its shareholders. "Clearly, this is not common practice."

Dooley was apparently able to place a short trade on his own account in the early hours of February 27, totalling between 10,000 and 15,000 wheat futures contracts on the Chicago Board of Trade (CBOT). External trades on electronic markets are subject to continuous monitoring to ensure clients do not exceed their trading limits. However, because the risk controls on internal terminals within the firm had been disabled, Dooley was able to put on his trade without raising any alarms.

As MF Global, a clearing member of the exchange, had inadvertently allowed Dooley to go so far beyond his limits, it was liable for the losses once the position was unwound. "Some individuals have personal accounts, but in general it's not encouraged, and they can never trade products they broker for clients," Davis said. "But this guy didn't have any customers - he had one historical customer who hadn't traded in some time."

The position was liquidated by MF Global within hours of the markets reopening at 9am on February 27 - but the damage had been done. MF Global announced the loss as a bad debt and drew $150 million from an established $1.5 billion revolving credit facility with a syndicate of banks to maintain regulatory capital levels. The loss equates to 33% of the broker's most recent quarterly revenues of $418.4 million.

Damaged reputation

The broker has since fired Dooley and has restored the controls to all internal terminals. Two external risk consultancies - Baltimore-based FTI Consulting and Washington, DC-based Promontory Financial - have been hired to overhaul the broker's systems. FTI "will be undertaking a forensic review of the order systems", Davis said, while Promontory will conduct a more general overhaul of the broker's risk management processes.

Meanwhile, the US Commodity Futures Trading Commission (CFTC) says it is monitoring the industry very closely "in light of recent volatility in the wheat futures markets". However, it refused to confirm reports it is investigating MF Global, and said the loss appeared to be "an isolated event".

Nonetheless, the broker's reputation has taken a battering. When the news broke, MF Global's share price fell from $29.61 to $17.55. It was trading at $9.43 on March 19. The broker also saw its credit rating cut from BBB+ to BBB by Standard & Poor's (S&P) and from A3 to Baa1 by Moody's Investors Service. Both agencies placed the firm on negative credit watch.

S&P blamed the cut on high financial leverage at the firm, dependence on market volumes and significant competition, while Moody's pointed to failings in controls, noting that "risk management had been viewed by Moody's as one of the chief strengths of MF Global's credit profile".

In electronic markets, execution speed is paramount - a one-millisecond improvement is worth $100 million to a brokerage, an IBM research team estimated in 2007. But in the voice broking market - which Davis said was small and declining at MF Global - there is less pressure for rapid execution. Even so, MF Global believed it could gain significant advantage by lifting the buying power controls on its internal trading terminals, leaving the loophole that Dooley exploited.

It is not the first time MF Global's risk management competence has been called into question. In December 2007, it paid $77 million to settle a complaint brought by the CFTC, which claimed its lax internal controls had allowed hedge fund Philadelphia Alternative Asset Management (PaamCo) to conceal its losses in MF Global accounts.

MF Global failed to notice its head of offshore fund trading, Thomas Gilmartin, was also a PaamCo shareholder - leading to a significant conflict of interest, the CFTC argued. The regulator also ruled the broker had "a diffuse and decentralised system of supervision and internal controls" between 2004 and 2005, adding that it "did not have an adequate system of supervision and internal controls relating to patterns of questionable trading".

MF Global has other problems besides its risk management. When announcing the downgrade on February 29, Moody's analyst Alexander Yavorsky pointed to a weakening of the company's capital. "Another factor contributing to the downgrade is a relative weakening of the quality of MF Global's capital structure and liquidity profile as a result of its not having refinanced its $1.4 billion in bridge loans with permanent long-term capital. MF Global has yet to establish its target capital structure, which was expected to include long-term debt of various maturities, as a replacement for the temporary financing in the form of bridge loans put in place at the time of its initial public offering (IPO) in May of 2007," he wrote.

