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BD/IA Risk Review June 2021

Cyber Risk Management|Financial, Executive and Professional Risks (FINEX)|Investments
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By Brian Cavanaugh , Jack Jennings and Jeremy Sokop | June 30, 2021

Massive stock portfolio stirs ripples in the financial markets.

Trade error

Earlier this spring, the Financial Times and a number of other outlets reported that a New York based Hedge Fund unloaded a massive portfolio of about $20B in US and Chinese stocks. That series of transactions sent a ripple effect through the financial markets with a few major investment banks warning of large losses as a fallout from the transactional exposure. The stock prices in those same investment banks were down significantly upon the announcement.

The Financial Times article and several news outlets including Reuters, CNBC, WSJ and Bloomberg News cite significant positions taken in ViacomCBS and other Chinese stocks. Those stocks experienced a dramatic decline over the last few weeks prompting margin calls from one of the fund’s prime brokers. That margin call triggered similar demands from other banks. One bank estimated their total losses at roughly $2B due to the margin call and subsequent unwind of the position (per The Financial Times). Sources cite another investment bank with exposure to the transaction carrying as much as $5.5B in total estimated loss.

The facts are intriguing, a large proprietary trader built up concentrated positions in a set of securities using “significant leverage” from its prime brokerage partners and quickly defaulted on its’ margin call. Then, to satisfy the margin demands by several banks, unwound its entire portfolio causing massive collateral damage. Upon further investigation and reading, the firm’s founder is no stranger to controversy.

Could insurance coverage be triggered for the New York Hedge Fund provided the above set of facts? More specifically, are today’s insurance policies sufficiently broad to address all facets of proprietary trading? We think regular improvement and adaptation is necessary.

Our case in point is ‘cost of corrections’ coverage. Cost of corrections or trade error insurance provides pre-claim coverage to the customer to correct or mitigate a trade error to avoid a claim by an investor. This type of coverage closely aligns the insurance purchaser and the insurance company to minimize the aggregate financial impact of such loss. The problem is that many of today’s insurance policies don’t consider things like block account trading scenarios, proprietary trading or even the underwriter’s own risk of loss – claim payment – for regulatory matters related to trade errors.

Take the above set of facts re: the hedge fund example. As pointed to by the Financial Times, the trades occurred almost exclusively in block accounts, scenarios that are sometimes unaddressed by cost of corrections wording (based on a review of multiple policy forms). Additionally, some policy forms include requirements that trades occur in non-discretionary accounts. This is where coverage could be easily clarified to better address the coverage intent – aligning the policyholder with the insurance company in minimizing financial loss to all parties. The conventional extension of coverage has served insurance purchasers well for decades, but more attention is needed to adapt these products to modern RIA models.

Inflationary blues

Deutsche Bank released warning of an inflationary ‘time bomb’ the consequences of which “will be greater disruption of economic and financial activity than would otherwise be the case when the Federal government does finally act.” Perhaps they’ve been to the hardware store recently.

Many clients and colleagues we’ve spoken with share the same or similar concerns. But how are firms addressing these inflationary risks, and more importantly, what are investors doing about it? We’ve seen an influx of questions concerning inflation hedges, such as commodities, foreign currency and cryptocurrency; however, the risks associated with inflation and inflation hedging may not be as straightforward as they seem.

Due to the widespread availability of E&O insurance covering the sale of conventional securities such as bonds, stocks, ETFs and mutual funds, firms can easily transfer risks related to the sales of these securities to an insurance carrier in exchange for an annual premium. In theory, the balance sheet risk to the firm (cost of litigation and settlement) is reduced by the amount of insurance coverage purchased. The reasons to be concerned about inflation as a risk manager are two-fold:

  1. Insurance coverage for commodities, foreign currency and cryptocurrency is very limited in the market, forcing firms to assume more litigation risk on their balance sheets.
  2. Without coverage for these products, firms may restrict hedging activity, creating investment risk within the investors’ accounts.

This underserved need is changing, and rightfully so. Insurance underwriters may be taking some comfort in the SEC signaling more aggressive policing of cryptocurrency exchanges. We’ve had conversations with at least a few underwriters that have expressed a warming reception to digital assets. Commodities and foreign currencies are generally underwritten separately, but are often excluded as a baseline in most Broker-Dealer E&O programs. We’re also seeing a warming reception to these products where adequate disclosures are made to the insurance carriers. Foreign currency is a question mark that remains to be dealt with in the majority of policy forms.

All of these strategies that might be excluded under conventional Broker-Dealer E&O programs lay in contrast to most RIA E&O programs which carry no such exclusions. The message is to fully evaluate your portfolio risks, asset by asset, to determine what coverages you may need.

Cyber insurance – What goes up must come down?

“We’re not a custodian so we don’t have any cyber exposure.” We hear it all the time. Unfortunately, the realities of cybersecurity for wealth managers are vastly greater than custodial responsibility. Both FINRA and the SEC signaled a bigger focus on cybersecurity in their examination and priorities letters. FINRA itself recently reported it was the victim of domain impersonation relating to a possible phishing scam targeting financial institutions, including wealth managers.

Many factors have contributed to a dramatic rise in cyber-related incidents, including: The dislocation of the workforce from the 2020 pandemic, an increase in sophistication of attacks and ransomware motivated crimes. All of these issues have contributed to a surge in cybersecurity threats, and the FBI is now reporting a staggeringly high 110.4% increase in phishing related scams from 2019 (total of 241,342 reported in 2021). In fact, nearly all categories of cyber crimes have increased by more than 70% (personal data breaches are the only category of crimes that have not – 18.61%.) You can view the historical FBI cybercrime trends.

What’s apparent from the data in the FBI’s report is that five categories of business-related losses account for more than 55% ($2.79B) of all cyber-related crimes for 2020. Those categories include: Business email compromise (the largest category at 36.99%), investment related losses (third highest at 6.67%), identity theft, spoofing and tech support scams. All are categories that business, including wealth managers, are exposed to daily and virtually none of these are concerned with custodial responsibility.

How can firms effectively manage cyber risk? FINRA has a number of tools available to assess and identify cyber risks including a small firm cybersecurity checklist that helps business owners create objectivity around cyber risk. Additionally, several insurance carriers have risk assessment tools as part of or separate from the underwriting process that are minimally invasive and provide guidance on possible vulnerabilities. Firms like ours can also offer resources from pro-forma loss modeling to informed conversations around risk management.

Please feel free to reach us to discuss more.


Disclaimer

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed subsidiaries of Willis North America Inc., including Willis Towers Watson Northeast Inc. (in the United States) and Willis Canada, Inc.

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