John Dizard: Rescuing a business model from the rubble

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Enron gave a bad name to electricity trading when it collapsed in 2002. Drexel Burnham cast the junk bond market into disgrace when it collapsed in 1990. Yet today both market-based electricity pricing and high-yield bonds are staple instruments of the financial world.

As the saying goes, pioneers are the ones who wind up with arrows in their back, and in the case of Enron and Drexel, those arrows were deserved. But there is now an effort under way to resurrect what is seen as a useful part of Refco’s business model, which until its bankruptcy in October of last year was the largest commodities broker in the world.

Refco Capital Markets, the unregulated Bermuda-based dealing operation was responsible for much of the company’s growth and, allegedly, was the instrument for the fraud that led to its collapse. Refco’s regulated brokerage business was snapped up after its bankruptcy by the Man Group. There were no customer losses in that process and Man’s takeover was pretty seamless.

Refco Capital Markets was another creature entirely. At the time of the group’s collapse it was supposed to have about $3.7bn in customer assets; apparently it had only about $1.9bn. Much of the remainder of the money had washed back and forth through accounts in the rest of the holding company. RCM’s customer money had been used as a piggy bank by management to fill gaps in the rest of the business’s accounts.

That still left the problem of who would get what part of the assets remaining at RCM. That pile has been increased by a settlement with BAWAG, the Austrian bank whose former management was intimately involved with the former management of Refco, and through a hedge fund’s disgorgement of a huge payout made just before bankruptcy.

Last week the court-appointed trustee for RCM released a settlement agreement among two of RCM’s big creditor groups: the securities customers and the foreign exchange customers. Another customer group, the funds related to Jim Rogers, the commodities guru, is still contending that they should not have to give up any money.

Leaving aside the question of whether the Rogers funds will settle in the end, it would appear that the securities customers will get 76 cents on the dollar of their accounts in the initial payout, and the FX customers about 30 cents. That is before any more money is recovered from Refco’s accountants, lawyers, and former management and other related parties.

This is where Carlos Abadi and Dresdner Bank step in. Mr Abadi, a New York-based investor who has been around the emerging market bond business for many years, thinks there is a business to be resurrected here, and one that could be a way for the RCM customer to make back another five or six cents on the dollar over the next three years. Mr Abadi believes, and there is evidence to back him up, that RCM’s business model, without the Refco ethics, is still viable.

Basically, Mr Abadi is asking the former Refco customers to move their accounts to the trading arm of the Dresdner Bank. They would execute their trades through him, with Dresdner holding on to their segregated accounts. He would give them notes giving them a share of his profits as a broker and intermediary, and, after three to five years, a share of the capitalised value of his brokerage business. “It is kind of like a Discover credit card,” says one Dresdner officer, where you get a rebate payment for doing business through them. “Altogether,” Mr Abadi estimates, “this would be worth another five or six cents on the dollar to the securities customers.”

That is an interesting way for Mr Abadi to build a large business quickly, and for Dresdner to increase its share of the prime brokerage business. What is more interesting is what it reveals as a market niche: small institutional and large individual money – more than $5m but less than $100m pools of money that want to be treated as well as huge hedge funds but aren’t. That is really who Refco Capital Markets serviced, and who Mr Abadi is pursuing.

“Refco had a very good business model. Its customers still want to trade with someone the way RCM was allowing them to trade. The problem wasn’t the business model, it was ethics and fraud. Twenty million dollar hedge funds are a pretty sad bunch. They cannot do much. They don’t have the ability to finance illiquid bonds, such as emerging market securities. They can’t offset new margin requirements on one asset with the reduced margin requirements on another. We will allow them to net out their margin requirements across their asset classes.”

Mr Abadi, through Dresdner, will give the customers standard prime broker terms on lending against illiquid or off-the-run securities. And unlike Refco, their assets will not be commingled or lent to other entities controlled by the parent.

When I bring up a trade idea that is even slightly exotic, I frequently get e-mails from readers telling me they can’t get execution through their account at a private bank. Over time, as sophisticated risk management techniques migrate down the customer food chain, that will change. For example, credit default swaps will probably become exchange-traded, clearing house-settled instruments.

If Mr Abadi and others like him succeed in bringing prime brokerage services to the masses with only $20m-$30m to their names, it could significantly add to the breadth of more exotic markets and put welcome pressure on the fees charged by portfolio managers.

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