This article was originally published on by Mark Melin. For additional behind the scenes insight, see commentary provided in the last paragraphs.


Hilary Till and Richard Heckinger have seen risk management succeed and fail from the inside. Both are veterans in the derivatives industry. Till, a former derivatives trader in Chicago and London for Harvard Management Company and Putnam Investments among others is currently a research associate for the EDHEC Risk Institute (2006 to 2017) and contributing editor of the Global Commodities Applied Research Digest published by the J.P. Morgan Center for Commodities at the University of Colorado Denver Business School. Heckinger worked at the Federal Reserve Bank of Chicago and is currently a member of the Working Gorup on Financial Markets and Contributing Editor of the Central Banking Journal. The Chicago Fed is a group that took a keen interest in ensuring the wrongs of MF Global are not repeated. In the wake of MF Global, the Chicago Fed offered to hold brokerage firm assets, ensuring that counterparty risk in customer segregation laws would not be violated again, is but one example. In a June 2017 research paper, the pair examines two overwhelming “debacles” in the listed derivatives industry – the implosion of Amaranth Advisors in 2006 and MF Global at 2 AM Halloween morning meeting in 2012 — and point to methods of due diligence that can help institutional investors avoid such troubles in the future.

Both Amaranth and MF Global had important similarities and differences that can serve as a teaching moment

The listed derivatives industry has traditionally prided itself on creating a mechanism of risk management that can be generally understood by all sophisticated participants. The core of a strong regulatory framework is clearly understanding derivatives packaged contents through transparency and standardization, eliminating derivatives counterparty risk through a neutral exchange system, maintaining the sanctity of customer segregated funds laws and proper portfolio management practices. Therefore, when disaster strikes – and a regulatory framework is tested under extreme conditions – it is here the most revealing insight is often on display.

Framing the situation from the standpoint of a teachable moment, the report considers Greenwich, CT-based Amaranth Advisors, which had the distinction of being among a rare breed of derivatives disasters to warrant a footnote-laden 380-page 2007 US Senate report titled “Excessive Speculation in the Natural Gas Market.”

Till and Heckinger go through the issues step by step in their own academic tome titled “Famous Debacles in the Commodity Markets: Case Studies on Amaranth and MF Global” and then connect dots that can assist institutional investors in conducting more thorough due diligence.

The report notes important similarities in what caused the disaster. “Amaranth’s position sizes were obviously too large for a financial entity that had no physical energy assets,” pointing to core leverage principles in one relatively small market in natural gas futures. Excessive leverage usage of a particular kind that had seldom been witnessed in the listed derivatives industry also bedeviled MF Global and “the Corzine trade” trade on risky sovereign bonds that ultimately drained the company of liquidity. But those were not the only caution flags on display.

The Amaranth “debacle” is about improper leverage usage in a small market (with strategy drift leading the way)

Amaranth Associates was a $6.6 billion loss for investors that resulted in a former energy trader at the firm agreeing to pay $750,000 to settle a Commodity Futures Trading Commission (CFTC) lawsuit that claimed they attempted to “rig prices of natural gas contracts.” The Amaranth trading executive also agreed to a ban on futures trading, as was the ultimate case of MF Global, while the trader neither admitted or denied wrongdoing.

One of several caution flags in the Amaranth case comes the form of strategy drift.

The founder’s original expertise was in convertible bonds, but the hedge fund, whose assets had grown to $9.2 billion just before the firm’s implosion, drifted into derivatives trading. By August of 2006, with 75% of the multi-strategy fund’s profits coming from energy trading, the more mundane strategies in the portfolio were convertible bond trading, merger arbitrage, long-short equity, were leveraged loans. Typically, when evaluating a multi-strategy hedge fund, algorithmic portfolio managers consider returns attribution and look for a degree of diversity that the hedge fund lacked.

The fund operated what is known in listed derivatives circles as a time horizon spread trade with a fat tail payout, as described in the report:

Amaranth’s spread trading strategy involved taking long positions in winter contract deliveries and short positions in non-winter contract deliveries. These positions would have benefited from potential weather events such as hurricanes and cold-shocks from 2006 through 2010.

Trades based on a disaster to payout are typically do not represent 75% of portfolio profits if the fail tail event has not occurred

Trades that are based on “fat tail” outcomes such as those involving disasters have a place in a portfolio, with certain algorithmic portfolio managers allocating a 5% to 35% exposure to the hedge depending on the beta market environment. But as Till and Heckenger note, the trade logic or wisdom wasn’t in question, it was violating algorithmic norms for exposure ratios and position size that mattered most.

The excessive leverage usage claim also comes into play when considering the markets traded. Amaranth was one of the world’s largest hedge funds at the time – the $10 billion club was yet to be a recognized elite status – yet the overwhelming amount of their portfolio damaging trading took place in the relatively small natural gas futures markets, buying the summer months and selling the winter months.

In listed derivatives risk management circles this is a relatively basic strategy, but Amaranth executed it differently than most managed futures CTAs who also engaged in such spread trading.

One of the first points of analysis when entering a market is to determine the liquidity and the point at which a trader might become “too big for the market.” Seldom does a major managed futures CTA enter a market without specifically discussing or having an internal document that addresses risk management and market liquidity tolerances. In fact, certain derivatives regulators require formalized plans of operation and inspect these plans during semi-regular inspections and performance audits.

Violating commonly known liquidity and exposure ratios sank what was then among the world’s largest hedge funds. Ultimately portfolio managers learned what margin to equity analysis and position exposure ratios really meant by facing a one-day loss $560 million on Thursday, September 14, 2006 after losing nearly 50% of the fund value in the month before.

The lesson that was learned in yet another derivative led implosion – Long Term Capital Management, which imploded in 1998, involved unregulated derivatives and leverage issues – was that institutional investors paid the price.

From the perspective of Till and Heckinger there are common lessons to be learned in this debacle much like what they call the “unlawful” events that occurred with MF Global.

Analysis / Insight / Opinion: 

This violated so many rules of algorithmic portfolio management I really don’t understand how this fund got so large without being called into question.