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The corridor of capital markets continue to remain labyrinths of darkness dreaded by retail investors. Despite increasing volumes in recent years, 98 % of the population shuns the stock market and 45% considers it “a sure way to ruin”. The World Council For Corporate Governance has, therefore, been vigorously advocating greater transparency in stock markets. Stock markets are the best human innovation. But like parachutes they can function only if open. There is a public outcry against the dominance of financial markets by entrenched incumbents. British government’s resolve to break the hegemony of big four auditors, bring transparency in the voting of institutional investors and the plea of EU’s Internal Market Commissioner Charlie McCreavy for one share one vote are good news. Unless these reforms are carried out swiftly and vigorously public confidence in the markets cannot be restored. Not long ago Refco had the reputation of being the world’s biggest futures and commodity brokers, the largest hedge fund with 2,400 employees in 14 countries and a market value in excess of $7 billion following its highly successful IPO in August. The swiftness with which fortune has since turned sour for Refco is incredible. The company has filed the fourth largest bankruptcy in the US. It has been brought to a collapse by the disclosure that its accounts disguised a $430m debt owed by Phillip Bennett, its then chief executive. He was charged with securities fraud and put under house arrest. Its unregulated capital markets business was closed after it ran out of cash to pay back depositors who made a run for their money. It has now been revealed that insiders siphoned off one billion dollars just before declaring bankruptcy. No sooner than the company had filed for bankruptcy that one of the white knights of Wall Street came with its shining armour to rescue the fund. The rescuer is no other than Christopher Flowers, the former Goldman Sachs executive whose company were the lead advisor of Refco for its IPO in August that raised $600m. It is not the size of the losses – $ 511m allegedly hidden in a hedge fund run by the firms Chief Executive Phillip Bennett nor the stature of the company which is not exactly a household name in the arcane work of futures broking. It is the fact that a business could so recently have gone through the intense scrutiny of a market listing supervised by no less than one of the most respectable bankers of Wall Street, the Goldman Sachs, with no trace of the alleged fraud. It is now revealed that the disguised loan deals entered by its chief executive dated back to 2002. It is also a sad reflection of the due diligence of its auditors, Thornton Grant, who were also the auditors of Parmalat, the failed Italian dairy giant. It now transpires that SEC had recommended in May that civil charges be brought against Refco Securities, the group’s securities brokerage for short selling following a four year enquiry. Even more worrying is the fact that a hedge fund was used for alleged deception. These businesses which appear to defy the law of the financial gravity by going up and up are able to evade the requirements of disclosures and transparency despite rigorous laws such as the Sarbane-Oxley Act. Offshore based and seldom listed in the market these outfits can make their owners huge sums of moneys or as in the case of Refco hide enormous liabilities. The issue is how many Refcos are hiding out there? GOLDMAN Sachs, CSFB and other US investment banking giants are facing
a multimillion-dollar lawsuit from America's leading class-action attorney
over their work as flotation advisers to Refco. Melvyn Weiss, head of
New York law firm Milberg Weiss, confirmed that he will file new court
actions this week on behalf of investors who have seen their Refco shares
collapse amid claims of large-scale fraud. Weiss, who piloted massive
shareholder compensation claims against Wall Street firms in the wake
of the dot-com crash, said that leading Are there any lessons? The story is repeating with unremitting regularity. The scandals of EF Hutton, Drexel Burnham Lambert, Solomon Brothers, Kidder Peabody and Barings and the memory of the collapse of Long Term Capital Management, arguably the best-known hedge fund, is still fresh in public mind. Regulators cannot afford a recurrence. The hedge fund industry has been growing rapidly. According to the latest asset survey by Eurohedge, the bible for hedge funds in Europe, funds under management in Europe alone have trebled since 2003 and now stand at $279 billion (£159bn) while, worldwide, there is now more than $1,000bn invested in more than 8,000 hedge funds. Some are very big. 50 funds in Europe and almost 200 in the US have assets of more than $1bn. The hedge fund is such a remarkable financial innovation that by going up and up it makes money for all its clients. Consequently, everyone in the financial industry is happy. CSFB has estimated that global investment banks made more than $25bn through their dealings with hedge funds. According to Heather Connon of Observer while such funds account for only about 5% of total assets under management they account for between half to one third of all daily transactions on the London and New York stock exchanges. Yet, public knows so little about these hedge funds. It is difficult even to have a list of managers as most are registered in tax havens such as Bermuda or the Cayman Islands where regulation is virtually non existent. The doom prophets say that even the most savvy regulators cannot hope to keep track of these funds and that when the disaster the size of life boat needed may have to be much bigger than that of LTCM and perhaps beyond the capacity of the financial system. Futures, options and swaps represent one of the most radical innovations of our financial system. The credit derivatives play a beneficial role in the market by spreading the risks from the banks to interested investors so that any future defaults are easily absorbed and shared. It is because of this that the expansion of this instrument has achieved an extraordinary growth. The International Swaps and Derivatives Association estimates that by June this year outstanding derivatives contracts totalled more than $12,000bn. The downside is that most of it is unregulated. As with all innovations we need far superior risk management techniques to monitor their progress. The increase in the pace of such innovations, the sheer complicity of derivative instruments, a rapid expansion of cross border transactions and the speed at which shocks can be transmitted throughout the global financial system require much greater sophistication in the risk management. We hope our regulators have the ability to grasp the magnitude of the problem and have the capacity to rise to the occasion, monitor the situation and take both corrective and preventive actions. The alternative can be a global disaster. Madhav Mehra |