Hedge Fund Regulation & Compliance

U.K. Markets Regulator
Warns of Hedge-Fund Dangers

By DAVID REILLY
Staff Reporter of THE WALL STREET JOURNAL
June 24, 2005; Page C1

The United Kingdom's financial-markets watchdog warned that "some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation."

As a result, the Financial Services Authority plans to take a more proactive stance toward hedge funds, in particular the so-called megamanagers who run billions of dollars in investments, the agency said in two papers released yesterday. The U.K.'s regulatory approach to the industry is particularly important as London is home to the vast majority of European hedge funds, lightly regulated investment pools open to institutional and wealthy individual investors. The papers will spark a debate in Europe's most important market as to whether there is a need for more stringent regulation. The FSA added that it was also concerned that the hefty fees hedge funds pay to investment banks could induce others "to commit market abuse."

The moves come as regulators around the world, including the Securities and Exchange Commission, are looking to step up their oversight of the funds, which now manage more than $1 trillion globally. In Europe, German Chancellor Gerhard Schroeder plans to call for global regulation of hedge funds at next month's U.K. summit of the leaders of the world's eight leading nations. (See related article1.)

In the two discussion papers that examine hedge funds and their impact on U.K. financial markets, the FSA didn't go so far as to propose new rules for hedge funds. The agency also noted that hedge funds play an important role in providing liquidity to markets and are an important part of the financial landscape. Hedge funds, for example, now account for between 30% and 40% of trading on the London Stock Exchange, Europe's biggest stock market, according to recent remarks by LSE Chief Executive Clara Furse.

But the FSA said that given potential risks posed by hedge funds, it plans to create a new unit that will focus specifically on them, while also undertaking "increased proactive surveillance" of both hedge funds and the banks that help them manage trading activities.

Some see tighter regulation ahead. "There's undoubtedly a risk that the ultimate effect will be a more intrusive regime for hedge-fund managers," said Peter Astleford, partner and co-head of the financial-services group at law firm Dechert LLP in London.

Although the FSA flagged potential abuses by hedge funds and investment banks, it didn't provide any direct evidence of wrongdoing or cite any firms. The agency currently is investigating trades at several hedge funds over potential abuses stemming from so-called premarketing by investment banks of sales of large blocks of stock or convertible bonds. It has yet to take any enforcement action on the issue.

Nor did the agency find that hedge funds pose an inherent, systemic risk to financial markets. It said there are risks from a potential blow-up of one large hedge fund, or from "a cluster of medium-sized hedge funds with significant and concentrated exposures." However, "the probability of an event on a scale that could significantly affect U.K. financial stability is relatively low," the agency said.

Write to David Reilly at david.reilly@wsj.com2

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The New Insider Trading?
Carolyn Sargent
June 20, 2005

Insider trading" may conjure up visions of Martha Stewart selling shares of ImClone Systems Inc. after being tipped by the company founder, but today it's not the stock market that's under the most intense scrutiny for potential abuse of material nonpublic information. Even greater opportunity for misdeeds may lie in the more arcane world of bank, bond and credit derivative capital markets.

That hasn't always been the case. But the rapid evolution of the leveraged loan business, which originates and trades speculative-grade bank loans, has profoundly altered the credit landscape. In the past three years or so, the secondary loan market has grown from a fiefdom controlled by tightly regulated commercial banks and insurance companies to a fast-moving, highly liquid market played aggressively by hedge funds and Wall Street's proprietary trading desks. And this full-throated participation by new, lightly regulated investors in an instrument that increasingly trades like a security is raising serious questions about standards of trading conduct.

"So far, nothing terrible has happened. There have been no big blowouts. Now everyone is just hoping that something terrible doesn't happen before the industry figures it out on its own, so the regulators don't end up coming in," says Marc Baum, the founder of Solel Group, a consulting firm that counsels hedge funds on legal compliance and regulatory issues.

The crux of the issue is this: Companies have a much closer relationship to their lenders than to investors in their public securities, and they give those lenders private information that public investors never see. Called syndicate-level information, it might include a whole bunch of items that aren't "material" to a company's financial position-like quarterly compliance certificates. But it can also include material information, such as updated projections of revenues and earnings, or plans for an acquisition or divestiture. In the hands of a reasonable investor, such info would likely cause a change in the price of a public security.

Lenders of all stripes-commercial banks, insurance companies, mutual funds and hedge funds-have an obligation to keep all syndicate information confidential. But investors in syndicated loans are often also traders, and many trade bank loans next to high-yield bonds and credit derivatives. Some, especially hedge funds, use the same professional to trade all the financial instruments across a company's capital structure. Keeping private information private under such porous circumstances obviously is a challenge.

"Is private information being used to trade public securities? Or are these investors really on the up-and-up?" one hedge fund manager asks. "The rumors and innuendos are definitely out there. And that is the key issue. Until you can get some resolution, or a slightly thicker Chinese wall, there will continue to be speculation."

Finger pointing

Both investors and universal banks have ample opportunity to trade on material inside information. "If you talk to the commercial bank people, they'll point to the hedge funds and say they don't have good Chinese walls, that they're getting private information from the other side. And hedge funds say the trading desks at the commercial banks aren't very good at keeping information separate," says a market source who declined to be identified. "So there's a lot of finger pointing out there, and as a result increasing concern."

Often fingered first are hedge funds, who became major players in the leveraged loan market in the recent economic downturn, when many credits deteriorated and couldn't be held any longer by traditional pools of capital-those held by commercial banks and insurance companies. Because hedge funds are only lightly regulated, and because so many of them are start-ups with small staffs, many have not established rigid internal control and compliance functions like the universal banks, which are regulated by a host of entities, from the Federal Reserve Board to the Securities and Exchange Commission and even state regulators. "Hedge funds are frequently just eight people sitting in a room. They're just not staffed at the same size [as more established, regulated entities]. What that means is that historically, they just haven't thought through the issues," Solel's Baum says.

