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The full story of Refco's rise and fall has yet to be told. Federal investigations are under way and more evidence of what went wrong continues to emerge. One thing that is clear, however, is that Refco's astonishing collapse had a very limited impact on the futures industry as a whole. Certainly there was a large and sudden movement of customer funds to other firms, and certainly there were worries about possible dislocations to the markets, at least in the first few days, when Refco's financial situation was not clear. But the shock did not spread. The futures markets remained just as liquid as before, with no ill effects on volume or open interest.

This did not happen by accident, of course. It happened because the futures industry is indeed a regulated industry, with well-established rules for preserving capital and protecting customer funds. It happened because responsible people have implemented the lessons learned from past crises. Most of all, it happened because the clearinghouses, the guardians of financial integrity, moved swiftly to contain the harmful effects of Refco's accounting disclosures and the disastrous loss of confidence that resulted.

This article is based primarily on comments by several clearinghouse executives at a panel discussion on Refco that was held on Nov. 9, during the Futures Industry Association's Annual Futures and Options Expo in Chicago. The discussion is available in its entirety at http://www.futuresindustry.org/expo2005-2576.asp.

Monday Morning Bombshell

It was on Monday, Oct. 10 that the Refco empire began to unravel. That morning, the company issued a brief statement to the public disclosing the existence of a $430 million debt owed by an investment fund controlled by Phillip Bennett, its chief executive. This previously hidden debt appeared to have arisen through the assumption of third party debts, the statement said. The company also disclosed that three years of earnings reports would have to be revisited.

The statement immediately created doubts about the company's finances. Within a matter of minutes Refco's shares began falling rapidly as investors worried what further accounting problems might emerge. The shares, which had been trading publicly for only eight weeks, plunged 45% to $15.60 on Monday, then fell another 11% to $13.85 on Tuesday.

On Tuesday evening, less than 24 hours after the initial revelation, the authorities arrested Bennett on charges of securities fraud. The television news carried live coverage of him being led away to prison in handcuffs, intensifying the attention to Refco's troubles and deepening the sense of alarm.

On Wednesday, the Manhattan District Attorney's office, flanked by officials from the Commodity Futures Trading Commission and other law enforcement authorities, held a press conference to describe the charges against Bennett. By Thursday, the shares had sunk another 50%, the New York Stock Exchange had halted trading, and the company was forced to shut down one of its unregulated units because of a lack of liquidity.

Crisis Management: The Clearinghouses Step In

In the first few days, no one knew for sure how much trouble Refco was in, and there was confusion about the status of its various entities. Although Refco had made its reputation in the futures business, its futures brokerage arm, Refco LLC, accounted for only half of its revenues, according to the prospectus that accompanied its initial public offering in August. The remainder of its revenues came from a regulated securities brokerdealer and an unregulated capital markets unit, which together were active in a wide range of fixed income and foreign exchange markets.

The first step for the futures industry, therefore, was to find out if Refco LLC was involved in or affected by the problems emerging elsewhere in the Refco group. That same Monday, the New York Mercantile Exchange sent its auditors into Refco's headquarters in New York to determine the financial condition of Refco LLC. According to Sean Keating, the head of the Nymex clearinghouse, Nymex was the first exchange to get its auditors into Refco because it was the closest to the company's headquarters in New York. In addition, Nymex was holding a large amount of funds on deposit from Refco, reflecting the firm's extensive operations in the energy and precious metals futures traded at Nymex.

The following day the auditors from Chicago Mercantile Exchange arrived, and from then on CME, Refco's designated selfregulatory organization, spearheaded the management of the crisis. The initial objective, according to Keating and Kim Taylor, the head of the CME clearinghouse, was to check Refco LLC's books and records, ascertain the status of customer funds and the firm's own capital, and lock down any activities that might harm the financial condition of the firm.

A default would have been disastrous. Following its acquisition of Cargill Investor Services that summer, Refco LLC ranked as the sixth largest futures commission merchant in the U.S. in terms of customer funds. The firm was a major participant on all six U.S. futures exchanges as well as numerous exchanges overseas. A collapse therefore would have caused widespread losses to Refco customers.

In addition, a default on its obligations to the clearinghouses would have severely tested the industry's financial guarantee system. Each clearinghouse has its own set of safeguards to protect against defaults, but generally speaking, these safeguards are a combination of the clearinghouses' default funds, plus in some cases an insurance policy or a line of credit. If these resources are not sufficient, the clearinghouses generally have the power to assess their clearing members.

