-Caveat Lector- from: http://www.thestandard.net/articles/display/0,1449,4072,00.html?home.ff <A HREF="http://www.thestandard.net/articles/display/0,1449,4072,00.html?home.ff" >The Industry Standard: Looks Like a Scam, Smell </A> ----- April 05, 1999 Looks Like a Scam, Smells Like a Scam ... By Mark Gimein One day in June 1994, police and federal agents in five cities swept through the offices of Frankwell Bullion. Frankwell, a Hong Kong-based company, promised investors huge profits in the international foreign-exchange market. Federal regulators charged that Frankwell was running an illegal futures brokerage. They padlocked Frankwell's doors in New York, San Diego, Houston and the San Francisco Bay Area and claimed, in charges the government was ultimately unable to prove, that the company never made the currency trades clients thought it was making on their behalf. One Commodity and Futures Trading Commission lawyer told a judge that the investments clients believed they held had "no value outside the house of Frankwell Bullion." Records retrieved by investigators from Frankwell's offices appear to show that dozens of investor accounts had been reduced to nothing. Among the Frankwell investors was a Russian immigrant named Mikhail (Mike) Dvortsov. A soft-spoken graduate of Moscow University, Dvortsov arrived in the United States in 1988 and used Frankwell's trading room to make speculative bets on changes in the values of foreign currencies. Dvortsov, like nearly everyone else who had invested with Frankwell, lost money. Two months after regulators shut down the operation, a federally appointed receiver returned some money to investors, and Dvortsov (who will not divulge the exact amount he lost) got back a fraction of his initial stake. At this point, most people would have called it a day, resolving to stay far away from currency speculation. Instead, Dvortsov, who had already incorporated a company called Money Garden with partner Alex Miklin, decided not long after Frankwell was closed down to open a foreign- currency brokerage of his own. Now Dvortsov and Money Garden, also known as MG Financial Group, are on the Web (www.forexmg.com), raking in thousands of dollars a day. The name Money Garden might sound a little rinky-dink; certainly the offices, in an aging office building down the street from the New York Stock Exchange, are uninspiring. But make no mistake: People like Dvortsov are busy developing techniques to separate fools from their money that make old-time investment scams look like penny-ante games. Off-exchange foreign-currency speculation is one of the darkest of the dark corners of the financial world. Banks trade vast sums of money daily in an unregulated and volatile currency market. Currency speculation is how billionaire financier George Soros made his fortune. He earned more than a billion dollars in a few weeks betting that the value of the British pound would fall (and picked up a reputation as "the man who broke the Bank of England"). In general, the currency market and the related derivative markets have not been amenable to individual investors. While it has long been possible to open currency-trading accounts with major banks, it generally takes an investment in the hundreds of thousands of dollars. In the early 1990s, however, a new breed of company � "off-exchange currency brokerages" � emerged, claiming to offer small individual investors a chance to use borrowed money to speculate in currency on margin. These "brokerages" let investors, in effect, write the firms IOUs for large blocks of foreign currency (or in some cases dollars), for an exorbitant commission. Investors are betting that over the course of a day or two the exchange rate will change enough for them to make a profit. In some cases, these investors manage their own accounts, using makeshift trading rooms equipped with Reuters terminals. In others, account managers do it for them and take additional fees in the process. Most brokerages don't last long. The Commodity and Futures Trading Commission has closed down dozens of such operations for various violations, including misleading investors, failing to execute trades and mismanaging accounts. In other cases, such as New York's AEL Fund, the brokerages simply shut their doors and disappear. Austin Forex was a Texas company headed by one-time University of Texas football player Russell Erxleben that promised to make clients money speculating in off-exchange foreign-currency bets. In November 1998, it went bankrupt without any help at all from regulators. The total loss for investors was some $60 million. Despite having received little attention in the press, off-exchange currency trading has become the 1990s' answer to old-style boiler-room stock scams. In 1997, Brooksley Born, the chairwoman of the CFTC, estimated that $250 million had been lost in foreign-currency fraud cases. Since then, the problem has gotten worse. In March, Born called off-exchange currency fraud an "epidemic." These brokerages exist in a kind of legal limbo. In general, currency transactions are exempt from federal regulation. (The law on this is governed by the 1974 Treasury Amendment to the Commodity Exchange Act, which was designed to let banks operate in what is effectively an international marketplace without government interference.) The CFTC assumed jurisdiction by claiming they engage in futures trading, and in most cases where the CFTC has moved to shut them down, the operators have closed up shop, surrendered some money and promised that they would not violate the law again. But when the jurisdiction issue was put to the test in the CFTC appeal of the Frankwell case, the CFTC lost. Frankwell's lawyers, in fact, argued that what Frankwell did wasn't futures trading and didn't take place on a CFTC-regulated marketplace, or "board of trade." A federal appeals court sided with Frankwell. Now the first generation of currency scams is giving way to Net-based currency brokerages. Money Garden and a Brisbane, Calif.