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Obscure hedge fund behind Morgan Stanley probe also roiled Citi

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In 2017, a tiny hedge fund emerged from obscurity in Hong Kong for a few months - just long enough to leave a trail of casualties across Wall Street.

[LONDON] In 2017, a tiny hedge fund emerged from obscurity in Hong Kong for a few months - just long enough to leave a trail of casualties across Wall Street.

The losses and finger-pointing from billions of dollars of exotic currency trades first roiled Citigroup Inc. Now they're reverberating across Morgan Stanley.

Both banks lost tens of millions of dollars in the transactions tied to the now-defunct Pandion fund, which was owned by one of China's biggest finance firms, people familiar with the matter said. The blowup left its lender Citigroup with those positions; as the bank sought to unwind them, it questioned how Pandion's counterparties at Morgan Stanley valued the deals. Citigroup complained, helping trigger an internal probe at Morgan Stanley and suspensions of top traders there, the people said.

The fallout highlights the unknown market dangers that can blindside risk managers - they don't have to stem from a global pandemic. The account of the complex trades and the connection between the Citigroup and Morgan Stanley losses is based on interviews with 12 people with direct knowledge of the matter who asked not to be named because they're not authorised to speak to the press.

"Global finance has become vulnerable to the butterfly effect," says David Knutson, head of credit research for the Americas at Schroder Investment Management, which oversees more than US$500 billion. "Complex connectivity, correlations and Balkanised regulations can result in potential global cascading errors."

While a surge in fourth-quarter bond-trading revenue drove Morgan Stanley's 2019 profit to an all-time high, the unit's unpredictability underscores why chief executive officer James Gorman has led a shift towards the more stable business of handling other people's money. The firm last month agreed to buy E*Trade Financial Corp, an online retail brokerage, for US$13 billion.

Spokesmen for Morgan Stanley and Citigroup declined to comment. Guangzhou-based GF Securities Co, which owns Pandion's parent, didn't reply to requests for comment.

The story begins in 2017 when Pandion hired Timothy Ball, an Oxford University graduate with a taste for exotic currency trades. He worked as a salesman in Hong Kong for Goldman Sachs Group Inc before Elliott Management, the US$40 billion hedge fund, hired him as a trader in 2013. After his managers there grew disenchanted with his focus on complicated deals, Mr Ball left and joined the Pandion fund.

Pandion was about 10 months old when Mr Ball arrived and had less than US$100 million under management. Around August 2017, Pandion traders began borrowing from Citigroup to finance its bets with Morgan Stanley. The positions included FX options and variance swaps, bespoke securities that are used to speculate on movements in asset prices. In this case, they were linked to emerging-market currencies, mainly Turkish lira. Many of the transactions weren't set to expire for years, a feature that added to their risk.

"The risk of crashes and their severity is harder to gauge in advance for emerging currencies," said Uwe Wystup, founder of Math Finance AG and the author of a 2017 book on currency derivatives. "And the longer the time, the harder it gets to predict."

Morgan Stanley was a willing counterparty because executives there had identified complex currency derivatives as a key revenue generator and they were on the hunt for deals.

The trades worked well at first. While Pandion's net assets swelled to a peak of US$109 million in August 2018 even as the Turkish lira melted down, they tumbled shortly thereafter, filings show. The fund lost US$130 million within a few months and went into receivership -- a form of bankruptcy - in April 2019.

The implosion at Pandion led to losses of between US$100 million and US$200 million at Citigroup, then chief financial officer John Gerspach told reporters last year. The setback was escalated to the bank's board and led to a reorganisation of the FX prime brokerage, the unit that catered to hedge funds betting on currencies. Sanjay Madgavkar, who ran the business, left in the aftermath.

The next chapter opened when Citigroup took control of the Pandion positions and sought to unwind them with Morgan Stanley. Citigroup traders were puzzled by the valuations assigned by their Morgan Stanley counterparts and complained to them.

To be sure, Wall Street banks often disagree with each other on such matters. The Pandion trades were over-the-counter deals, arranged in private rather than through a public exchange, and one firm's valuation of such a transaction can differ from another's.

"We see discrepancies all the time," said Jackie Bowie, co-head of Europe at Chatham Financial in London, which advises firms on financial risks and disputes. "Generally, how something is valued on a bank's books is up to them."

Still, the disparity between Citigroup and Morgan Stanley on how they valued the Pandion trades was so large that they struggled to find a middle ground and left the trades in place. It's unclear whether they've settled the disagreement.

Around the same time, Morgan Stanley's FX options team, which managed the Pandion transactions and related positions, began to lose money on another batch of trades; some of those were hedges linked to Pandion. At some point, executives at the bank decided to start a review of the division's trading practices.

Morgan Stanley's FX options business lost about US$150 million last year on deals linked to Central and Eastern Europe, the Middle East and Africa, according to a document reviewed by Bloomberg. While that's hardly a catastrophic blowup for a fixed-income trading business that generated US$5 billion in 2019 revenue, the unit is now at the centre of the internal probe.

The Morgan Stanley board is overseeing the review, which is focused on whether employees improperly priced some transactions, concealing millions of dollars of losses. The bank has installed a swathe of new leaders at its currency-trading business within the past few weeks, Bloomberg has reported.

Back in Asia, GF Securities has faced problems of its own in the wake of the fund's collapse. China's securities regulator asked it to improve risk management and bolster compliance, as well as to submit a written report on who should be held responsible, filings show. In August 2019, the watchdog banned the firm from expanding in over-the-counter derivatives or adding new businesses for six months.

Mr Ball left the company in August, according to Hong Kong's Securities and Futures Commission. He declined to comment. At Morgan Stanley, the outcome of the internal investigation and the future of the FX options business and the role of the executives who oversaw it remain open questions. And there's the whole matter of episodic blowups that, more than a decade after the financial crisis, still expose banks' vulnerabilities.

"Do banks ever really know where the next risk is," said Larry Tabb, founder of Tabb Group LLC, a capital markets research firm in New York. "Depending upon the product, leverage and reporting, it's difficult for even a single bank to understand all of the data and risks they have within their four walls and its even more difficult when you try to aggregate this information across banks."