The Rise and Fall of Refco Segregated Funds December 2001 - October 2005 Source: Commodity Futures Trading Commission

Given that Refco was active on so many exchanges, a critical part of the initial reaction was the coordinated sharing of information among the various exchanges and clearinghouses involved in the crisis. CME's clearinghouse executives organized a daily conference call to share information, such as large customer positions held by Refco. This was especially important as the firm's major customers began transferring their money out of Refco to other brokers.

"The free flow of information back and forth among the clearing organizations has been tremendous," said Nymex' Keating. "Without that, I think we would probably be in a worse situation, not knowing what one exchange is doing versus another exchange."

This interaction was not limited to the U.S. Refco Overseas, a London-based sister company to Refco LLC, was a major participant on futures exchanges in Europe and Asia. Consequently LCH.Clearnet, the clearinghouse for Euronext.liffe, London Metal Exchange, International Petroleum Exchange and a number of other markets, had an important seat at the table.

By fortunate coincidence, LCH.Clearnet happened to have a senior risk official in New York that very Monday, so the clearinghouse was able to monitor the situation firsthand from the first day onwards. In addition, CME quickly reached out to Andrew Lamb, the head of LCH.Clearnet's clearinghouse in London, to make sure that it was involved in the daily calls and a full participant in the crisis management process.

David Hardy, the chief executive of the LCH.Clearnet group, commented at the FIA panel that the CME clearinghouse, and Kim Taylor in particular, made sure that the information flowed freely to LCH.Clearnet. "We have been in very regular contact, and that facilitated and oiled the wheels terrifically well," he said.

In this particular instance, the framework for communication was already in place. The main players already knew each other well, and their institutions have reached agreements on the protocols for the sharing of confidential information.

With respect to the U.S. exchanges, the framework has been institutionalized through the creation of the Joint Audit Committee, a quasi-official body that sets standards for the auditing of futures brokers. In cases like this, it also provides a readymade structure for coordination and cooperation. In addition, there are regular contacts between the key institutions in the futures industry and their counterparts in the securities industry through the Unified Clearing Group, which was set up in the aftermath of the stock market crash of 1987.

As Jeffrey Ingber, a managing director at the Depository Trust & Clearing Corporation, said at the FIA panel, this group mostly acts in an informal way. "We get together a couple of times a year. One of the benefits is that we stay in regular touch, and that comes in handy in this kind of situation."

One challenge ahead will be to extend this framework as the industry continues to globalize. As it happened, Refco was in the midst of a major expansion in Asia, with joint ventures operating in Korea, India and Taiwan, and had just received permission to establish a joint venture in China.

Limited Impact

The clearinghouses quickly discovered that Refco LLC was in healthy financial condition. The customer funds had not been siphoned off and the firm had more than enough capital to cover its margin requirements. The clearinghouses therefore did not have to intervene and move customer accounts to other firms, as they have done with troubled firms in the past.

At the same time, it was becoming clear to the markets as a whole that Refco's problems might not be as severe as originally suspected. Certainly the parent company was in trouble—Refco Inc. declared bankruptcy on Oct. 17, one week after the initial disclosure—but its futures commission merchant subsidiary was able to continue operating, and the futures exchanges saw no overall pullback in trading volumes or open interest. Customers may have lost confidence in Refco, but not in the futures business as a whole.

Tom Kloet, the Fimat executive who chaired the discussion at the FIA Expo, noted that the Refco crisis had no lasting impact on the share prices of exchanges that offer trading in futures. Shares in CME, for example, rose nearly 16% during the fourweek period between the first revelation of the accounting problems and the FIA panel in Chicago. Even more telling, the Chicago Board of Trade went ahead with its own IPO on Oct. 19, right in the midst of the Refco media storm, and saw its shares rise considerably thereafter.

"One of the things that the market might be saying is that our industry continues to be in good health, and that the volume will continue to flow to the exchanges," commented Kloet. "As a market participant, our observation would be that to date we have not seen any kind of systemic decrease in liquidity. These events, while important and instructive to us, have not changed the liquidity profile of the various products we offer."

