There's No Escape From Futures Shock
Sydney Morning Herald
Wednesday March 15, 1995
DON'T imagine that because you don't speculate in futures the latest derivatives scandal doesn't affect you. Any investor can be wiped out. Virtually all companies, fund managers and other financial institutions deal in futures. And even a conservative investor should pay close attention to what they are and how they are used.
In the latest scandal, a former managing dealer managed, by trading in Nikkei-225 index and Japanese bond futures, to lose almost $2 billion - enough to have sunk the royal and ancient merchant bank of Barings plc if it hadn't been taken on board by the Dutch banking and insurance group ING. Had the problem been bad debts, as in 1890, the Bank of England would probably have come to the rescue; but not for derivatives.
In their simplest form, futures are a tool for marketing commodities. Let's take the Sydney Futures Exchange (SFE) wool futures contract, which inaugurated futures trading in Australia in 1960. Some months before shearing, a squatter sells a futures contract to a wool processor, undertaking to supply a stated amount of clip at an agreed price on an agreed date. The parties gain a guaranteed market or source of product at a known price, and can budget accordingly.
There is, however, the chance that one or other party might "close out" his position by buying back or selling the contract respectively. The transaction then becomes a form of financial insurance called "hedging".
If the price of wool falls, the squatter will get less than anticipated when he comes to sell, but the futures contract will also have fallen in value when he buys it back. So he will yield a profit on settlement. Conversely, the processor incurs a loss when he sells the contract for less than he paid for it but obtains his raw material at a price lower than expected.
Squatters may, however, offer more wool than processors want, or vice versa, and the parties may have such divergent views on a fair price that trading is difficult. Here, speculators come in. These are people who have no wool to tender, and the last thing they want is bales of it dumped on their doorstep. They simply have money to spare and views on the market. As with shares, they buy contracts if they expect price rises or sell contracts if they expect falls. They take care to close out their position before expiry.
Apart from avoiding problems in handling the physical commodity, futures give speculators the advantage of leverage. Currently a wool futures contract involves 2,500 kg of 22-micron wool worth around $8.40 a kg - valuing the contract at $21,000. As wool is a stable commodity, the minimum deposit required by the SFE is a mere $750, or 3.6 per cent of the contract's value, though a futures broker may demand more from a new client. Put another way, the return on your outlay is 28 times what it would have been if you'd paid cash - and if the market moves in your favour.
Of course, if it moves the wrong way, your percentage loss is magnified 28 times. If you've bought a wool futures contract and its price falls 30 cents (which may be more or less than the fall in wool's spot price), you've lost the buffer of your deposit. Any further fall leaves you exposed to a "margin call" to supply more cash immediately to cover the deficit or be closed out and obliged to pay the shortfall.
A futures speculator therefore dreads a broker's phone call - and even more the thought of missing one. If you pay the call, the market may happily reverse tomorrow. But it may continue to fall indefinitely. This open-endedness makes futures unsuitable for conservative small investors and explains why the Bank of England abandoned Barings.
If you're rich and risk-tolerant, you should find a futures broker who's reputable, experienced, financially sound (though the SFE operates a fidelity fund) and supported by good research and dealing staff. The local market operates by "open outcry" on a trading floor by day and screens by night. Though orders are executed in a minute or two, don't specify the latest price if you want to get out quickly; and ensure your broker notifies you immediately what price you achieved.
Only the very reckless should establish a "managed futures" account where your broker manages your portfolio for you. Apart from the risk of being landed with bogus losing trades, remember that futures brokers also trade as principals and at each daily settlement are likely to allot the best deals to themselves and the worst to you.
A typical scenario from the '80s, but capable of resurrection at any time, is: you establish a managed account with a balance of $20,000; in a couple of weeks you're advised of a $2,000 profit (260 per cent annualised) and rush to accept the invitation to put in another $20,000. Some months later you're asked for a further $20,000, but this time because your account balance is too low to trade or is in deficit. Thereafter communication becomes increasingly difficult and finally impossible.
Of the 31.6 million contracts traded on the SFE in 1994, over 90 per cent were in three financial instruments: three-year and 10-year Treasury bonds and 90-day bank bills. The main players weren't individuals, however rich, but banks, insurance and other companies, fund managers and governments. If you bother to read the fine print of prospectuses, you'll see it was your banks, your company and your fund manager. You may assume they're properly hedging an existing exposure, but how do you know they're not another Barings?
Regulators shrug and say "Accidents will happen", but that's little comfort in an increasingly deregulated, market-oriented, cost-cutting and accident-prone financial world, where the accidents grow ever bigger. The main problem seems to be a combination of indolent, computer-illiterate senior management and get-rich-quick, computer-literate junior executives. These yuppies have a five-second rather than a five-year view of investment, fraternise only with like-minded people and use equipment with a five micro-second response. When disaster strikes, they become "rogue" operators; up till then they're glorified "whizz-kids".
The SFE's CEO, Mr Les Hosking, told Money a Barings situation could not occur in Australia as all transactions record dealers and principals and all company exposures to open positions and margin calls are monitored daily (and nightly) by the SFE's surveillance division and wholly owned clearing house and by the Australian Securities Commission. Australia has no "electronic highway", without human intervention, between trading programs and trades and thus no "circuit breaker". "We prefer to stop the trader, not the market."
The SFE theoretically knows about all futures trading locally and overseas emanating from Australia but not from overseas branches of Australian companies. And it's hard to see what could stop collusion between "rogue" dealers and regulators.
Sundry best-practice codes and regulations apply to insurance companies and other investment institutions. Nevertheless, shareholders, unit-holders, superannuants, insureds and other clients should demand more internal and external controls over speculative trading in derivatives and more prosecution and less cover-up when fraud is detected.
© 1995 Sydney Morning Herald
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