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REFCO - What happened? What should you do?

October 17, 2005

 

It has been a very busy week for those in the futures industry as the name REFCO has been all over the financial news since last Monday. The company first announces that they had not reported a $430 Million receivable from a company owned by CEO Phil Bennett as a "related party" transaction.

Mr. Bennett was arrested shortly thereafter and charged with securities fraud, but credit downgrades, a shuttering of their non regulated derivatives business, and the unwinding of positions at their stock and bond trading arm followed.

This was a very big deal to those who had invested in the August initial public offering (IPO) of the stock, and investors reacted accordingly - sending the stock down 72% last week alone. This was also a bit of a shock to over 200,000 futures customers around the world who see Refco at the top of their daily account statements.

But I am here to say that all such futures customers who hold their accounts through Refco, your funds remain 100% safe, as they are in a segregated funds account at non affiliated banks such as Harris Trust and Bank in Chicago. Customer funds are not considered an asset of Refco's, and Refco can not use customer funds to meet any debt obligations, pay fines, etc.

Even if Refco' stock went to "0.00" and the firm went bankrupt, the introducing brokers such as Attain who use Refco as a clearing firm would still be able to execute your trades and your funds would still be in their segregated accounts. I liken it to flying on United airlines even though they have gone bankrupt. The airline doesn't get to take your luggage and sell your belongings to meet their debts, and their planes don't randomly fall out of the sky. They remain operating and servicing their customers.

What Happened?

What happened was some fancy accounting to make Refco's balance sheet appear about $430 Million stronger than it may have actually been. Details are still unclear, but here is what we know.

The company has not been reporting a $430 Million receivable from a company owned by CEO Phil Bennett as a "related party" transaction for several years.

As reported in the Wall Street Journal reporters Kara SCANNELL and PETER A. MCKAY:

"Mr. Bennett kept his debts to the company hidden through a fairly simple arrangement under which he essentially rented the balance sheet of one of Refco's customers, so that it would appear that the customer owed Refco the money, rather than Mr. Bennett. That had the effect of covering up a massive so-called related-party transaction that companies are supposed to disclose to investors to alert them to potential conflicts of interest that could hurt the company down the road.

In one example outlined in the criminal charges against Mr. Bennett, a Refco subsidiary named Refco Capital Markets on Feb. 23 lent $335 million to an unnamed customer — identified by knowledgeable people as Liberty Corner. The loan was to be repaid two weeks later, March 8, just after the end of Refco's fiscal year.

Simultaneously, Liberty Corner lent the same amount to Refco Group Holdings Inc., the entity prosecutors charge Mr. Bennett controlled, for the same two-week period — at an interest rate 0.75 percentage point higher. That higher rate gave Liberty Corner an estimated profit of roughly $90,000. "The result of these transactions was to substitute a $335 million debt to Refco by the customer for a $335 million debt" owed by the Bennett-controlled entity, the criminal charge said."

What is a Clearing Firm? Why are they in the picture?

A seeming simple question which has come out of all of this is what exactly does a clearing firm do, and why does a firm like Attain need to open its accounts through a firm like Refco? The answer to that question goes back to where futures contracts are traded. Futures contracts are traded on regulated futures exchanges such as the Chicago Mercantile Exchange (home of e-mini and full size S&P futures) and Chicago Board of Trade (home of Soybean and Bond futures).

In order for anyone to trade a futures contract on one of these exchanges, they must be a member of the exchange. But with millions of different firms and individuals wishing to trade these products, it is impractical for each and every one of them to be a member of the exchange. For one thing, it's darn expensive, with recent seat prices at the Chicago Board of Trade going for a record $2.25 Million in July and memberships at the New York Mercantile Exchange where energies are traded going for $2.75 Million in September.

So without each and every individual willing or able to become a member of the various exchanges, several members created clearing firms to place the orders of individual clients and firms interested in trading futures. The clearing firms then "clear" these trades, which is a fancy way of saying they do the trade on the customer's behalf - then assign the trade to the customer - all the while making sure the customer has enough money to be putting on the trade, etc.

For a firm like Attain Capital which trades across nearly 15 different futures exchanges, it is impractical to become a member of each exchange, and we are therefore an Independent Introducing Broker with multiple clearing arrangements across the futures industry. The clearing firm acts as an intermediary between Attain and its customers and the various futures exchange. The clearing firm owns the expensive memberships allowing them to transact business on the exchanges on the customer's behalf, while Attain deals directly with the customer and uses the clearing firm to process customer trades.

Dispelling Rumors:

Rumors were flying last week about customer accounts at Refco. Many investors worried that they would lose their assets held at Refco, or at best lose the ability to withdraw or transfer their funds. These rumors were not helped by Refco's announcement on Wednesday that they were imposing a 15 day moratorium on customer withdrawals at Refco Capital Markets.