Preserving Confidence

Once the auditors were in place and the clearinghouses had determined that Refco LLC could continue meeting its obligations, the emphasis instead shifted to protecting the FCM from problems elsewhere in Refco and facilitating the smooth transfer of customer funds to other firms. That same week, several clearinghouses issued notices assuring the public that Refco LLC continued to be a member in good standing, and confirming that customer funds held by Refco LLC were fully protected. The clearinghouses also stressed the importance of distinguishing between Refco LLC and other parts of the Refco group, especially with respect to customer protections.

The first to issue such a notice was CME. On Oct. 13, three days after the accounting disclosure, CME issued a statement emphasizing that Refco LLC was a separate company with its own accounts, assets and customers, and reminding the public that customer funds could not be drained away by Refco.

"These accounts, assets and customers are protected through a comprehensive federal statutory and regulatory regime and other financial safeguards and risk management protections provided by the CME Clearing House," the notice said. "All customer funds are required to be segregated from the firm's assets, are held in specially identified accounts and are not subject to any creditors' claims against the firm."

David Hardy, reflecting on the issuance of these notices a month later at the FIA panel, commented that the clearinghouses were seeking to preserve confidence in Refco LLC and prevent a "self-fulfilling prophecy" from destroying the firm. In those early days, customers and creditors were extremely nervous about the firm's financial condition. Very little information was available from Refco about the extent of the accounting irregularities, and the news media filled the vacuum with dire speculation about what might have gone wrong and what the impact might be.

In addition, very few articles made any distinction between Refco LLC and the rest of the group, and almost no one in the media seemed aware of the customer protections in the regulated futures world. In this context, the public statements from the clearinghouses were important signals of confidence that at least one part of Refco was continuing to function.

At the same time, however, the clearinghouses were quietly preparing to shut down the firm, if necessary, and transfer customer positions to other firms. As noted by Taylor and Keating, the clearinghouses confidentially contacted several firms to find out if they would be able to accept customer accounts from Refco. In some cases, individual firms approached the clearinghouses on their own to say that they would be willing to accept accounts if the firm had to be shut down.

As the clearinghouses made these preparations, they kept in mind the importance of not triggering any additional concern about Refco's financial condition.

"Probably all of the clearing organizations represented here operate normally with the skeleton of an emergency plan already in their pockets," said CME's Taylor. "Ever since the news broke on this situation, we have been building out incrementally the details of what actions we would take if certain events occurred. Many of those actions require cooperation from other clearinghouses, other firms on the Street, other regulators, and banks. So part of the challenge in managing this type of thing has been managing the contingency process without having that trigger reactions on the part of the people you are talking to."

"As clearing organizations," added Hardy, "part of our duty is to ensure that there is a calm in the community as well. So all of us have put messages out saying, ‘yes, we are still taking business from this firm, we are sitting behind it'. We have to make sure that our position is not eroded, but calmness in the market is really, really important because otherwise the whole thing becomes a self-fulfilling prophecy."

The clearinghouses also put in place measures to prevent the upstreaming of capital to the parent organization and insisted on a larger than normal "buffer" to cover margin requirements. As Taylor explained, the clearinghouses immediately clamped down on Refco LLC's excess margin, preventing the firm from shifting this capital elsewhere in the group without their permission.

Despite this concern about capital, the clearinghouses managed to avoid a damaging "land grab" for Refco assets. In a situation like this, a clearinghouse may be tempted to freeze disbursements to protect itself against a loss due to a firm's default. The resulting loss of liquidity makes it impossible for the firm to continue operating.

Fortunately, the clearinghouses worked together on this front. As explained by Keating and Taylor, the clearinghouses held onto a "reasonable" amount of collateral, but at the same time, they did not block the outflow of funds as customers closed out positions or moved accounts out of Refco. Above all, they worked closely with Refco to make sure that the firm could continue conducting its business, opening and closing trades on various exchanges, and moving margin in and out of its accounts as necessary.

"I think all of us would be irresponsible to not be holding onto some amount of excess collateral in a situation like this," said Taylor. "But I think the tradeoff is to be reasonable about it. I know there were times when we dipped into what we would consider our excess collateral reserve on an intraday basis to facilitate funds flow, as the firm was transferring customers or liquidating investment transactions. I think everyone was cooperative in doing that."

"We did not want to disrupt the flow of excess funds out of original margin to further cause disruption," added Keating. "So we worked very closely with JPMorgan [the settlement bank] and with Refco's back office to ensure that the collateral was moved in a timely manner."

