Refco

The Interbank forex market used to be limited to those institutions who were creditworthy enough or had the right credentials to be a part of the elite to have access to the core price. Refco were always trying, but could never really get in. They weren't a bank and they weren't a broker. Various scandals at offices around the world made banks very wary of them.

Since that time, Refco became the 800-pound gorilla in the online trading market. Several of my ex-Interbank colleagues shook their heads as Refco became 'respectable' and started doing deals that would cause them to dominate the online forex market, such as 'partnering' with FXCM and ACM and buying into an electronic trading platform, Currenex.

That is why, when the news broke last week of problems at Refco, I said in my last newsletter 'It had to happen'. That a broker would become insolvent did not surprise me at all. It is clear that undercapitalized firms taking on huge forex positions from clients based on the client's deposits as 'capital' is a recipe for disaster. That it was Refco, perhaps the biggest player, made me immediately draw parallels with the Herstatt crisis in the forex market in 1974: This may be a defining moment.

The story so far:

In August this year, Refco was introduced on the New York stock exchange and raised $583 million. Last week, after an internal inquiry, the company reported that the CEO, Phillip Bennett had been suspended because he had hidden the fact in the accounts that he had borrowed $430 million. Shortly after he was suspended, he was arrested and charged with fraud.

He had repaid the loan and thus claimed innocent. Apparently he repaid the loan in Euros. Think about this: borrowed dollars 3-4 years ago and repaid now in Euros. In between EURUSD went from 90 to 120+.

After repaying the loan, he paid $55 million in bail. Not a poor man by all accounts.

The point is that investors who bought Refco shares were not informed of the loan 'arrangement'. The case started to become a source of major embarrassment to the institutions involved in the issue, Credit Suisse First Boston, Goldman Sachs, Bank of America and accountants Grant Thornton.

800-pound gorilla

Refco were big. According to the last accounts, last year Refco handled 654 million transactions for 200,000 customers on a global basis in commodities and forex. In addition to the share issue, in the past year they have issued bonds for $600 million and borrowed some $800 million from banks.

The authorities are not happy, understandably. Richard Breedon, a former chief of the SEC said to Bloomberg that the situation requires 'immediate action' and 'Customers can't wait and accept promises that things will be sorted out in days or weeks or months'.

In the meantime, Refco's bonds plummeted to around 30 but the price has bounced because of talk of a quick fix. The firm of J.C. Flowers was quickly put forward as a buyer. No surprise there really as Christopher Flowers is a former partner of Goldman Sachs, one of the firms heavily involved. You always get a bargain in a fire sale.

It is clear that the scandal around Refco is not as big as around Enron, but the fact is that this is a scandal in the heart of Wall Street.

On October 12th, Refco Capital Markets put a 15-day moratorium on its operations, because it did not have sufficient capital  to continue its operations and wanted to 'protect the value of the enterprise'. Clients had already started to pull their funds. On the 14th, Refco Securities, a subsidiary, announce that it was going to unwind proprietary and client positions.

On the 17th, Refco filed for bankruptcy including its non-regulated subsidiaries. At the same time a group of investors offered some $763 million for the futures business.

There are many claimants expecting to be paid out including many currency funds. It has been said that clients of Refco Capital Markets may stand a better chance of getting refunded quickly as in theory, at least, trades were done 'back to back' with market makers, therefore the assets and liabilities should be fairly matched.

The question remains: Where does that leave FXCM and ACM among others, because Refco had stakes with these firms? Although these two firms have announced that they are not per se a part of this, it is strange that apparently the same statement was issued by both companies. Any reference to the connections with Refco has been removed from the FXCM website. It has been said that FXCM will actually buy Refco's forex division.

ACM of Switzerland, in a press release, said that they were looking to buy the 51% stake back that Refco have in them. They say that they have not been affected at all, because they use predominantly Swiss-based market makers  and did not have capital at risk with Refco. They are not affected in the bankruptcy. They have assured me that all margin accounts are segregated and place with banks and funds can be withdrawn within 24 hours of receipt of a faxed withdrawal form.

Other brokers have shown their true face, in my opinion, by trying to capitalise on the situation. FX Solutions had a 'flash' presentation on their home page which claimed that 'it could never happen here' and how great they are in comparison with Refco.

The same situation is found at Refco Canada, which is a separate legal entity. That means that funds are protected under Canadian securities legislation.

The result looks like that the Refco forex business will continue, but with new owners. The question will be if they can hold on to clients.

It seems that Refco have lost 30% of their client accounts and the remainder are 'locked in' at the present time, meaning that they can still trade but cannot withdraw funds. This must be a challenging time for these clients.

The lessons

Clearly, you have to know who you are trading with and be sure that the funds are in the best case totally segregated and placed with a fully regulated bank ( in an equally fully-regulated environment). Secondly, that you can withdraw your funds at short notice.

Refco was a big player, so think what might happen with lesser firms? It is clear that their were misdemeanors at

the top. Brokers should be broking and not act as the other side of the trade'

Richard Olsen of Oanda says " There has to be a 'trust' factor: Be transparent in your operations, conduct your business in the right way and treat your customers well on a day-to-day basis"

This scandal may well be forgotten in a few months, but there will probably be a long term effect. I see a 'flight to quality', that is that banks will start offering trading facilities to private investors on a larger scale, perhaps widening spreads, but giving the assurance to the client that they are sufficiently capitalised and that all funds are covered by a guaranty fund.

As for regulation, Richard Olsen says "More innovative regulation is required, not simply more regulation".

For any one looking at trading forex, I would say that by and large this is not a crooked industry. There are honest firms around and you must do the due diligence to find them. Being 'over the counter', the market will probably always be 'unregulated' and as such will attract low-life. There is a good living to be made from forex trading if you are prepared to invest the time in learning how to do it and treat it as a business, with all the caveats that normally follow, especially 'know who you are dealing with'.

Briefing

Are you bothered with spam to the extent that you can't see what is legitimate and what is not? Does your mail service provider filter so much that you miss the right information? I must say that I have these problems. As a site owner, I get bombarded by spam.

I have also found a way around it.

First of all, you need a decent spam blocking program. I use MailWasher Pro 5.0. This is a filter that displays mails as they get to the server but before you open the mail application. It supports most mail services, such as POP and IMAP. I have several mail accounts, so I route them through MailWasher. It learns what is spam and bounces the spam. It even has a facility to report spam to Spam Cop.

Secondly, you need to have newsletters and alerts sent to a mail address or addresses,but you don't want to be continuously opening those mails. Neither do you want to risk spam getting as far as your mail app, such as Outlook or Eudora. What I need to see is the subject line of these mails, so if I see something I want to read, I camn open directly in a browser. With MailWasher, this is possible. So you can see the link without opening the e-mail. Smart, huh?

To handle the volume of traffic, I opened a Google gmail account. This has massive capacity, is free and links very well to MailWasher. Now, I have streaming news and fundamental analysis plus my chosen newsletters all in one place and the scroll on MailWasher . Really handy to keep in touch with news and views during trading.(Gmail accounts may still be by invitation only. If you need an account, I will send you an invite if you replay to this mail with 'Invite me to gmail' in the subject lien)

Good luck!

Steve Pickering

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