Reply #26: Refco's collapse underscores risks in derivatives [View All]

[UpInArms]

http://www.post-gazette.com/pg/05292/591299.stm

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.

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The financial-statement line detailing Refco's receivables (what its customers owed) should have jumped out at investors who read its initial public offering documents. (There must be someone out there who did beforehand, right?) That now-unreliable document said receivables related to "foreign currency and other OTC derivatives transactions" took a gigantic leap to $811 million as of Feb. 28, compared with just $38 million a year earlier. That's Refco's derivatives exposure -- the money it put up to make all those deals go through -- and raises potential risk to entities on the other sides of these trades.

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