Refco Capital Markets is NOT the entity which handles futures trades, and is in NO WAY associated with processing exchange traded futures trades. Refco LLC is the entity responsible for processing the futures trades, and as has been confirmed by the CFTC and CME — Refco LLC is in excess of the capital they are required to have per government regulations. Thus the ability of clients withdrawal or transfer funds remains and has remained 100% intact.

The reason Refco Capital Markets had to impose a moratorium and the reason Refco LLC, the entity which handles the futures business, will not — is that Refco Capital Markets handles the off-exchange, non regulated derivative transactions for the firm; while Refco LLC handles regulated, exchange traded derivatives.

Refco Capital Markets acts as the counterparty to these off-exchange transactions, meaning they guarantee the profits and losses of investors utilizing non-regulated derivatives through them. An example of an off exchange, non-regulated derivative is Forex trading. As the counter-party to these types of trades, they obviously need a great deal of capital and their recent credit downgrade and stock decline has led to them taking moves to protect this capital in order to continue to act as a counter-party to those trades. Refco LLC handles futures trades done on regulated exchange traded futures. An example of these would be full size S&P or emini S&P futures traded on the Chicago Mercantile Exchange (CME). The CME is the counterparty to these trades (NOT Refco), and the CME guarantees the profits and losses due to customers form these trades (NOT Refco)

The next rumor that startled investors was the disclosure on Friday that Refco Securities LLC was unwinding proprietary and customer positions. The obvious worry many individuals had was that their positions would be unwound without their consent and without notification. What the brilliant talking heads on the news forgot to mention was that 1. this was Refco's stock and bond trading side, 2. that this unwinding of positions was for Refco's own positions, and 3. any unwinding of customer positions was at the request of the customer.

So, while this all may seem very confusing and a little disheartening, the fact of the matter is that the futures industry has been designed by its participants and the government to handle situations just like this, and there are layers of protection for the customer. For those investors that trade regulated, exchange traded futures, you are protected by the government (regulated) and the exchanges (exchange traded).

What if Refco goes Bankrupt?

As a general matter, the laws and regulations governing the insolvency of FCMs and clearing firms are designed to minimize losses to customers by providing certain protections to customer accounts. These protections include requiring the segregation of customer funds from those belonging to the FCM or clearing firm, giving priority to the claims of customers, and expansively defining the category of property that may be considered "customer property" subject to a customer's claim.

Should Refco go bankrupt,(or any FCM for that matter) here are the answers to some specific questions:

1. What happens to the cash in my account?

The Commodity Exchange Act requires that funds deposited by a customer with an FCM be maintained in a "segregated" account for the exclusive benefit of the depositing customer. The term "segregated" refers to separating the funds of all the customers (treated as a class) from the FCM's own funds (sometimes referred to as "proprietary" funds) which the FCM uses in its own operations.

If an FCM became insolvent, the FCM would be prohibited from using "customer property" to pay obligations it owes to persons other than its commodity customers. (The term "customer property" includes cash, securities or other property received, acquired or held by the FCM to margin, guarantee, secure, purchase or sell a commodity contract for a customer, as well as an open commodity contract itself.) The "segregated" funds held for customer accounts should remain intact and the customers would be protected from the FCM's insolvency.

Generally, in such circumstances, cash in customer accounts is promptly transferred, along with the customers' open positions, to a solvent FCM even before a trustee is appointed to administer the bankruptcy. After such a transfer takes place, the customer is free to transfer his funds and open positions to the FCM of his choice.

2. What happens to open positions in my account?

If there were no shortfall in the amount of funds segregated for customers, generally the customers' open positions would be transferred to another FCM as quickly as possible.

3. What happens to Treasury Bills purchased for my account but in the name of the commodity company?

If there were no shortfall in the amount of funds segregated for customers, then the Treasury bills held for a particular customer would be transferred to another FCM along with the customer's cash margin and open positions.

What should you Do?

The first thing you may want to do is hear from one of the regulators. As Refco is a member of the Chicago Mercantile Exchange(CME), the CME has been all over the story and insuring the proper capitalization levels are in place to protect customer funds.

I would encourage all concerned parties to contact Mr. Dale Michaels, director of risk management at the CME. Mr Michaels has offered to answer any and all questions regarding customer positions and funds. His number is (312) 930-3062.

For those Introducing brokers who introduce clients to Refco and are looking for a relationship with another firm, Attain Capital has been doing due diligence on all of the available clearing firms for over 2 years now, and is happy to share our experience and contacts with the different clearing firms with any fellow brokers or brokerage firms.

From and individual investor perspective - we realize there may still be several investors out there who may still feel uncomfortable with Refco. Attain has been in contact with each and everyone of its customers through the past week and several have decided to make a move.

If you are thinking of making a move, Attain is prepared to facilitate a transfer of your funds and positions to another clearing firm we deal with - Peregrine Financial (PFG) - whom we have been working with closely and have the greatest of confidence in.

If you would like more information on how that may work - please call or email us at your earliest convenience.

- Jeff Malec