-based company called E-Forex were the first American firms to offer online currency trading. Craig Harper, the CEO of E-Forex, estimates that there are now 100 online currency brokerages. (E-Forex is no longer running its own brokerage because it finds selling software to companies setting up Net brokerages more lucrative.) A quick search of the Net reveals dozens of brokers and advisors, all promising to let individual investors into a game of highly leveraged currency speculation. The list of Web addresses goes on and on: Valhallaforex.com, IForex.net, Salmonbayglobalforex.com, Forexonline.com and more. Some of the brokerages merely resell each other's services. Some confine their advertising to the Net. Others, like Valhalla Forex, post blind ads in the New York Times classifieds � a favorite marketing tool of the older generation of fringe investment schemes. You want a managed account? No problem. You want to open an account with $1,000? No problem. There are foreign companies to invest with, too � Currency Management in the U.K. and Midas Fondsmaeglerselskab (easier for Amer icans to remember as www.forextrading.com) in Denmark. ===== April 05, 1999 Looks Like a Scam, Smells Like a Scam ... By Mark Gimein Frankwell, the foreign-currency exchange company that the CFTC raided, is a case study in how the foreign-exchange game works. At Frankwell, customers would go through a training course in foreign-currency trading and then put up deposits from a minimum of $5,000 to tens of thousands of dollars. It is not clear, as the government claimed, whether any "trades" were executed, except as a transfer of numbers on the balance sheet � if that. Frankwell said it offset the trades through Hong Kong commodities dealers, but an SEC investigator found that a dealer with whom Frankwell claimed to trade, Raymond Poon, lost his license in 1987. By the affidavit of Frankwell's own manager, Frankwell's five offices were garnering commissions at an annual rate of $3.67 million a year. The total money held in accounts by Frankwell investors, available in records that came to light in the CFTC lawsuit, was $2.38 million. That means Frankwell, by its own description, was getting $1.50 a year in commissions from every dollar in currency-trading accounts. Frankwell customers were churning their accounts into nothing, sometimes on their own and sometimes with the help of Frankwell account executives who acted as their brokers. The court-appointed receiver who examined Frankwell's own records found that 60 accounts were listed as having a negative value. That means the investors actually owed Frankwell money. That's a big red flag: Whatever Frankwell was doing, it was a lot different from what ordinary stock or commodity brokerages do. For comparison, while investors can borrow money to buy stock from their brokers, SEC regulations require the broker to issue a margin call, asking for money to cover losses, long before the account's value is down to zero. The Net can turn a good scheme into an even better one. Currency trading requires minute- by-minute information. The early off-exchange brokerages centered around trading rooms, where investors could come to track the currency markets using Reuters and simple analytic tools. Obviously, this required a lot of time. In 1995, Dvortsov, with an experienced bank trader named Dixon Fong and a programmer named Aleksandr Ryvin, started developing a trading system that would let clients put in orders to buy and sell currencies online. As with online stock trading, Money Garden lets investors easily monitor their portfolios from home and trade at lower cost. Like a market maker in the stock market, Money Garden buys blocks of currency at one price (the "bid") and sells to investors at another (the "ask"). All the transactions are done on credit: An investor puts up as little as $500 to purchase $100,000 worth of foreign currency. (That's like trading stocks on a margin of 99.5 percent.) In general, the spread between the bid and ask prices will give Money Garden a gain of $35 to $50 on each transaction, but it can be significantly larger. In every case, Money Garden is the counterparty in the transaction. If you buy 15 million yen (a typical block, worth about $125,000 at current exchange rates) from Money Garden, Money Garden, not another individual investor, is the buyer. (Investors can also "go short," or sell foreign currencies.) That's why Money Garden can extend such enormous credit lines: The company does not have to put in an order for actual currency on any exchange. The "transaction" is purely notional. Think of it as a kind of IOU � an investor writes the MG Financial Group what amounts to a note promising to deliver, say 15 million yen. Money Garden, unlike earlier practitioners of currency schemes, doesn't even put up the pretense that there is anything going on in its transactions but an exchange of IOUs between the investor and the brokerage. If the exchange rate changes, an investor can make or lose money. If its risk gets too great � if, for instance, a lot more of its investors