Derivitives Trading, Refco and Why Wall Street Hasn't Learned It's Lesson

Interesting article on the risk in derivatives trading and the (currently) hidden dangers around unmanaged complexity.

Refco's Collapse Underscores Risks Inherent in the Derivatives MarketOctober 19, 2005 – WSJ – Jesse Eisinger
A month hasn't gone by recently without some regulator or obscure commission sounding an alarm about privately negotiated derivative deals.

If you wade through their speeches and reports, you find out there's a small problem with these fast-growing markets: Traders don't have a clear idea about who ultimately is on the other side of derivative trades that aren't executed on regulated exchanges.

The debacle at Refco, the commodities and securities firm that filed for bankruptcy-law protection this week, gives us all a reason to care about this stuff. So far the spectacularly rapid flameout has been mere spectator sport for most investors. There has been little market fallout. There is good news: Refco doesn't appear to have been a significant broker in the main area of regulatory concern, credit derivatives, where investors buy protection against bond defaults. And the longer the markets go without panicking, the lower the risk.

The bad news is that painless lessons tend not to stick.

Derivatives are designed to make markets more efficient and spread risk, and mostly work well. In their most vanilla form, a derivative allows you to, say, offset the risk of owning ABC stock, worth $55 a share, by buying the right to sell ABC shares for $45. That's called a put option, and those aren't a problem. But derivatives get endlessly more complicated -- defaults can be mind-bending, involving a cascading series of risk buyers -- and regulators are concerned, rightly, about that market's growth.

The main problem is inadequate record-keeping. Joe Buyer sometimes doesn't know who the ultimate seller is, so he's taking it on faith the seller will make good on the deal. That's why brokers like Refco are so important. They are go-betweens that can put up money to make the deal go smoothly. If the market loses faith in the broker, watch out. This problem is multiplied by the risk appetite of short-term investors who borrow to increase returns, primarily hedge funds.

It turns out Refco, a major broker in futures and more-complicated derivatives, woefully underinvested in its "back office," the folks who are supposed to keep track of all this buying and selling. That's not comforting for a firm that is an agglomeration of more than a dozen smaller firms, acquired rapidly. It clearly isn't alone.

That there hasn't been contagion is gratifying, but the firm's troubles are barely a week old. The regulated futures brokerage has a takeover agreement with private-equity fund J.C. Flowers. The area that could pose more problems is the firm's unregulated prime brokerage business. That unit makes its money arranging private "over the counter" trades, including derivatives, without the transparency of an exchange, like the Chicago Mercantile Exchange. Refco has frozen its customer accounts in this unit indefinitely.