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November 13, 2005
The Refco game, Sun., Nov. 13, 2005, 7:19 PM
So here is a slice of my life. It shows that I am semi-knowledgeable about some things like the commodities and futures business.
You know what they say about a little knowledge? It can get you into a lot of trouble.
A reader by the name of Fred sent in a comment to yesterday's Week in Review. If you didn't catch it, I'll repeat it here, verbatim. He has seen my posts re Refco, and wants to know more.
A new comment has been posted on your blog Bill Cara, on entry #1280
(Week #45 (2005-11-12) in Review).
IP Address:
Name: Fred
Email Address:
URL:
Comments:
Have I mis overestimated the scale of the problems at Refco? I expected the unwinding of those positions to be a big mess. Not so?
By the way, what does btw mean?
LOL
So I'll reprint my reply below, verbatim (since I don't have time to polish it to perfection" for an article. As you know I am no expert in commodities.
But first, here is his reply to mine:
Bill, This is the clearest explanation of the implications of Refco I have seen. Your e-mail is a complete article as is. (Yeah, I know. You will polish it to perfection first.)
Thanks much,
Fred"
Fred,
Refco sold their business on the basis of the regulatory capital remaining in it. The accounts and systems and employees are still there, which had a value to a third party like Man Financial.
There were two problems at Refco:
(i) In trades that were handled by Refco as a middleman, there are owners of capital who held winning positions that are worried these positions might not be honored by other owners of capital. Refco held the accounting only. That business still exists, and has now been sold apparently to Man Financial. The obligations still exist, regardless of the middleman who managed the original trade.
(ii) In trades than were owned (directly or indirectly) by Refco (as a principal through an unregulated part of the holding company), Refco failed, and the capital of the holding company is at stake, and if the net losing positions of Refco are not settled by payment (because they have insufficient capital), then the owner of the other side (the winning side) will lose both the unrealized gain as well as (some or all) the principal. I don't know how big the net losses on these Refco-owned trades are. Presumably since Refco conducts trades in derivatives, which could be as little as a couple pennies equity on the dollar value of the trade, the capital losses (individually and in the aggregate) could be significant.
Here is where the government needs to be vigilant. Refco was dealing with many offshore accounts. Many of those accounts went offshore to avoid high onshore taxes on capital gains. Those gains when realized would never be taxed in places like Bermuda, Luxembourg, Cayman Islands, Bahamas, and so forth.
The problem those account holders have is that a jurisdiction that has no capital gains tax (for offshore accounts) offers no financial benefit for capital losses.
Since many of these offshore accounts are really controlled by onshore parties, I believe there is (or could be) a problem with money laundering, which happens whenever there is a conscious effort to position gains offshore and losses onshore. I believe the whole commodities and futures industry has thrived because of money laundering.
Since a futures contract is not a security, but only a zero-sum transaction, I (as owner of capital) would have no difficulty in my holding each end of the trade, as long as I pay the middleman his cut for settling and clearing the trade that I did with myself.
Since I don't want to take losses offshore (just gains where they will be untaxed), and I want all my losses to be onshore (where I can apply them against my other onshore taxable gains), I just need to pay a courier to handle the exchange from left pocket to right pocket. I need that courier to give the transaction a degree of legitimacy.
That's fine as long as the courier stays in business, and markets continue to fluctuate where at times I am in a profit or loss situation at any time onshore versus offshore. I just know that before each contract expires, I have to close it or renew it if I am in a loss position offshore. Stopped in mid-stream, I could be left holding unrealized losses offshore.
In the case of Refco, the clock suddenly stopped. What are these offshore accounts to do? I am not surprised that it was Man Financial (an offshore trading house) that emerged as the successful bidder for Refco's agency business.
I believe that (some of) Refco's clients (i.e., those who are having positions closed on them) may try to send their losing book back to the onshore jurisdiction. If they succeed, that would become a theft of government assets (i.e., tax on income that would have otherwise occurred in those accounts without the offshore loss applied to it).
I don't have a problem with accounts being offshore, but it's just like a trust; you can't play both sides against the middle. Financial transactions are not like advocacy, where lawyers can say this or they can say that, depending on the position they want to take. A financial transaction is like a bullet shot from a gun.
You set up a trust, that means the principal gives up the right to control that asset. You set up an offshore account, that means you give up the rights and privileges of onshore accounts.
With the onshore account, the obligation to pay tax is balanced by certain rights, including the right to offset losses against gains. Unfortunately some people in this world are miscreants, and, alas, they happen to work in the biggest financial trading companies of the world too.
Now that Refco has caused them a problem, which is one of the risks of dealing between offshore and onshore, they legally have no right to go back in time to change the transaction or the account. Some will try. And if they are discovered trying to do that they should be charged with money laundering. As I see it, anyway.
Fred, please tell me what you think. I'm probably going to write about this.
/Bill
Now a lot of Commodity Trading Advisors are going to be ticked off with my opinion. It is, like everything else I write on this blog, an opinion.
But before you write me nasty notes, let me tell you where I got my education. My only partner in an offshore financial business I set up in the 1990's happened to be one of the world's biggest commodity trading brokers. One of his early clients (early 1980's) was reputed at the time to be the richest individual in the world (that was before Gates/Buffett came into the lead), and my associate would fly all around the world on that man's jet looking at commodities. He once did what he told me was the largest trade in copper in history. He was to his friends a private man who was chauffeured daily to the office in a black stretch limo with black windows, which added to the mystique.
Although it is completely irrelevant, I have a good story. One day I was introducing this partner to my associates in a popular business tavern in the Bahamas. We weren't talking commodities at all, but one of the local CTA's picked up the hint of expertise from one of my partner's remarks.
So he asked him, rather drunkenly, what size did he trade: Two?" and the man laughed when my friend pointed up. Five?" and then man shouted out, So we have an expert in the house!" when my partner pointed up.
Ten?" and then as my partner pointed up, the other man exploded in a litany of expletives to a roomful of onlookers: This man is a fraud. He claims he trades more contracts than me. I am the biggest trader in this country!"
Needless to say we departed quickly. That was a tough crowd. Outside, my partner told me that he traded more than a thousand contracts per trade, on average, and that's when he told he who his clients were.
I tell you, I don't trade commodities. Never have. I believe in equities.
Btw, my former partner is no longer trading commodities. He now believes in equities.
But he did teach me a thing or two about that business. And I learned enough not to want to hear anymore.
You see, there are people in this world who are ideally suited to commodity trading. I just happen not to be one. There are also gamblers, and for a few years I happened to live a three-minute walk to the famous Atlantis casino at Paradise Island. Needless to say I spent a lot of time there, but I never gambled.
And when my daughter was in elementary school, one of my proudest moments was watching her use her Bahamas experience to win first prize in Math in the Math and Science Fair in Toronto " for 18 school boards " hundreds of thousands of students. She too learned something from that casino at Atlantis; her project was The Probabilities of Winning at Cards and Dice".
Her university and college markers even told her she could discuss the concept of standard deviation (at the age of 12) as well as their own students. Alas, Math was her worst subject and she's not the least bit interested in trading, now that she's graduated from University of Toronto.
Posted by Posted by Bill Cara on November 13, 2005 07:21:11 PM | Category: Commodities