Worse, it is often a single trader at a hedge fund who deals in all of a company's debt instruments. "You can't put a Chinese wall through someone's head," says Michael Kaplan, a partner in the corporate practice at law firm Davis Polk & Wardwell.

Buyside sources say a trader could use the material nonpublic information received through a loan participation to trade the company's bonds, convertibles or even stocks. A trader could also use that knowledge to write credit protection in the credit default swaps market.

Traders can gain access to this information easily, and with just a small capital commitment. "A hedge fund might get into the loan business by buying very small amounts of loan syndications of various borrowers. And in so doing, the fund gets access to any information a bank would have access to: financial statements, growth projections and any renegotiations of covenants, or new covenants, or an update on the state of some type of negotiation" such as an acquisition, says one credit investor. "The temptation is great, and there is no barrier to entry."

Chris Dialynas is a managing director and portfolio manager at Pacific Investment Management Co., one of the world's top bond investors. He has written about the possible misuse of private information in the credit markets. Indeed, research that Dialynas authored in October 2002 "was directly responsible for the Joint Market Practices Forum," a consortium of industry associations that a year later introduced guidelines for the handling of material nonpublic information by broker/dealers, says Marjorie Gross, regulatory counsel for the Bond Market Association.

Dialynas believes that "the probability of acting on the temptation increases as the reward to people who might do the misdeeds increases." A large part of a hedge fund manager's compensation is based on a percentage of performance, he notes, "and that would give them a greater incentive to cross the barrier." The same principle would apply to a trader making bets for the proprietary account of a universal bank.

Such behavior would be less likely to occur at traditional investment managers, Dialynas argues. That's because most asset managers have a longer-term horizon, they don't get compensated strictly on performance, and generally they have more franchise risk, he says.

The information divide

That's not to say traditional credit investors don't have to cross this potential minefield, too. 40/86 Advisors, a Carmel, Ind., asset manager, invests in bank loans, high-yield bonds and collateralized bond obligations, or pools of corporate credit that have been repackaged into new securities bearing various levels of risk.

40/86 employs separate portfolio managers to run its bank loan and high-yield bond investments, but its managers share the same headquarters. To avoid the possibility of mishandling private, material information, 40/86-like a growing number of loan investors-chooses not to receive private, syndicate information in most cases. "We have a policy of remaining public, and if and when we make the decision to become private on a name, the name is identified and tracked on a restricted list. My concern is that these policies and procedures may not be in place universally to avoid the misuse of material nonpublic information," says Amy Gibson, vp in charge of 40/86's high-yield group.

An investor who chooses to be a "private" lender may receive material nonpublic information about the borrower. Antifraud provisions of the securities laws prohibit any investor from using private, price-sensitive information to trade the public securities.

But just because an investor refuses to receive syndicate information doesn't mean it isn't readily available, should he have a change of heart. "It's a little bit too much on the honor system right now," said one portfolio manager who declined to be identified. "Even though we are public right now, we could go out and ask for private information-and get it."

Self-policing, then, does not seem to be the answer, in part because private information can be so tantalizing. One hedge fund manager who focuses solely on credit opportunities says that he, too, refuses to receive private loan information-except in rare instances when a company has no outstanding public securities, and the only way to participate in a loan is to receive syndicate information. "When you participate in those deals, you get a glimpse of what other [investors] might be seeing about public companies, and it piques your curiosity, particularly on a complicated deal."

Given that insight, he says, he sometimes has to walk away from a deal if he thinks the playing field isn't level: in short, if he faces an information disadvantage that prevents him from making an effective judgment about the investment.

At least one big loan information provider has recognized the problem-and come up with a solution. IntraLinks Inc. makes information about many large U.S. bank loans available through an Internet-based document distribution system. Historically, investors agree, it has been very easy for so-called public loan investors to receive private information via IntraLinks simply by clicking on the icon for a folder that contained private documents. "The information is all on IntraLinks, and in theory it has been very easy to press the wrong button" to receive private information, says a loan investor.

But in late March, IntraLinks launched a redesign of the system's architecture to try to prevent investors from being accidentally exposed to private, material information. Now, lenders are required to self-declare as public or private investors before they gain access to any loan documents. Fund managers who identify themselves as public have access only to loan documents that the agent bank deems appropriate for public investors. The same goes for the correspondence they receive from the agent bank.

"This system allows syndicating agents to feel better about how they disclose information to their investors. And from an investor's standpoint, it provides them with greater safeguards to ensure they don't get accidentally tainted," says Andy Fieweger, IntraLinks' product marketing manager for debt capital markets.

The IntraLinks innovation does help agent banks and investors manage their information flow, but it isn't fool-proof-nor was it expected to be.

For one, as an increasing number of lenders have chosen to be public, agent banks and borrowers have found it difficult in some cases to secure the requisite number of approvals on credit amendments, according to market sources.

A good many credit amendments require approval from a simple majority, or 51%, of a company's lenders. But those that involve serious changes to a loan's terms-such as one that would decrease pricing-require approval from all investors. "If the company has designated the amendment as private, and the bulk of its lenders have designated themselves as public, then you have a quandary because there aren't enough lenders to vote" on the amendment, says Gibson of 40/86.

When that is the case, banks end up calling investors individually to solicit votes-an interaction that the buyside says can cause confusion. In April, Six Flags Inc. was looking for approval of an amendment to its $1 billion credit facility that would expand its letter of credit capacity and permit a separate financing for its Montreal facility, allowing the company to have Canadian dollar-denominated debt. The company designated the amendment as private and posted it as such on IntraLinks, says James Dannhauser, Six Flags's chief financial officer.

