Issues raised over 'prime brokers'

The appointment by Allfirst of so-called 'prime brokers' raises managementand control issues, writes Mary Canniffe.

Just more than two years ago, in February 2000, the AIB subsidiary Allfirst appointed prime brokers to deal with some or all of its foreign exchange trading. These appointments, involving an outsourcing of the settlement, valuation and reporting of foreign exchange deals, appear to have provided the opportunity for foreign exchange trader Mr John Rusnak to engage in the high volume/value trading which eventually resulted in a loss of $691 million (€790 million) for the AIB Group.

Prime brokers are large banks offering consolidated clearance, settlement and reporting of foreign exchange deals. In effect, the client bank outsources most of its back-office functions to the prime broker who provides the opportunity to trade with other financial institutions in the broker's client chain.

Depending on the agreement involved, the prime broker can offer margin netting - one margin or cash call for all open foreign exchange positions. Because deals are netted, there is very little daily settlement risk - in other words, the exposure at the end of each trading day is reduced.

In the case of Allfirst, if netting was not available, the high settlement risks on the value of the deals should have raised questions. In their advertising literature, prime brokers say the service gives their clients more time to focus on trading and profitability.

Banking sources say the Allfirst decision to outsource could have been aimed at reducing costs. But some have questioned why a regional bank with a relatively small foreign exchange trading operation needed to deal through prime brokers. The Allfirst prime brokers were Bank of America and Citibank.

In addition to the obvious question as to why a supposedly small treasury operation like Allfirst needed to use even one prime broker, the appointments raise a number of management and control issues. Who took the decision to appoint prime brokers? Banking sources say such an appointment would have to be signed off at a high level. What was the explanation given for the need to make the appointments? Were specific reporting and control procedures put in place to manage the new risk? Much of the risk was switched out of the back office through the appointment of primer brokers.

This should have led to an assessment of the new risks and the implementation of new controls. Were trading limits set for dealing through the prime brokers? Was Allfirst getting daily end-of-day valuations from its prime brokers?

Did Allfirst receive detailed daily transaction reports? Who received these reports? Who checked them? Who oversaw fee payments to the prime brokers?

Banking sources suggested the checking of daily transaction details should have drawn attention to the large volume/value trading being carried out by Mr Rusnak. They suggested that the levels of fees paid to the prime brokers should have provided some indication of the trading volumes involved.

One banking source outlined a possible scenario: Mr Rusnak started doing big deals through the prime brokers. Over time his negative position increased and the prime brokers called for payment.

To meet this call, the trader sold a European style deep-in-the-money option which gave the buyer a right to buy dollars on a date in the future at a price agreed when the deal was struck.

An AIB spokeswoman declined to comment on the issues involved pending the release of the findings of US banker, Mr Eugene Ludwig,