November 14, 2005

Refco's Lessons Learned?

CHICAGO (HedgeWorld.com)--Picking through the rubble of the Refco meltdown has turned up some positives, chief among them the degree to which communication among clearing firms, exchanges and regulators on both sides of the Atlantic kept the financial chicanery involving Refco's books from destroying the firm's regulated futures commission merchant and broker-dealer operations, and from cascading into a more widespread industry problem.

Those were among the conclusions drawn by a panel of futures industry and clearing experts Wednesday [Nov. 9] at the Futures Industry Association's Expo, being held this week in Chicago. The conference's panel session on Refco and the industry's ongoing response to the situation was organized late in the planning process and replaced the traditional session on clearing.

Panel moderator Thomas Kloet, senior executive vice president and chief operating officer at Fimat Group, noted that the session's start time coincided with the beginning of the auction process for Refco's FCM business, Refco LLC. "I guess life does have its little ironies," Mr. Kloet said.

A winning bidder for Refco's FCM business was expected to be chosen on Wednesday [Nov. 9] and ratified in bankruptcy court on Thursday [Nov. 10].

Earlier in the day, Alaron withdrew from the bidding process after learning that Refco's private client group, for which Alaron had submitted a bid, would not be separated from the other Refco LLC entities. "We are disappointed that we are unable to participate in the auction but we congratulate whoever acquires the business," said Steven Greenberg, president and chief executive of Alaron, in a statement.

Four firms were left vying for Refco Inc.'s regulated futures business, among them Man Group, Interactive Brokers Group and J.C. Flowers, according to published reports.

Refco Inc., the parent of Refco LLC and another regulated business, Refco Securities LLC, a broker-dealer, as well as a number of unregulated subsidiaries, imploded in early October after revelations that its chairman and chief executive, Philip M. Bennett, hid debt owed to Refco by a company he controlled. The debt totaled about US$430 million, and it was effectively kept off the books via transfers between Refco, the company Mr. Bennett controlled and a New Jersey hedge fund, Liberty Corner Capital.

Liberty Corner has since maintained that it did nothing wrong and that Mr. Bennett duped it as well.

The nearly half-a-million dollars in debt was kept even from those investigating Refco in advance of an August initial public offering.

In discussing Refco and its fallout on Wednesday, each of the panelists pointed out that the company's problems stemmed from bookkeeping fraud, and had nothing to do with the futures industry part of the business. Additionally, they said, Refco's regulated businesses were effectively insulated from the problems throughout the rest of the company, showing that the current regulatory regime is effective.

Mr. Kloet said he performed his own quick analysis to gauge how the market had reacted to the scandal. He found that share prices of the publicly traded exchanges where Refco did a lot of business actually increased between the time Mr. Bennett's allegedly fraudulent accounting came to light and the end of business Tuesday [Nov. 8].

The Chicago Mercantile Exchange's per-share price rose from US$335 on Oct. 7 to US$388 at Tuesday's close. The Singapore Exchange increased in value from US$2.51 per share on Oct. 7 to US$2.67 per share as of Tuesday. Euronext's stock price rose from 35.11 euro on Oct. 7 to 36.77 euro on Tuesday. And the Chicago Board of Trade, which went public in October at US$54 per share was trading Tuesday at nearly US$117 per share.

"It appears as if one of the things the market might be saying is this industry continues to be in good health, and volume will continue to flow to the exchanges," Mr. Kloet said. "As market participants, we've not seen systemic decreases in liquidity. These events, while important and instructive, to us have not changed the liquidity profile of the various products we offer."

Kim Taylor, managing director and president of the Chicago Mercantile Exchange's clearing house division, said that immediately upon learning of Refco's accounting problems, her organization put auditors in Refco's offices and began overseeing daily accounting. The CME is the designated self-regulatory organization for Refco LLC in the futures industry.

Before long, a number of the exchanges and clearing organizations had established what they called a Joint Audit Committee, which coordinated information gathering and dissemination via daily calls among all involved. Ms. Taylor credited those on the audit committee and others involved in trying to sort things out with their professional approach to the situation, saying without them, things could have been much worse.

"The reason it wasn't was because the industry approached it in a mature and grown-up fashion," she said.

David Hardy, group chief executive of LCH Clearnet in London, said that although his firm had employees in Refco's office in New York on the day the accounting problems came to light (on an unrelated matter), "We were sort of stuck on the other side of the Atlantic."

He said Refco's employees in the United Kingdom didn't have a lot of information, and he credited Ms. Taylor and Jeffrey Ingber, managing director and general manager of fixed-income clearing and settlement at the Depository Trust and Clearing Corp., with keeping a constant flow of information coming.

Mr. Hardy said thanks to the measured and open nature of the industry's response, Refco's FCM and broker-dealer operations are still up and running today. "We're talking about conducting an autopsy [of Refco] but we haven't got a corpse," he said. "It's still functioning, still solvent and is going to be sold. There is still, in our books, Refco Overseas and CIS (Cargill Investor Services, which Refco bought earlier this year) and a whole bunch of client business that hasn't gone anywhere. As we see it, something's gone wrong back at the base, but there's nothing to do with the instruments we're clearing through our books."

In fact, said Sean Keating, senior vice president for clearing services at the New York Mercantile Exchange, although NYMEX initially saw a number of customers leaving Refco's FCM platform in the days after the scandal broke, recently he has seen clients returning to Refco. "Everybody's not just leaving," he said.

Both Ms. Taylor and Mr. Keating said their clearing organizations and exchanges came up with contingency plans for various scenarios, and that they secured promises from other member clearing firms to pick up Refco business if that became necessary. Mr. Keating emphasized the quiet nature of those discussions, however. "It's a fine line the clearing organizations have to maintain," he said. "You don't want to cause a panic situation" by suggesting help will be needed.

As the panelists spoke, it became clear that many people at many firms played roles small and large in keeping Refco's regulated entities solvent and preventing a market-wide panic. JP Morgan Chase, Refco's clearing bank, assisted in a significant way with the wind-down of the broker-dealer arm, said Mr. Ingber, a process that required heavy trading in a number of different markets.

Mr. Ingber also praised U.S. regulations, in general, for their role in keeping order. "It exemplifies the brilliance and the beauty of the regulatory structure we have," he said. "While everything was falling apart at the non-regulated entities, there was this protective shell around the FCM."

Nevertheless Kenneth Rosenzweig, a partner in the financial services practice at the law firm Katten Muchin Rosenman LLP, said he saw room for improvement in how regulators communicate with the public. He said he hopes the Refco situation persuades the Securities and Exchange Commission and the Commodity Futures Trading Commission to work more closely together to come up with better ways to get information to the public about situations like Refco, and about how the regulatory structure protects investors.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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