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Third party risk rears its head
In the yearly 1980’s, I became the client of a young broker who was with a major multi-national trading firm. He and I hit it off well so I continued to use his services for hedging and later on an occasional speculative trade. He later changed companies but I continued to do business with him because he understood my strategies. Maybe more importantly, he understood my psychological makeup.
After being his client for many years, one day I called and he was gone. He had gotten some kind of dementia and no longer worked for the firm. He subsequently passed away from his affliction. The company switched my account over to a different broker. I discovered that the new guy had been a grain merchandiser in my area. He was well liked by farmers in the area and did a good job for me. Like the first broker, he understood my emotional makeup.
Occasionally this second broker would be absent, attending to health concerns. After a few years, one day another member of the firm called to tell me that this second broker had died of a heart attack shortly after the close of trading that day. My account was changed to a third individual whose company cleared through the same firm. The new broker was much younger than the first two. He did an adequate job of making the few trades I make every year now that I am almost retired from farming.
I got a phone call late Monday night of this week from the broker informing me that the clearing firm his company used for making trades at the board of trade had filed for bankruptcy. He said that the trades in the active accounts would be switched to a new firm but that the funds had been frozen by the judge in the case. As of Tuesday night he was not sure when things would return to normal.
This leaves me with a position in the futures market that I can get out of but with no way of changing it at the present time. Given my distrust of bankruptcy judges, I wonder what to do. I had cashed in my hedging profits two weeks ago, so that is not an issue. What is an issue is what I will do when I again want to trade futures contracts. I have become a victim of third party risk!
Farmers are, out of necessity, financially dependent upon many other entities. Generally, the risks are fairly obvious. You have price risk in growing and marketing a crop. To offset this risk you sell the grain. The buying party then has the risk. To make that risk transfer there is usually an elevator involved. The elevator becomes the third party in the transaction. If the elevator goes broke during the transaction, either of the other parties can be hurt. Farmers in my county learned that lesson a couple of years ago.
I am not sure what the answer is to dealing with third party risk. Due diligence will only go so far. I had been dealing with the firm for over 30 years. However, changes beyond my control took place and I had no reason to suspect that the risk had changed also. Diversification has limits. Most farmers are not going to spread futures trades among several firms. You might spread cash sales with more than one elevator. You are not going to do that with hedges.
Government regulation is necessary. However, some events take place so fast that the regulators do not have time to act. Or for some reason they are slow to act. Lawsuits and bankruptcy cases take forever in the court system. Folks who need the money may not have that much time.
In my 43 year farming career, this is the first time I have been a victim of third party risk. There have been other instances in my community and around the country. Fortunately, I have not been involved. I am lucky that my futures account is very small. I will probably not lose it all. If the system works correctly, I will not lose any of it. I tell farmers in my marketing workshops that during my career I have seen just about everything. That statement is even more true today than it was one week ago!