The first we heard of MF Global’s problem in the wheat market was in a press release from CME Group Thursday morning assuring everyone that MF Global had met its obligations.
Once we heard the problem involved trading in the wheat market we didn’t think it was anything more ominous than a trader not keeping up with market volatility. After all Chicago wheat had set its all time high and Minneapolis wheat the day before had hit $25, multiples above the all time high just above $7 set in the fourth quarter. The only surprise was that the firm was MF Global instead of one of the niche grain brokers who specialize in clearing wheat traders. Several of those firms were tested in October of 2006 when a bull wheat market trapped locals bear spreading wheat in front of the commodity fund rolls to the tune of $100 million.
But we soon found out that this was not a story of an over leveraged trader but another tale of a hole in a firm’s risk management allowing one “rogue” trader to create a huge loss.
MF Global announced that a U.S. registered representative of the firm trading wheat futures at the Chicago Board of Trade exceeded his authorized trading limit, losing $141.5 million on Feb. 27. The trader, confirmed as Evan Dooley working out an Memphis MF Global office, was terminated immediately.
In a press statement, MF Global said, “A failure in one of the company’s retail order entry systems permitted the representative to establish significant positions in his own account, which were liquidated later that morning …The company believes it has made the appropriate adjustments to its order entry systems to prevent a recurrence of unauthorized trading of this type in the future.”
MF Global CEO Kevin Davis said in a conference call Thursday morning that certain MF Global retail order entry systems didn’t have “buying power control.” The risk management mechanism would not have allowed trades exceeding an account’s limits. Davis said, “Some offices do not having buying power control,” adding that the safety mechanism can make trading less efficient.
Davis went on to say that from now on all retail entries will have buying power control and the MF Global will, “Sacrifice some efficiency for safety.” He added, “It is embarrassing for all of us.”
MF Global has brought in a third party to review what happened and go over its risk management procedures. The initial third-party review of its order systems is expected to take a few weeks, with a more thorough review slated over several months.
Based on the MF Global statement and interviews with CBOT traders it is apparent that Dooley entered large short positions in several wheat contracts in the early morning hours. When the positions were discovered, MF Global covered the positions on or around the day session opening when the March, May and July wheat contracts all spiked more than $1.50 in the first 10 minutes. The scuttlebutt on the floor was that a trader had made a fat fingered error, selling 5,000 lots instead of 500 lots. Based on the market movement, the size of the loss and comments by Davis, the unauthorized short positions were around 15,000 to 20,000 contracts spread across several wheat contracts. Secrets are hard to keep on the trading floor and based on the opening rally, the market sensed that someone was in trouble and needed to get out of a large short position.
Wheat futures markets have experienced unprecedented volatility in recent months. The CBOT (CME Group), Minneapolis Grain Exchange and Kansas City Board of Trade has raised daily price limits in wheat. Current limits are set at $1.35 and MGEX recently pulled its limit on its March ’08 contract.
This was not a risk management breakdown on the scale of Soc Gen where one rogue trader was allowed to hide unauthorized positions for months but a breakdown nonetheless representing perhaps a calculated risk taken in the name of speed and efficiency. In a sense it is much more worrisome than the Soc Gen situation. If Soc Gen got what they deserved for lax risk management, the MF Global story tells us—particularly in light of recent skyrocketing volatility across all sectors—just how much damage can be done in a short period of time when all your risk management I’s are not dotted and T’s are not crossed.