are buying yen than selling � Money Garden can go to another broker, but it doesn't have to. Money Garden charges only a $10 commission (in addition to the profit Money Garden makes on the difference between bid and ask prices) on accounts under $10,000, and none at all on larger accounts. That's a lot better than Frankwell, Dvortsov insists, which, in addition to a spread, charged commissions on every transaction of at least $35 (and, according to Fong and Dvortsov, as much as $80 on each transaction for managed accounts). But have any of the investors with Dvortsov and associates actually made money? Here are some of the answers: "That," says Dvortsov thoughtfully, "is not a good question. It depends on what the time period is. It depends on what their goals are. It depends on how they trade. Do they trade every day? Or only once a week or once a month? What is their strategy? Maybe they can lose on two trades out of every three, but make money on the third." "You should ask," says Fong, "'How many futures investors make money?' I think 85 percent lose." "You have to be very disciplined," says Fong, "There was one guy who made money for two years. Then he changed his strategy and wiped himself out. Why did he change his strategy?" "Some people," says Fong, "have several accounts. They can use one to hedge, so they lose money on one account and make money on the other. If someone has an account with us that loses money, and made money with the opposite trades on another account, has he made money?" Dvortsov goes deeper: "One of the interesting points on a philosophical level is 'What is your responsibility as a human being?' or 'Where does fair play end?' Doesn't common sense tell us that if you make the trading decisions yourself, you should be responsible for them?" asks Dvortsov. It's like arguing that when the cat gets skinned, it's the cat's own fault for getting caught in the first place. Can people make money speculating on foreign currency with a Money Garden account? It doesn't look like it. The reason is the same as in other "foolproof" systems in the financial markets: transaction costs. On every highly leveraged currency transaction on Money Garden's system, investors wind up absorbing transaction costs in the "spread" of, say, $35 to $50. Plus a $10 commission if the investor's account with Money Garden goes below $10,000. An investor who opens a $1,000 account with Money Garden in effect loses as much as 6 percent of his or her investment on every transaction. Money Garden officials say that some investors trade only once in a day or a week; others trade as many as 30 lots (quantities roughly worth $100,000) of currency every day. An investor with a $5,000 account who trades one lot of currency a day � a scenario that Money Garden officials agree is fairly typical � winds up paying $225 to $300 a week to play. That's $11,250 to $15,000 a year, even if he takes a two-week vacation. But wait: The investor started with just $5,000. That means that he would have to make well over 200 percent returns just to cover costs and break even. ===== April 05, 1999 Looks Like a Scam, Smells Like a Scam ... By Mark Gimein Fong claims skilled investors manage profits of 30 percent to 40 percent a year. With transaction costs of 200 percent a year, it doesn't seem likely. As the risk disclosures on Money Garden's site say, "Money Garden expects to make a profit on each transaction equal to the 'spread,' or difference, between the prices at which customers buy and sell currencies at different times." So your 200 percent transaction costs are Dvortsov's 200 percent profits. "When you put it like that, transaction costs of 200 percent," says Dvortsov, "it sounds crazy. How could you make money? But that's not the right way of thinking about it." So what is the right way? several days after an interview with Dvortsov, Marc Prosser, his public-relations aide, sends over an analysis of an investor's prospects with Money Garden. The key point is that since investors are trading on margin using borrowed money, investors can, based on the degree of fluctuation in the currency market, turn a profit as great as 2,600 percent per year. Prosser derives a ratio of "potential profits" to "transaction costs" of 8.33. The barrage of numbers is seductive. It seems to mean that one can realize a profit of a little over eight times one's transaction costs if one always guesses right about the direction currency prices will go. But and important part is left out: The same leverage that inflates the "potential profits" makes it likely that a couple of wrong guesses will wipe out a naive investor's entire stake. Dvortsov won't divulge the amount of money investors have on deposit, but he says that the company has enough insurance to cover all the money in Money Garden accounts, and a note on the Web site claims they're insured for $4 million. Chief trader Dixon Fong says that the firm trades from 300 lots to 400 lots a day. At $35 on the typical trade, 300 lots a day, five days a week, that means that Money Garden's investors are paying an absolute minimum of $2.73 million a year in transaction costs. Add in $10 more per trade on accounts under $5,000, and realistically the total comes out to $4 million-plus. "Some people," says Dvortsov, "try it out, lose $500 and decide they don't like it." One small hitch in the scheme: When you bleed your investors as fast as Money Garden does, it's hard to grow at any impressive speed. Seems that a moneymaking scheme this hot has got to be illegal. The CFTC must