Looking for approval from the majority of the Six Flag lenders, agent bank Lehman Brothers wound up calling investors to solicit votes, a practice market participants say is not uncommon. One "public" lender was told that while the amendment was marked private, it didn't contain any material information, and thus it was okay to receive. The lender found that advice confusing. "If it didn't contain material information in the first place, why not make it public?" the lender asks.

Traditionally, banks have used standard language regarding confidentiality agreements when they launch a syndicated loan deal on IntraLinks. But banks are starting to customize that confidentiality language. Bank of America, for example, is implementing changes to include the requirement that lenders designate a recipient either inside or outside the firm-an attorney, for instance-to receive private information from the borrower or agent, which would ensure that the bank doesn't have trouble getting approvals in the future. "We felt we needed to explicitly require each lender to declare that they would have the ability to receive all communications from the borrowers," says Alex Spiro, associate general counsel.

IntraLinks is also testing a feature with a handful of buyside firms that would provide greater visibility to compliance officers and counsel on activities within their firm. "We have seen a growth in the number of investment firms wanting the ability to monitor activity with regard to what specific individuals are looking at what documents," says IntraLinks' Fieweger. For those clients, IntraLinks is now providing daily reports on activity across the firm's user base. It is planning to offer this service to a much wider audience, perhaps as early as this year.

Definitions misunderstood

To further complicate matters, many investors get confused about the definition of materiality, and exactly what "public" information means.

While well defined in securities laws, in practice the interpretation of materiality is always subjective. "One never knows whether something is really material until it is challenged or disputed," says one credit investor. "What might affect the value of a security in one situation might not affect it in another. If I saw a company's projections a year ago, am I still private, or has that point passed?"

The securities laws define public information as that which is widely disseminated. But what constitutes widely disseminated? Consider the information coming out of a bank meeting, in which commercial bankers meet with investors to share information about a borrower. These days, it is standard practice to ask public investors to leave midway through the meeting so that syndicate-level information can be provided to private investors.

"Clearly, a lot of things happen after a bank meeting ends. Calls get made, and loans start to move in the market," Baum says. "Based on which direction trades are taking, it becomes rather obvious to public investors what is happening. That raises the question as to whether that information is then really public."

The permeability of some information walls is underscored by the fact that more companies are choosing not to provide as much information to private investors as they have in the past. Notes Gibson of 40/86: "Too often the information in a private' lender call got out on the press wires within 20 minutes. So companies are now erring on the side of not sharing as much information, even though it is supposedly to private lenders." Some companies are also further stratifying information disclosure, choosing to share the most private information with only the managing-agent level of banks, market insiders say.

The tension is that "everybody wants to be on the safe side," Gibson says. "Our policies prohibit me from acquiring or accessing certain information, so, if I am not sure, I am not going to open an e-mail, and if a company is not sure, it will mark that correspondence private. Each party is asking the other to make the determination, which in some cases is forcing everybody into inaction."

Six Flags' Dannhauser concurs. "We mark everything private because we'd be stupid not to," he says.

Street questions, too

Investors aren't the only market participants under fire. "To the extent that a bank participates in the CDS market and is an underwriter or lender to that same name, it presents a natural conflict and a potential regulatory concern," says Pimco's Dialynas.

"We are not aware of any specific situations of abuse, but it is certainly a question that people ask," Gibson says. And, says a hedge fund manager: "Many investors have lingering questions with regard to banks' behavior."

In October 2003, a consortium of industry associations led by the BMA put out a statement of principles and recommendations regarding the handling of material nonpublic information for the U.S. market. Among others, those best practices include establishing written and formalized policies and procedures, an independent compliance function, the physical and functional separation of departments, procedures for communications across Chinese Walls and for restricted lists, watch lists and trading reviews.

In part due to those best practices, investors say they have more confidence now that broker/dealers have adequate safeguards to prohibit the transfer of material nonpublic information from their lending business units to the desks that trade bank debt, bonds and credit derivatives. By and large, banks are also perceived to have walled off from lending their credit portfolio management activities, or those operations undertaken to offset risk in their loan portfolios.

But no single model is evolving. When the BMA guidelines came out, Gross says, "firms were debating whether their loan traders and credit portfolio managers should be on the public side or the private side of the wall."

Earlier this year, JPMorgan Chase moved its bank-debt trading operations to the public side of the house, an effort that could avoid the perception of wrongdoing. But the fact that Citigroup, an archrival in both loan origination and debt underwriting, has chosen to keep trading bank debt on the private side simply underscores how fluid best practices may be.

Gross says a universal bank "can be in compliance either way, but it needs policies and procedures for making sure it is not misusing material nonpublic information, as outlined in the 2003 paper."

That said, a proprietary trader working for a broker/dealer could very easily find himself in rough seas. For example, says one market participant, that trader might consistently work with a certain hedge fund, and might have a strong suspicion-from seeing the fund's participations in lending syndicates and subsequent trades-that the fund is acting on material nonpublic information. "The second the fund puts on a series of trades-say, buying a small piece of a loan and then buying protection on it-it has transferred that information" to the trader, says one market participant. The trader who then puts on the same trades as the hedge fund could be viewed as having violated antifraud provisions of the securities laws, lawyers say.

Warnings in Europe

The potential for mishandling private, price-sensitive information is also getting attention in Europe. In late April, European banking groups warned members dealing in credit derivatives to maintain strong Chinese walls between their lending and trading departments or potentially face insider dealing charges. In May, those banking groups-including the International Swaps and Derivatives Association, the Loan Market Association and the BMA-published a manual of best practices similar to those introduced in the U.S. 20 months ago.