Protective Shell

These actions highlight the ability of futures clearinghouses to isolate customer positions and protect them from problems coming from elsewhere in the firm. As DTCC's Ingber said at the FIA panel, the segregated funds rules, the capital requirements, and all the other elements of the regulatory system created a "protective shell" around Refco LLC. Although the investigations of Refco have not yet run their course, it appears that all customer funds were protected, so long as they were inside this shell.

On the other hand, funds that were not inside this shell were not protected. The FIA panel noted that several investment funds had filed lawsuits against Refco seeking restitution of customer funds that had been allocated for the trading of futures. These funds allegedly were transferred to affiliates of Refco LLC without customer permission. Lawyers for Refco have argued that the customers had agreed to these transfers in order to earn higher returns on excess margin. As this issue went to press, the courts had not yet ruled on these disputes.

Even though a number of protections were in place, many customers were worried about their funds and unsure about what would happen. Ingber mentioned that he received a number of telephone calls from ordinary investors asking about the money in their accounts at Refco LLC. Even though he was not involved with the futures side of Refco, he told the investors that he did not think there was any reason for concern. He felt comfortable saying this, he told the FIA panel, because the money was in a regulated entity overseen by the CFTC and CME and others.

"To me, that is the essence of this protective shell," Ingber said. "Even more than enabling the clearing corporations to do their job, it provides a level of comfort to the public in general."

Many customers chose to flee first and ask questions later. More than half of all customer funds moved out of Refco in the next two weeks. According to CFTC data, the total amount of segregated funds held at Refco fell from $6.47 billion at the end of September to $2.53 billion at the end of October. In other words, somewhere in the neighborhood of $4 billion was transferred to other firms in the space of about 15 working days.

This exceptionally large movement of customer accounts required intensive monitoring by clearinghouses and close coordination with the banks that handled the custody of securities and cash involved in Refco's trading. The custody and funds transfer parts of the futures industry rarely attracts much attention, but proper management of this function is essential. During the FIA panel, CME's Taylor and LCH.Clearnet's Hardy complimented the settlement banks for their "grown-up" handling of this aspect of the crisis.

Contrary to comments from various observers in the media, the collapse of Refco had nothing to do with any weakness of CFTC oversight. In fact, the futures industry emerged from the crisis as the "eye of the storm," as one panelist put it. Refco LLC was by far the best-protected and most stable part of the Refco group.

Of course, the next crisis very likely will pose different challenges, and there is no guarantee that the system will work perfectly every time. On the other hand, it is worth noting the fact that Refco LLC was the only major asset to survive the Refco collapse. In fact, Refco LLC was still healthy enough that the parent company was able to sell the firm to Man Financial to help pay off creditors to other parts of the group.

Initially the purchase price looked to be around $1 billion. J.C. Flowers, the first to indicate an interest in buying the firm, offered $770 million in cash, and by the time of the auction, at least five other firms had entered the bidding. In the end, Man Financial won the auction with a bid of just $323 million, far below the $1 billion that some had predicted. Man Financial's bid did not include, however, the acquisition of Refco LLC's regulatory capital, which was worth approximately $750 million, so the effective value of the transaction, at least from Refco's point of view, was indeed over $1 billion.

The preservation of this regulatory capital at the FCM, in spite of the troubles at the parent company, is another example of how the futures industry's regulatory system operated successfully during this crisis. As mentioned above, the clearinghouses put controls in place to prevent the upstreaming of capital from Refco LLC to the parent company without their permission. Their goal was to make sure that Refco LLC had sufficient capital to meet the CFTC's regulatory requirements and protect customers from losses. Once the customer accounts had been transferred to Man Financial, the regulatory requirements no longer applied, and Refco's parent was free to apply that capital to other needs. For its part, Man Financial faced the same requirements once it assumed the customer accounts from Refco, but for business reasons it chose to do that on its own, rather than paying Refco to have that money transferred with the customer accounts.

Refco Exodus U.S. FCMs with more than $100 million in customer funds, ranked by segregated funds as of October 2005 (in millions). Note: This represents the total amount of funds that an FCM is required to segregate on behalf of customers who are trading on a designated contract market or derivatives transaction execution facility. Industry-wide total includes all FCMs that report to the CFTC. Source: Commodity Futures Trading Commission