ANYONE assessing risks to the stability of the financial system would rank high the collapse of a company at the centre of international hedge fund trading. That risk has become reality.

Refco, born in Chicago, claimed to be the world’s biggest specialist derivatives broker. It also offered sensitive services to hedge fund clients, including settlement of transactions worth thousands of billions of dollars. Without warning, eight weeks after a storming New York Stock Exchange flotation sponsored by the biggest names in world banking, the £1.8 billion company disintegrated in a week.

Refco’s board did not see the collapse coming. It had made sure that an undisclosed £280 million apparently owed to it by a hedge fund linked to Phillip Bennett, its chairman, president and chief executive, was repaid at no loss to the company before it reported what had happened and admitted that its accounts were faulty.

Bawag, an Austrian bank that had previously backed Refco’s development, was equally surprised. It lent Mr Bennett the money to make the repayment, taking his Refco shares as security. They have since been delisted.

Funds and banks smelt trouble and rushed to disengage from Refco. The run froze or took out too much cash for even a well-capitalised company and confidence collapsed. No wonder so many companies try to hide even external fraud. We cannot yet tell whether Refco is riddled with financial holes, like Enron and WorldCom, or the £280 million was a relic of some plan to disguise loan losses or flatter profits in tougher times a few years ago.

If the fraud was isolated, Refco might have survived intact if it had stayed as a private company. Mr Bennett would still have had to go but the board might have reassured regulators of its financial position without a confidence-sapping announcement on its accounts that triggered a share price collapse.

There is a lesson here. A stock market listing usually boosts status, transparency and reputation. For companies ultra-sensitive to financial confidence, the value of which depends on goodwill rather than assets, private ownership may be preferable to a listing. If they are quoted, shares should carry a discount for the panic factor.

In principle, clients’ business with Refco should be sorted out over time without any significant loss, especially in the regulated US businesses. But the mere thought of widespread losses has focused attention on international banks that have lent nearly £300 billion to hedge funds, often on thin margins. Some retrenchment seems likely.

Hedge funds now play a leading role in most financial markets and dominate some speculative ones. They probably account for a third of dealings on the London stock market, more in Tokyo, a little less in New York. Forget supposed gloom over interest rates. Caution among hedge funds, until the Refco affair has been worked out, is likely to have been the main cause of this week’s renewed falls in Japan’s and Europe’s stock markets, and of currency and commodity trends softening.

These effects may prove temporary. The lessons of Refco’s collapse for investors are enduring. Mr Bennett has been charged with fraud, not against Refco but against investors induced to buy Refco shares in the August public offer on what now looks like a false prospectus.

Auditors have long admitted that fraud by senior management is the hardest to detect. They vet control systems more than individual transactions at big companies. Top managers know how to get round controls. More often, they are the control mechanism. So auditors need to make their own judgments about the controlling directors and plan their audits accordingly. Grant Thornton, which is in the hot seat at Refco, took over from the late Andersens and appears to have made some effort. It pointed to gaps in financial controls in the prospectus, but the whistle was finally blown internally.

After the Maxwell/Polly Peck era, the UK moved to separate the roles of chairman and chief executive, as well as to make accounts more transparent. Even post-Enron, US presidential culture is so ingrained that the mountain of bureaucracy heaped on corporate America does not include these simple safeguards, but relies on the threat of prison.

Investors, too, can take simple precautions. Always think explicitly of risk, especially catastrophic risk, when evaluating returns and rating shares. Distrust any company with a profit source that is mysterious or too complex for someone who knows the product to understand and explain. And, as with any savings product, remember: things that look too good to be true usually are.

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