In the world of investment management, operational risks lurk around every corner. Every so often, highly public reminders such as the Madoff fraud, the Lehman collapse and now MF Global’s bankruptcy capture the spotlight. These are the big names, but there are many smaller incidents that go largely unnoticed by the public and soon fade from memory. Devastating is the list of innocent bystanders – the long line of thousands of firms that suffer collateral damage. Many firms survive despite their financial losses while others encounter a worse fate. The critical take-away is an investment manager’s long term viability is predicated on a healthy dose of paranoia, skepticism and a willingness to continually evaluate and improve its processes – in terms of internal controls, risk reporting and monitoring, data centralization, transparency and security.
The MF Global case should be a real wake-up call: the Dodd-Frank OTC central clearing model is not a panacea for counterparty risk, since customers are still exposed to the risk of mismanagement by their clearing members. Therefore, when it comes to OTC derivatives (whether bilateral agreements or central clearing), the lesson learned is placing collateral in 3rd party custodian bank accounts (“full physical segregation”) is unquestionably the best practice. Another concern raised by this incident is the insufficiency of controls over the wiring of free cash movements – do firms have a clear separation of duties, are there multiple levels of approval, is there a highly transparent audit trail, etc.
The above topics are front and center – relevant, timely and fresh – and will be probed in this issue of our newsletter.