The Frightening Truth About PFGBest

Includes: IXG, IYF, IYG, VFH, XLF
by: Elite E Services

Forex brokers have been going under nearly on a monthly basis, as any forex trader or client can attest for the last few years. The most recent, PFGBest, was also a futures commissions merchant with over 70,000 clients and a reported $500 million in customer funds.

The Differences Between PFG and MF Global

It is rumored that many MF Global customers will receive anywhere from 90%-98% of their funds from the current custodian. While this figure may vary depending on individual circumstances, we have not heard that customers may lose more than 15% of their deposit max. While this is an unfortunate situation, and also considering funds will be locked up while the procedure continues, it is not a 100% loss.

It is still too early to tell how PFG will play out, but based on available information, PFG only had $5 million on deposit with obligations well over $200 million in missing funds -- not counting possible lawsuits and other obligations they may have had. For a company that size, $5 million will not cover the legal fees. But assuming there are no expenses unraveling PFG, 5/200 = 2.5%, suggesting clients will get a maximum of 2.5% of their invested funds -- a near-complete loss.

The Differences Between Now and Forex 2007

The forex industry is not new to this. It has happened before with Refco, FXLQ, CFG, One World Capital, and countless others. However, there are key differences that make this a lot scarier:

  1. Before 2010, forex was largely unregulated globally. While many firms chose to register with the NFA voluntarily, registration was not explicitly required until the passage of Dodd-Frank. So it was a lot easier for scammers and unregulated clowns to operate.
  2. PFGBest was a medium-sized company, but one of the most respected in Chicago. Russell Wasendorf Sr. was a pioneer in electronic trading who later expanded into publishing, forex, and investment management. It is not yet clear when the fraud began, but certainly not more than five years ago. PFGBest was a highly regulated, well-respected company in the industry.

What Is Scarier

FCMs and FDMs report daily seg funds to NFA. PFG was a medium-sized firm with different divisions (compared to a small business where a single individual may have multiple roles). After the MF Global meltdown, PFG was audited by the regulators. PFG had external auditors both for regulatory and accounting purposes. Wasendorf served on the NFA advisory committee.

What's scarier: that this fraud was perpetrated by a group of insiders, or that executives, accountants, and regulators all missed $200 million?

Also, with all the new regulations and rules, if they can't stop PFG from happening, then what can they stop?

PFG Compliance

Anyone who worked with PFG on a professional level can attest to the fact that it was very uptight about compliance issues. This may have been a ruse, to pretend to be strict on compliance while hiding an elephant in the room. Or it may have been a policy created by a single conspirator to mask the massive loss of $200 million. Either way, PFG compliance took issue with legitimate IBs and CTAs while $200 million in customer funds went missing.

If this can happen to PFG, is it possible it could happen anywhere?

Stock Play: Short the Financial Sector

We do not trade or recommend stocks as we are a forex CTA. Our concerns over institutional risk are that of having a custodian to hold our funds and client funds offering access to forex markets. However, our analysis researches all global markets as they are connected.

Jim Rogers said several years ago he was shorting the financials. In a recent article, "Modern Institutional Decay," we elaborated on the decline of financial institutions in their quality. This was before the situation with PFG. The PFG meltdown opens up many questions about other institutions. The big concern is that on the outside, PFG seemed to be a credible, well-regulated, trustworthy institution. PFG had fines and lawsuits, but many similar institutions have similar types of fines and lawsuits.

If one wanted to bet on others suffering the same fate, one might consider shorting financial stocks. Many institutions are private companies, such as PFG, but many are not. We have witnessed JPMorgan's (NYSE:JPM) involvement in a number of questionable practices this month.

Here is a list of the ETFs of the financial sector:

Global Financial Sector ETFs
iShares S&P Global Financials Sector Index Fund (NYSEARCA:IXG)

Broad US Financial Sector ETFs
iShares Dow Jones U.S. Financial Sector Index Fund (NYSEARCA:IYF)
iShares Dow Jones U.S. Financial Services Index Fund (NYSEARCA:IYG)
Financial Select Sector SPDR Fund (NYSEARCA:XLF)
Vanguard Financials ETF (NYSEARCA:VFH)

Careful Trading on Rumors

Another strategy, rather than shorting an index, would be to research the financial sector companies individually to see if any were troubled. However, this would not have proven successful if PFG were a public company because up until the last moment, even insiders at the highest levels had no idea of the fraud. Also it would not be wise to make a trade based on mere rumor.

Starting with the credit crisis of 2008, frauds have been uncovered more and more often. In the case of Bernard Madoff, he was never discovered by regulators, but simply could not cover the amount of withdrawals requested by investors (simply to cover other losses) so he basically turned himself in. Something similar may have happened to PFG, and may happen to other institutions as the economic situation deteriorates globally.

On another note, instead of taking an offensive position on financials, expecting to profit from their potential demise, those who are already long financials may consider selling and exploring other options. If one does have financials in his or her portfolio, one should take a second look at any potential red flags associated with the firm. Phil Flynn, previously of Alaron trading (a Chicago local), said the red flag for him at PFG was not the $700,000 fine by the regulators, but the fact that they allowed an account holder (who later turned out to be a ponzi scammer) to use different client accounts to cover margin, which is against current rules.

To conclude, as we stated in our previous article about institutions, all one can do is do as much due diligence as possible (or open your own institution). The risk of loss in trading foreign exchange markets can be substantial.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Forex Risk: Disclosure here.