As in the U.S., there haven't been any public cases of insider dealing in credit derivatives brought against European banks thus far, but the measure may not be totally pre-emptive. A report published earlier this month by two researchers at the London Business School concluded that over the past four years, price movements in the CDS market indicate that some banks could be misusing private information to take trading positions.

Richard Metcalfe, senior policy director and co-head of ISDA's European office, says the paper's particular emphasis is on credit portfolio management, "because that is where the nub of the issue is. Questions are being raised about whether banks in the lending business could gain some advantage that would ultimately aid their credit portfolio management activities."

The guidelines were triggered in part by the European Union's Market Abuse Directive, which goes into effect on July 1. The paper tightens the definition of insider trading in many European countries and explicitly brings credit derivatives into the regulatory regime. As it stands, insider trading laws in some EU member states do not extend to securities not traded on public exchanges, such as credit derivatives, Metcalfe says.

Ahead of the curve'

In 2004, the Securities and Exchange Commission is said to have conducted a sweep of the major universal banks, including Citigroup, JPMorgan Chase, UBS and Credit Suisse First Boston, with the aim of examining the way leveraged loans are traded. The questions raised in that sweep have subsequently shown up in routine examinations of other broker/dealers, sources say. The agency's continuing interest in this topic has spurred the loan industry to be very proactive in formulating appropriate internal policies and procedures to prevent misuse of private, price-sensitive information.

A spokesman for the SEC, following its customary practice, declined to confirm or deny any investigative actions.

The BMA guidelines, aimed at the broker/dealer community, are seen by some as a good start. Those recommendations suggest that Chinese walls should exist between the people who are privvy to inside information through the bank loan market and those who are trading the securities and credit derivatives, and that those policies should be very rigid. Gross, the BMA's regulatory counsel, notes that the October 2003 forum paper-formally released by the Joint Market Practices Forum-"had nothing to do with pressure from regulators and everything to do with staying ahead of the curve with regard to all the legal and reputational issues that arise when a bank hedges its credit exposure to a company that gives it nonpublic credit information, by trading securities and security-based derivatives of the same company."

Pimco's Dialynas is impressed with parts of the proposal. But he and others have criticized the BMA guidelines because they don't include a mechanism to ensure that the recommendations are being implemented. "That begs the question whether there was anything significant to come out of [the guidelines] in a real sense. The recommendation was quite good, but again, if there is no policing mechanism, and penalties are not well stipulated, then there is always the temptation to cheat."

As a trade association, the BMA does not see itself as having a regulatory role. "The law provides penalties for misuse of material nonpublic information," says Gross. "We don't need to."

Meanwhile, the Loan Syndications and Trading Association is in the midst of a confidential process to "determine what guidelines, if any, should be developed in the broader loan capital markets," according to spokesman Jon Teall. Because the association takes in all participants in the loan market, it has a tough, and possibly long, road ahead to build consensus among players with a disparity of interests.

Materials handed out in an April LSTA seminar on the subject outlined an ambitious goal: "to establish general standards of trading conduct that are applicable to all market participants in connection with all loan market activities."

Are loans securities?

Heightened regulatory oversight of hedge funds could put the brakes on some dodgy trading practices. In February 2006, the investment advisers to most hedge funds must register with the SEC. As such, at least in theory, the funds will be subject to a physical walkthrough once a year by an agency examiner. Among other things, says Baum, "that means the SEC will look through a fund's records to figure out whether the fund has given the best execution to its accounts. And it will look at basic documentation, to make sure they're trading properly."

And then there's the possibility that loans traded in the secondary market will be deemed securities, which would cut off the flow of private information to lenders. It's a possibility former SEC Chairman Harvey Pitt believes is sufficiently real-and told LSTA members as much at its annual conference in late October.

The Supreme Court has ruled that traditional commercial loans are not securities. But that decision was premised on a number of assumptions, one of which was that there was an alternative regulatory apparatus-the Fed and the OCC-to oversee commercial banks, which at that time held the loans, securities lawyers said.

Today, "the real question is, Are these loans really loans, or are they securities?'" says one securities lawyer. The types of loans that hedge funds and mutual funds buy-called B-term loans-are structured more like a bond than a loan, with a bullet maturity and minimal amortization schedule, of, say, 1% a year.

"When you look at a term loan B, you don't have the alternative regulatory scheme that you have with commercial bank loans, because you don't have commercial lenders, you have hedge funds, which are all lightly regulated," the lawyer explains. "So now you have a whole bunch of people who are basically high-yield bond buyers who are buying loans and high-yield bonds and effectively viewing them as fungible. Clearly, the question arises as to whether they really may be securities."

And that's an outcome, however unlikely, that the leveraged loan market will fight at any cost.

(c) 2005 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.

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FSA is not poised to support retail hedge funds
Thu Jun 16, 2005 4:41 PM BST

By Tom Burroughes

LONDON (Reuters) - Britain's Financial Services Authority is not poised to support freeing up direct mass market sales of hedge funds as some recent media reports have suggested, a senior FSA official said on Thursday.

The regulator is due to publish discussion papers next week about issues affecting the $1.0 trillion sector (550 billion pound), hoping to shape debate about these fast-growing funds, Dan Waters, sector leader for asset management at the FSA, told an Investment Management Association conference.

He said the FSA was not about to urge a change in the law allowing direct investment in hedge funds by the public.

"The first thing to do is correct the impression that the FSA has decided to open the door to retail investment in hedge funds," Waters said. He did not elaborate on which reports had suggested such a change was on the cards.

Present rules restrict hedge funds to institutions or wealthy individuals able to invest a minimum sum, typically of one million pounds.