MF Global was previously known as Man Financial, part of Man Group's commodity brokerage. It bought the futures broking arm of bankrupt New York-based financial services company Refco in 2005 for $282 million, before being spun off in an IPO in 2007. In its prospectus of March that year, the company said it had proven risk controls, and that errors and bad debts varied between 1% and 2% of net revenues, compared with an industry average of 5%. It also said it would "monitor clients' open positions and margin levels on a real-time basis" and raise additional margin as necessary.

A one-year bridge loan of $1.4 billion, used to repay borrowings and interest rate swaps with Man Group at the time of the IPO, was to have been replaced by long-term debt - but this did not happen. Instead, in January 2008, MF Global extended $1.05 billion of the bridge loan from June 2008 to December 2008, in exchange for a 40 basis point (bp) increase in coupon, to be followed by further 25bp increases in June and September, and fees of another 10bp.

With the extension, MF Global has bought itself some breathing space. But, as Eileen Fahey, a New York-based analyst at Fitch Ratings, points out in a note published on February 28, the "incident could further hinder debt issuance" - issuance on which the broker depends to improve its financial status and close out its bridge loan.

The market in which the losses took place has changed beyond recognition in the past few months. Andrew Wilkinson, a senior market analyst at Interactive Brokers Group in Greenwich, Connecticut, remarks: "Commodity markets are very adventurous. You get massive run-ups in price, then it kicks everyone out." And, in recent months, the wheat market has been even more volatile than usual.

MF Global's Davis pointed out that Dooley had only been able to put on the unauthorised trade because of the dramatic growth in the wheat futures market in recent months: "Wheat had become much more liquid in the previous 14 days, which is why he could put on positions large enough to lose so much money at one time. We are seeing moves in a day that we would have expected to see in a month."

Having touched a record high of $13.495 a bushel on February 27, the CBOT wheat futures contract for May delivery tumbled to close at $11.65 the following day and $10.86 on February 29. Open interest for the May contract totalled 419,681 contracts on February 27 - well above the normal levels of 20,000-60,000 contracts a day. "Grain and other agricultural products have gone berserk," remarks Wilkinson. "There is a lot more speculative money in the market."

The soaring price of wheat

Several factors have driven up the prices of wheat, corn and other agricultural products such as soya beans. Growing demand for biofuel feedstock - predominantly maize corn in the US - may have led farmers to ditch wheat, soya beans or other crops in favour of maize, reducing supply. At the same time, demand for grains and soya beans is rising as a result of increasing wealth in China and India - wealthier people eat more meat, which in turn requires more animal feed. Droughts in Australia and floods in China, both important wheat exporters, have delivered further supply-side shocks to the wheat market, and world stocks have fallen to record lows of 18% of annual consumption. Rising oil prices are also making food production more expensive by driving up the cost of fuel and fertiliser.

In addition, commodities are an attractive alternative to US dollar assets, drawing a wider universe of investors to the market. "Hard assets are said to be a hedge against the value of the US dollar. There is a concern the dollar will continue to decline and this is a hedge against that. It's an asset allocation decision, and they do it through futures," Wilkinson adds.

A report by the International Grains Council, an industry association based in London, blamed a combination of supply problems and speculative capital for the recent volatility in prices: "Tight nearby supplies of premium quality North American spring wheat, combined with extraordinary investment fund activity, lifted Minneapolis wheat futures to their highest level ever," it wrote on February 28.

Despite the rise in trading volumes and price volatility, some observers question how Dooley's massive directional trade was not spotted by the exchange. However, David Lehman, director of commodity research and development at the CME Group, the parent company of the CBOT, points out that individuals are limited to holding 5,000 futures contracts from any single month, and a total of 6,500 contracts - but these limits are only monitored at the end of each day, not in real time.

Lehman adds that the system of centrally cleared trading at least had the benefit of limiting the damage to MF Global, rather than letting it spread to a number of counterparties. Nonetheless, it is likely rival dealers and brokers will be reviewing their own processes and controls to ensure they are not subject to the same failures: "I hope everyone now has a heightened awareness of how this volatility can affect their clients," Lehman adds.