Risks with Financial Counterparties
As discussed herein many times, counterparty risk is an important consideration before entering into any transaction or relationship. (Monitoring default probabilities and the economic fallout if non-performance occurs is likewise a worthy exercise and should be done on a regular basis.)
A recent alert ("The Risks Associated with Financial Counterparties") by Schulte Roth & Zabel LLP attorneys looks at what could happen if a prime broker falls on hard times. Citing the U.S. Bankruptcy Code and the Securities Investor Protection Act of 1970, Jessica Fainman and Lawrence Gelber remind that there is always some risk, even when the law seeks to protect "customer property." The article also includes an explanation of collateral possession under various scenarios, describes the impact of contract netting and lists prophylactic measures to avoid loss.
We concur with the general theme. Investors must be "vigilant in monitoring the financial condition of its brokers." This extends to pension plan fiduciaries who are ill-advised to allocate funds without having a solid understanding of operational and legal risks (in addition to feeling comfortable with a host of other uncertainties, including market and model issues).
Given billion dollar "lemons," making lemonade in the form of mitigating operational risk (including assessment of vendor controls) is a big step in the right direction. This blog's author adds another preventative item to the list. Ask prime brokers and related parties for a copy of their SAS 70 report. Gauge whether (a) good controls are in place (including the monitoring and safeguarding of collateral) and (b) how often controls are validated for effectiveness.