Last September the FSA said it was considering hedge fund regulations following steps to free up laws in some other European nations,

Hedge funds have grown rapidly as investors have been attracted by these portfolios' ability to make returns regardless of market movements due to techniques such as short-selling. However, the sector has suffered weak returns in recent months.

The FSA is also carrying out a survey of prime brokers to understand their financial exposure to hedge funds, and also assess the impact of the industry on market stability.

Activities of hedge funds have become a political hot potato in countries like Germany, where there have been calls for tighter controls on these traditionally secretive institutions.
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Handbook flags directive’s impact on hedge funds

IPE.com 15/Jun/05: IRELAND – The European savings directive on the funds industry will have an impact on Hedge funds and hedge fund of funds, according to a handbook from Dublin- and London-based funds consultancy Carne Global Financial Services.

The directive is due to come into force on 1 July 2005.

“Many hedge managers have taken a view that the directive does not affect any hedge funds,” said Carne CEO John Donohoe. “This is not true.”

The handbook notes that, depending on their domicile, hedge funds may be directly or indirectly affected by the directive.

Hedge funds domiciled outside specified territories, for example Bermuda and the Bahamas, do not appear to benefit from the directive’s exemption of UCITS-type funds. Consequently, if they are held by EU-taxable individuals and involve a cross-border payment, for example a redemption payment by a paying agent within the specified areas, such a payment could fall within the reporting or withholding tax requirements if the fund breaches the various asset tests. “

It also lists other complications for hedge funds, including:
Hedge fund of funds may require asset tests from the underlying hedge funds regardless of the underlying funds’ domicile, so hedge funds domiciled in the Cayman Isles or Dublin may need to supply asset tests even though they may be outside the scope of the directive;
Asset tests may be very complex especially where leverage or derivatives are used;
Long/short funds can hold considerable cash, thereby affecting asset test;
Many hedge funds are administered in Dublin or Luxembourg resulting in the paying agent being based within the EU.

“It is imperative that managers understand their ultimate investor base and be able to look through nominee accounts where possible to determine any impacts,” said Donohoe. “Where a fund may be directly or indirectly impacted the manager should determine the need for investor communication and ensure full compliance with the directive.”

Copies of the handbook are available from John Donohoe at john.donohoe@carnegroup.com or on +353 1 489 6800.

American Banker: The Financial Services Daily
Greenspan: Giving Hedge Funds New Rules Won't Work
From:
Friday, May 06, 2005
By Barbara A. Rehm and Rob Blackwell

CHICAGO -- Federal Reserve Board Chairman Alan Greenspan warned bankers Thursday to demand more of their hedge fund customers, while U.S. Bancorp chairman Jerry Grundhofer warned against following nonbanks down a slippery slope to a pile of problem credits.

Mr. Grundhofer said competition for commercial credits is fierce, with hedge funds and other nonbank lenders making pricing irrational.

"There is margin compression everywhere," he said in a luncheon speech at the Federal Reserve Bank of Chicago's annual Conference on Bank Structure and Competition.

U.S. Bancorp accepts that and attempts to make up for lower rates with higher volume, he said, but that's "a tough call, a tough line to walk." U.S. Bancorp is trying not to "reach too far for marginal credit." But some nonbank rivals, including hedge funds, are not as disciplined, he said.

"Overall credit standards have deteriorated. Certainly pricing has, and we're starting to see problems with structure as well," he said in an interview after his speech. "They may be the smartest underwriters on Earth," he said of hedge funds. "We'll see who's right and who is wrong."

U.S. Bancorp is "trying to be aggressive on pricing, and get new business, but not fool around with" changes in loan terms and conditions, he said.

Mr. Greenspan said that banks had made "considerable progress" in strengthening oversight of their relationships with hedge funds since the fall of Long-Term Capital Management in 1998.

But he said a recent central bank study of banks' management of hedge fund credit risk found several "weaknesses."

"Competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds," Mr. Greenspan said. "The review suggests that banks and their supervisors need to be alert to the possibility that further slippage of credit terms could result in material increases in credit risk to banks, a material loss of market discipline on hedge funds, and a material increase in the potential for hedge fund leverage to adversely affect market dynamics."

Mr. Greenspan urged bankers to persuade hedge fund managers to provide more information about their portfolios, including "forward-looking measures of the risks that the funds are assuming."

"Most banks' policies," he said, "could be improved by the establishment of clearer and firmer links between credit terms and transparency."

Mr. Greenspan also urged bankers to aggregate stress-test results across hedge fund counterparties "to assess concentrations of exposures in volatile and illiquid markets."

However, Mr. Greenspan said he opposes ramping up regulation of hedge funds. Any additional disclosure requirements would be fruitless. "Most of the data would tell you their strategy of last night. This morning they would have a new one. It's their very nature to be innovative and ever-changing," he said during a question-and-answer session.

Speaking on other risks to the financial system, Mr. Greenspan said concerns that credit derivatives have transferred too much risk outside the banking system appear to be overblown.

There were $4.5 trillion of the derivatives as of June, and some experts have become concerned that losses to nonbank risk-takers could force them to liquidate their positions if credit spreads widen appreciably.

But Mr. Greenspan cited a study conducted last year by the Joint Forum that said the notional values of derivatives had "significantly overstated the amount of credit risk that had been transferred outside the banking system."

Mr. Greenspan also reiterated his position that the mortgage portfolios of Fannie Mae and Freddie Mac should be reduced.

But instead of recommending specific caps, as he has done in the past, Mr. Greenspan said he agreed with Treasury Secretary John Snow's recommendation that a proposed new regulator for the GSEs have power over the portfolios and get specific guidance from Congress on how to treat them.

"Specifically, the GSE should hold only the minimum level of assets needed to accomplish the primary missions mandated by their charter," Mr. Greenspan said.

