Published On: Thu, Jan 17th, 2013

Putting All Your Eggs With One Broker

Case Study: Putting all your eggs with one broker

Case Study: Putting all your eggs with one broker

How can a buy-side best protect itself from its broker’s collapse?

Dragon Partners is a super power in low-latency, high-frequency trading in Asia. This event driven technology-powered hedge fund generates its profits through hundreds of different strategies providing liquidity and removing inefficiency in the markets it trades in. Dragon uses the capital of its two principals, John Wong and Chris Leung, and has no client money whatsoever. John is the brains behind the strategies having spent 20 years at various roles perfecting his craft. Chris is the risk and operations expert, making sure margin calls were met so the firm wouldn’t go under if an algorithm backfired.

To realize volume discounts, Dragon is an executing member of the Australian Securities Exchange (ASX), Singapore Exchange (SGX) and the Osaka Securities Exchange (OSE). It clears through broker AB Global Group’s local subsidiaries, in each market where its capital can most efficiently be used across asset classes and to pay rock bottom margin rates.

Like most businesses that are speed-centric when it comes to computer-driven algorithmic decisions, Dragon Partners develops its own trading system in house utilising cutting edge hardware with programming conducted in C#. The head of development was poached for a small fortune a few years ago from a Japanese investment bank. In order to maintain its latency edge the firm chooses to use the colocation facilities of the exchange where it pays top dollar. Colocation at the ASX costs US$5,500 per month for one rack, US$1,375 for extra power and US1,500 for a redundant rack in case of emergency. Access charges to the exchange gateway cost close to US$1,000 per session and a high capacity API to ASX Trade allowing for 50 orders per second costs a further US$2,800 per month. Accessing liquidity on TradeMatch, PureMatch and VolumeMatch, the ASX’s alternative execution facilities costs an additional US$1,750. Market data from all venues is another US$3,500 per session. Hardware comes in at an extra US$25,000 and US$150,000 more for staff to manage the exchange connections and internal IT. Similar costs are borne for the setups in Singapore and Japan.

Lily Tsang is the Global Head of Professional Trading Groups and the CEO of the Hong Kong subsidiary of AB Global. She is also an old friend of John Wong having known each other as children when their parents would frequently meet for yum cha on Sundays.
Last year, during the Formula 1 in Singapore at a client event hosted in the paddock by MF, Lily told her customer, “Our group CEO has taken the firm in a new direction outside its traditional agency execution and clearing business”. She continued, “He is using the firm’s capital to invest in sovereign debt which he believes is oversold.”
The CEO had a background in buying distressed assets and selling them at a profit, so John thought no more of it.

This year at the Hong Kong Rugby Sevens John saw Lily once again. “Lily”, He said, “the Europe situation seems to be getting worse and that the bottom wasn’t insight.” Lily agreed and said “While volumes appear to be drying up in Europe the volatility had been good and has caused volumes to rise in Asia.” John smiled and agreed “Yes, we have been very busy and very profitable.”

One morning not too long ago while John was having his breakfast before attending an industry conference in Mumbai where he was scheduled to give the keynote address his phone rang and it was Lily.

She sounded frantic. “Have you seen the paper?”
“No” he replied.
“It’s a complete disaster. We are bankrupt,” she continued without sugar coating it.
“You can’t be serious,” John responded still in disbelief at what he had just heard. “What happened?”
“Our CEO was wrong about the Eurozone debt. Now client money is missing,” she said.
Just then a beep came through on his phone. It was another call, his partner, Chris Leung. “Hang on Lily”, John said, “Chris is on the other line. I’ll call you right back.”
“Chris, I just heard from Lily. What’s going on?”
“It’s unbelievable.” Chris replied angrily. “We have just been notified by the ASX and the OSE that they have suspended AB and because they are our only clearer we have been suspended too, until we can find a new one.”
“Calm down” said John “we’ll just open an account with another clearer and transfer our funds. We get calls from the banks everyday asking us for our business.”
“You haven’t heard everything” began Chris. “We haven’t completed the roll of the Nikkei 225 future yet. We are still short 500 contracts and they are set to expire next week. If we can’t offset our position we’ll owe just over US$5million. It could take weeks or months to figure out everyone’s exposure.”
“Chris, you call the exchanges and see what they are doing about client positions and I’ll call Lily back and try to see what they are doing.” John hung up on Chris and dialed Lily’s number.
She answered right away. “John I was just about to call you back” she spoke quickly.
“What is going on with our positions and cash?” John asked holding back his anger.
“Legal is just on the phone with the OSE right now but I have some more bad news” she hesitated. “Our compliance just told me that in Australia there is something called Regulatory Guide 212. It basically says that the parent company is allowed to use client money to hedge OTC positions which is exactly what those Eurobonds are. It is very possible you won’t see any of your money held in Australia.”

Question: In order to avoid the risk it found itself exposed to, with one bankrupt clearing broker and its capital tied up for weeks or even months, what could Dragon Partners have done to protect itself in this scenario?

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