be chasing Money Garden, right? Actually, Money Garden is chasing the CFTC. The company has spent two years trying to get the CFTC to clarify its legal situation, and it still has no answer. Dvortsov is confidently pursuing the commission because what he's doing is almost certainly legal. Remember Frankwell Bullion, the foreign-exchange currency-trading firm raided by the CFTC? The CFTC claimed that any retail currency transactions that don't take place on an exchange like the Chicago Mercantile Exchange are illegal. But Frankwell won the case � and also won an appeal by CFTC to the 9th U.S. Circuit Court of Appeals. In October 1996, in a dizzying humiliation, the CFTC was forced to pay Frankwell $165,000 in costs. Frankwell's U.S. operations are back in business. The CFTC has stopped pursuing off-exchange currency scams in the western U.S., where the 9th Circuit decision is binding. The CFTC has had some success asserting jurisdiction in the 2nd Circuit, which covers New York. But in 1997, the CFTC lost an important Supreme Court case, Dunn vs. CFTC, in which the Supreme Court ruled unanimously that the CFTC cannot regulate foreign-currency options trading. If the trend continues, the CFTC's authority to control off-exchange currency fraud will be even more limited. Meanwhile, the off-exchange currency brokerages are becoming more pernicious. In Dvortsov's system, the out-and-out fraud that plagued the shadiest of the off-exchange currency-trading operations is essentially superfluous. The big profits come from the brokers doing exactly what they say they'll do. Why bother cheating when you'll get all the money through commissions anyway? The final irony is that it is not clear that Money Garden's customers would have things any other way. As Prosser proudly proclaims, "We've been doing this for three years, and there hasn't been a single complaint to the Better Business Bureau." Even in the affidavits filed in the case against Frankwell management, investors who have been thoroughly plucked argue cheerfully that their initial losses were the result of their own imperfect trading, and big profits were just around the corner. "At the outset," one Frankwell investor, Jeffrey Moss, says in his affidavit, "[Frankwell] represented to me that foreign-currency trading is a high-risk investment. In fact, I was told that it was possible I would lose my entire investment. [Frankwell] continually stated that this was a highly volatile market and stressed the risk factor involved." Investors seem to reason that if higher risk means higher potential for profit, then extreme risk must mean extreme profit. On an Internet bulletin board devoted to day trading in foreign currency, a trader from London last week posted a story that has been going around the Net for some time. The story is about a bricklayer who decided to move a barrel of bricks from the roof to the ground. Rather than just toss the barrel down six stories to the ground, he attached the barrel to a rope and set up a pulley system. Back on the ground, he untied the rope that by now was the only thing holding the barrel in the air. He thought that holding on to the rope was the best way to keep the barrel from crashing down. But the weight of the barrel jerked the bricklayer off his feet. He went up, slamming into the barrel on its way down. Then the barrel lost its bottom and flew up, hitting him again on his way down. He finally landed on the bricks, which had fallen out of the barrel. Then the barrel came down again, breaking his legs. Another trader wrote back, giving thanks for a story that would give him comfort next time the market was "unloading" on him. If only the trader had drawn the right lesson from the story: You can have a degree in physics, but that won't make it safe to stand under a barrel and try to pull it off a roof. It is seductive to try to test your wits against the market. Day traders obsess about technical indicators and "head-and-shoulders" patterns; the foreign currency bulletin boards are full of references to arcane subjects like "stochastic" indicators. And all of it is a great, inglorious sham. ------------------------------------------------------------------------ Here's How It's Done: The Anatomy of a Foreign-Currency Trade The Account: Investors deposit money with Money Garden. The account can be as small as $1,000 or as large as $50,000 or more. The Trade: The investor writes Money Garden an IOU, promising to exchange dollars for a large block of foreign currency. In a typical trade, an investor will promise to buy 15 million yen or 100,000 euros. The money in the account guarantees the IOU. An investor hopes to profit by a change in the exchange rate. Investors who write Money Garden IOUs for euros, for example, hope that the euro will be worth less later. The Trade II: An investor who wrote Money Garden an IOU for 100,000 euros � or "bought" euros � sells the euros back to Money Garden and gets back the IOU. Money Garden buys and sells currency at slightly different rates. The difference, or spread, is Money Garden's gain. On a 100,000 euro trade, the spread is usually about $50. To make money, investors must not only guess which way exchange rates will go but also "beat the spread." Otherwise, they'll lose money even if they guess correctly. The Long View: Thanks to the spread and an additional commission on smaller accounts, investors can easily wind up paying hundreds of dollars a week in costs on an account of a few thousand dollars. 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