Sensitive Boundaries
Goldman Faces New Tensions
In Trading, Serving Hedge Funds

Salesmen Both Advised Clients
Of Firm and Influenced
Its Own Bets on Market
Word of a Stock Sale Leaks
By ANITA RAGHAVAN
Staff Reporter of THE WALL STREET JOURNAL
June 6, 2005; Page A1

LONDON -- One day two years ago, as Goldman Sachs Group was readying a sale of millions of shares held by German industrial giant Siemens AG's pension arm, the stock started falling, suggesting that word of the deal had leaked. Early word of it would have given an investor valuable information that the stock was about to face downward pressure.

When Goldman investigated, it found that a managing director in its London office had tipped off an important hedge-fund client of the firm. While it didn't appear the tip had caused the stock's fall, Goldman fired the managing director.

The incident opened a window on new tensions inside investment banks as their business models shift. When stock markets are flush, as in the 1990s, big securities firms like Goldman rake in cash by underwriting numerous new stock offerings for corporate clients and collecting commissions from stock investors. The bursting of the stock-market bubble in 2000 hurt both of those traditional mainstays. Goldman and its rivals have since looked increasingly to other activities that could still offer rich profits.

One of these is playing the markets with their own money, known as proprietary trading. Another is serving the one set of clients that still provides lush trading commissions: hedge funds, or lightly regulated investment pools for institutions and the rich. In the increasing focus on these lines, new possibilities for conflicts of interest arise. The tensions are well illustrated at Goldman's stock-trading operation in London, which has been aggressive in pursuit of these activities.

Goldman hasn't drawn any regulatory flak for its practices here. But in some cases it has faced questions about its practices from within its own ranks. It also has discontinued some of them. Goldman says employee concerns weren't the reason, while adding that it always investigates such concerns.


A look at the London stock operation shows how the big securities firm has periodically reassessed its practices as it seeks to find the proper boundaries. "Changing market dynamics bring new challenges," says a Goldman spokesman, "and we are particularly mindful of the way in which we conduct business."

In 2002, the London office set up a small group of stock traders, taking proprietary positions, who sat near the salesmen and traders who handled transactions for clients. Many securities firms physically isolate their proprietary traders, to make sure they don't overhear clients' orders and take unfair advantage of the information.

Goldman, for a time, also gave this set of traders access to a computer system that showed client buy orders and sell orders. (Client names were usually omitted.) No rules bar such access. But some former Goldman traders and salesmen say this practice posed a risk that the traders would be tempted to jump in with their own orders ahead of clients. That could put the investment bank in the position of profiting from trades that in turn drive up the cost paid by clients.

"It's only logical that banks would use information they glean from clients such as trading intentions...to support their own proprietary-trading activities," says Richard Kramer, a former top-ranked Goldman analyst now at Arete Research in London. Indeed, he says, "we think proprietary trading could be the next scandal" in financial services.

In another move, Goldman allowed stock salesmen who gave investment ideas to an important hedge-fund client to contribute some of the same ideas to Goldman traders taking proprietary positions. Here, one concern was that Goldman and the hedge fund could benefit at the expense of less-favored clients who might be pitched these same ideas later.

In later discontinuing these practices, Goldman says it found no evidence its traders had acted improperly. It also said its reason for putting traders who took proprietary positions adjacent to salesmen wasn't to overhear client orders.

For hedge funds, Goldman and other major securities firms offer a wide array of services: executing hedge funds' many trades; lending them money; lending them shares to "short" when they want to bet on a stock to fall; sometimes investing in the funds; and providing them with research and investment ideas for sometimes-complex trades.

Wall Street and hedge funds "are feeding off each other -- the broker-dealer needs the order flow from the hedge fund and the hedge fund needs the information," says Matthew Nestor, a former Massachusetts securities regulator. Goldman got more than a third of its stock revenue last year by doing business with hedge funds, according to a Merrill Lynch & Co. analyst's estimate. Goldman has no comment on that.

At the forefront in nurturing Goldman's ties to hedge funds in London is Phillip Hylander, chief of its European stock-products group and head trader in Europe.

Until Mr. Hylander arrived at the London office in 2002, its top traders -- the people who actually execute trades -- shied away from speaking to clients during market hours. Client interaction was left to stock salespeople.

Direct trader-client contact is risky, says Gary Williams, who was Goldman's European stock-trading chief until the end of 2001. The reason is that each side often has information the other would like to know, but some of this may be confidential, such as how a competitor's deal is faring or insight into the placing of a block of stock. "Head traders are privy to information that neither clients nor those speaking to clients should know," Mr. Williams says.

But one of Mr. Hylander's strengths when Goldman hired him as a trading executive was his close relationships with hedge funds. Colleagues say they often heard him on the trading floor chatting with clients, using his cellphone. And after the botched 2003 stock sale for Siemens, Goldman investigated whether Mr. Hylander might have used his cellphone to tip a client to the impending sale. It concluded he hadn't.

Goldman says it's no longer out of the ordinary for traders, at Goldman or elsewhere, to talk to investment clients. "Our clients want to talk to traders to get a sense of the market," says J. Michael Evans, co-head of Goldman's global securities division. Mr. Hylander, for his part, says he talks to clients because "they demand it. It would be a mark against you if you didn't."

Mr. Hylander, 36 years old, was behind some of the proprietary-trading initiatives, such as setting up a small group of traders who sat on the mammoth stock-trading floor and made bets with the firm's own money. He encouraged stock salesmen to tell the proprietary traders if they had gleaned "useful information" from dealing with clients, according to three people familiar with the situation.

