Sunday, February 1, 2009

The Next Big One - FX

The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.

One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.

Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.

Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.

The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.

Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.

The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.

My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.

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