Asked about this, Mr. Hylander said, "There is a very pure reason for people to talk to each other, and that was the context for this remark." A Goldman spokesman, Lucas van Praag, elaborated, saying, "An important component of every broking business is open debate about investment ideas...internally with colleagues and externally with clients.... Needless to say, this sharing of information does not include anything price-sensitive or otherwise inappropriate."

This group of traders was known as the Risk Unit. Mr. Hylander says it had been set up not just to do proprietary trading but primarily to "manage franchise risk," and for that reason it needed access to client orders.

Still, the firm took away the Risk Unit's access to client orders in October 2003, a year after giving it access. Goldman did so to "avoid any perception of impropriety," its spokesman says. Several months later, in 2004, it closed the Risk Unit altogether. Mr. Evans says this was because "it wasn't making money."

Mr. Hylander also gave salesmen -- the people who pitch investment ideas to clients -- a say in investing a small amount of Goldman's own money. They could contribute ideas to proprietary-trading portfolios that bore their initials.

'I Just Tipped It'

One of Mr. Hylander's client relationships was with a London hedge fund called Marshall Wace Asset Management. Colleagues tell of hearing him chatting on the trading floor with a founder of the fund, Ian Wace. Mr. Hylander and Mr. Wace, through spokesmen, describe their conversations as infrequent.

Mr. Hylander set up one proprietary portfolio that traded in some of the stocks Goldman salesmen had recommended to Marshall Wace. The portfolio was called MW TIPS. After making a recommendation to the fund, a Goldman salesman would sometimes tell a proprietary trader what the recommendation was, saying, "I just tipped it," according to people familiar with the situation.

An arrangement like this can disadvantage other investors, says John Wheeler, head trader at the American Century mutual-fund family. "Any time someone you rely on to provide investment advice contributes to [proprietary] investments in similar securities, there is an inherent conflict," he says. One risk is that the firm would later promote the same stocks to less-favored clients -- whose subsequent buying would boost the value of holdings for the securities firm or its favored hedge-fund client.

Mr. van Praag, the Goldman spokesman, says the firm didn't "sequence our sales ideas" to favor any one client, such as Marshall Wace. He says Goldman required traders who'd been told of a recommendation to Marshall Wace to wait 30 minutes before making a trade for Goldman's account in the same security. One reason was to give clients time to act on the trading idea first.

He adds that there was no direct correlation, in either timing or the direction of trades, between ideas recommended to Marshall Wace and trades made in the MW TIPS proprietary portfolio. Indeed, the Goldman spokesman says in an email, at times a Goldman "salesman might have suggested MW buy the stock [and] our traders might have shorted it."

A spokesman for Marshall Wace says it "does not and cannot prevent or monitor securities firms trading on their own ideas."

One Goldman trader, Boris Pilichowski, complained of being uncomfortable trading for the MW TIPS account, say people familiar with the matter. Besides sharing the concern Mr. Wheeler describes, Mr. Pilichowski had an additional one: That some trades might be based on information about other clients' intentions. He suggested that ideas from salesmen be sent to traders electronically, creating a record of where they originated and forcing salesmen to be sensitive to any possible impropriety.

Mr. Hylander raised the trader's concerns with compliance officials. Goldman says it looked into them and found no evidence of any abuses. It also says it assured Mr. Pilichowski, who moved to Morgan Stanley this year, that he had total discretion about whether to do trades proposed by the stock salesmen.

Goldman didn't adopt his suggestion about sending ideas electronically. It disbanded the MW TIPS account in May 2004. One reason was a new United Kingdom rule that said ideas from salesmen could potentially be viewed as research, which securities firms generally can't trade on until it's published.

Another Goldman trader raised concerns about how the firm behaved when approached by an institutional client that wanted to buy or sell a basket of stocks. Such a client will often ask firms to bid to handle the deal, without naming the stocks or saying whether it wants to buy or sell. But securities firms can often guess, based on their knowledge of the client and on questions the client asks about a particular sector. The securities firms then sometimes quickly start loading up on -- or dumping -- the stock. The practice is known as "pre-hedging."

Goldman sometimes pre-hedges. It says it doesn't do so if clients object.

Last year, according to people familiar with the situation, Goldman trader Geoffroy Houlot told Mr. Hylander he thought pre-hedging hurt clients, because it could move stocks' prices before clients' trades took place. Goldman says Mr. Hylander raised Mr. Houlot's concerns with the compliance department, which found no impropriety. Mr. Houlot left to rejoin his old firm, Morgan Stanley, last year.

Following questions this year from The Wall Street Journal, Goldman retained a law firm to review activities of its London stock group. The law firm, Freshfields Bruckhaus Deringer, declines to comment.

Sale for Siemens

The loudest internal complaints concerned the stock sale for Siemens on March 18, 2003. Siemens had decided to sell 36 million shares its pension arm held in a firm called Infineon Technologies. Goldman's role was to buy the Infineon stock from Siemens in a block, unloading it to other investors later.

That morning, the two sides discussed a possible price in a moving market. But shortly before 3 p.m., with the sale approaching, Infineon shares started to slide. On the Deutsche Börse's electronic Xetra exchange, they traded around €7.55 at 2:52 p.m. By 3:39 p.m., when the sale was announced, they were down 5% to €7.15. The result: Siemens got several million dollars less than it had expected. Goldman itself lost millions of dollars, because after it had become the owner of the shares, they continued to decline.

Goldman later said in a regulatory filing that a managing director of the firm named Andrea Casati had alerted a client about the imminent offering. "We reviewed people's taped lines and discovered that he had shared this information with a client just before the trade was launched," says Goldman's Mr. Evans.

Yet he adds that the "conversation didn't seem to have had any effect on the price" of Infineon's stock. That left the cause of the drop still unknown. Goldman told regulators that the tip occurred less than two minutes before the Infineon sale, and that the client said it hadn't acted on the tip. The client, hedge fund GLG Partners, declines to comment.

Goldman discharged Mr. Casati, a top-producing stock salesman, for violating policy. It reported the matter to the U.K.'s Financial Services Authority and other regulators. Mr. Casati, now at UBS AG, declined several requests for comment on Goldman's account.

Cellphone Logs

Goldman says it investigated all involved in the trade, including Mr. Hylander, the top trader who often used a cellphone on the floor. A Goldman executive says there was "whispering, rumors of people pointing fingers at a number of people, including Phil, over this trade." The executive says the firm sifted through cellphone logs and other records and found "absolutely nothing" to suggest Mr. Hylander behaved improperly.

Mr. Hylander says that on the day of the Siemens deal he used his cellphone to talk to his senior management, not to clients. He and a Goldman spokesman say Mr. Hylander, far from tipping off an outsider who could profit from knowledge of the sale, urged that the sale be aborted when Infineon shares started falling.

The internal inquiry couldn't delve into stock-exchange records that would have pointed to who was selling Infineon shares at the time in question. Only regulators have access to such records.

One Goldman executive questioned whether the firm really did a thorough probe. Christian Meissner, concerned about Siemens's unhappiness with the stock sale, pushed for a fuller inquiry, says someone familiar with the matter. This person says Mr. Meissner -- then co-head of European stock capital markets for Goldman and now working at Lehman Brothers -- pressed Goldman's compliance department to examine cellphone records more carefully. The person says Goldman lawyers rebuffed Mr. Meissner and told him to let the matter go.

A Goldman executive acknowledges telling people inside the firm to "let it go," adding that "there was a lot of whispering and gossiping that I thought was destabilizing." The executive says the firm did a complete investigation, including a full look at mobile-phone records.

Actually, Goldman had a policy barring traders from using mobile phones to talk business with clients. Many firms encourage use of land lines, since their calls can be taped. After its inquiry, Goldman reiterated its policy against using mobile phones on the trading floor to talk business with clients. Later, it barred all use of mobile phones on the trading floor.

Mr. Hylander says he has a duty to lead by example, and is following the newest mobile-phone policy. Without that ban, he says, "we were putting ourselves in a place that we didn't want to be."

Write to Anita Raghavan at anita.raghavan@wsj.com1

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washingtonpost.com
Greenspan Sees Threat in Free-Trade Curbs
Fed Chief Also Warns of Possible Losses From Risky Trading Strategies

By Nell Henderson
Washington Post Staff Writer
Tuesday, June 7, 2005; D06

Federal Reserve Chairman Alan Greenspan said yesterday that recent efforts to restrict international trade and hinder free markets represent a "truly worrisome" threat to global prosperity.

He also warned that many hedge funds -- highly leveraged private investment firms -- are pursuing high-risk and complex trading strategies that could result in significant losses. He added that he did not believe those losses would be significant enough to pose a threat to broader financial stability.

Speaking via satellite to a bankers' conference in Beijing, Greenspan did not mention specifics. But his remarks come at a time of increasing tension between the United States and China over textile trade and China's unwillingness to let its currency's value fluctuate.

Greenspan warned that he and other economic policymakers cannot always foresee and prevent financial crises. The best insurance against such events is to promote financial "flexibility and resilience," he said.

Financial "flexibility" is Greenspan's shorthand for policies that allow free markets to drive the movement of prices, interest rates, currency values, labor and investment. Such policies have made the U.S. economy highly resilient, as was clear by the way it was able to absorb the shocks of the Sept. 11, 2001, terrorist attacks, he said.

Greenspan did not comment otherwise on the health of the U.S. economy or the likely path of the Fed's interest rate policy in coming months.

But he did express concern that the U.S. and global economies could be hurt by the movement away from financial flexibility. "The recent emergence of protectionism and continued structural rigidities in many parts of the world are truly worrisome," he said.

The Bush administration and the European Union, responding to a surge in Chinese textile exports, recently imposed new limits. Beijing responded by lifting textile export tariffs that it had earlier imposed on United States- and Europe-bound goods as a goodwill gesture.

Meanwhile, the U.S. and some European governments are taking an ongoing dispute over aircraft manufacturer subsidies to the World Trade Organization. And President Bush faces an uphill battle to win congressional ratification of his proposed free-trade agreement with Central America.

Greenspan didn't spell out what he meant by "structural rigidities," but many economists would point to China's currency peg as one obvious candidate. China maintains the value of its currency, the yuan, at 8.28 per dollar, a rate many U.S. manufacturers complain is too low, unfairly boosting Chinese exports in global markets.

The Bush administration has urged China to relax its peg, stepping up the pressure recently by threatening to brand Beijing a currency "manipulator" in the future if it does not do so.

Greenspan, responding to a question after his prepared remarks, said it would be "to the advantage of the Chinese to allow a little more flexibility in its exchange rate" and added, "I'm sure it's something they will take on reasonably soon."

He also indicated he hasn't found a convincing explanation for why long-term interest rates are so low globally. The Fed has raised short-term U.S. rates steadily for nearly a year, and long-term rates typically follow. This time they have fallen, a situation he said "is clearly without recent precedent."

"Yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasurys over the same period," he added.

Greenspan said this phenomenon has caused increasing numbers of investors -- often operating through hedge funds -- to take greater risks in their "search for yield," or efforts to make a bigger profit, he suggested.

"But continuing efforts to seek above-average returns could create risks for which compensation is inadequate," he said. Put more bluntly, "the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy."

But, he added, if banks and the others who lend money to hedge funds are managing their credit risks effectively, "this necessary adjustment should not pose a threat to financial stability."