Over the wall

Chinese walls: they sure don't make them like they used to. At one time, a single decree was all it took to begin construction of a wall hundreds of miles long to defend China's Qin empire against the warring Mongols to the north. Yet, two millennia on, some financial institutions seem unable to put up even a plasterboard Chinese wall to halt flows of sensitive market information.

Hedge funds are now at the centre of the debate over just how seriously investors are taking the issue of insider trading. In September 2006, the US Senate brought together regulators, brokers and investors at a special hearing to ask how widespread the problem had become in the financial markets. And, although leadership of the judiciary committee passed to the Democrats this January, the topic remains at the top of the agenda with some pushing for a clampdown.

The UK Financial Services Authority (FSA) has also voiced its concern about insider trading. The regulator's asset management sector leader, Dan Waters, told an audience of fund managers in Hong Kong in October that the FSA believed "some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation".

Indeed, the FSA's victory against GLG Partners, a London-based hedge fund, and its former director Philippe Jabre in August 2006 has been perceived as a sign that the supervisor is taking the issue seriously. The UK regulator levied fines of £750,000 against both Jabre and GLG for market abuse. The case was portrayed as an important step towards cleaning up the markets - although some say the FSA's fines were too small to act as any serious deterrent to insider trading.

The case goes back to 2003 when Jabre was 'wall-crossed' on February 11 in a telephone conversation with Goldman Sachs regarding a new issue of convertible preference shares from Japanese banking group Sumitomo Mitsui Financial Group (SMFG). Goldman had been to trying to gauge - on a purely restricted-information basis - how the new offering might be priced. Jabre was warned of the confidentiality of this information at the outset of the telephone call, and of the fact that he would not be able to trade on any securities in the company after being party to the confidential information.

But, over the subsequent three days, Jabre short-sold ordinary shares in SMFG as part of an investment strategy for GLG's market-neutral fund. Six days after the initial phone call, on February 17, the Japanese financial company announced its decision to the markets and, over the next few weeks, the company's share price fell by almost half, from Yen403,000 on February 12 to Yen206,000 on March 11 (see figure 1).

The FSA said that Jabre had traded improperly on this knowledge, and he was charged with committing market abuse under Sections 66 and 123 of the Financial Services and Markets Act 2000.

Loan origination

One particular area of concern recently has been that of loan origination. Originally the domain of investment and regional banks, hedge funds have become more active over the past year, with many now originating their own loans to investment- and sub-investment-grade corporates. The non-banking sector accounted for around 60%-70% of deals in 2006, compared with around 30% the year before. Funds have been tempted in by returns of up to Libor plus 300 basis points and a relatively stable credit environment.

But the way in which loans are negotiated and structured mean that originators are often privy to market-sensitive information. That is because - as part of their loan applications - companies habitually provide non-public data on intra-reporting-period financial performance, business plans and up-and-coming deals. Such non-public information could, in theory, be used to make profitable insider trades in the equity and credit markets.

"Despite the fact that a lot of work has been done in this area to tighten up procedures, there are some out there who are willing to ignore the compliance issues just to make a quick buck," one London-based investment bank loans trader told Risk.

Obligation

Traditionally, banks have been obliged to set up procedures to manage such conflicts of interest as a matter of course. Under the FSA's Principles for Business, it is clearly stipulated that a regulated entity must "manage conflicts of interest fairly, both between itself and its customers and between a customer and another client".

So seriously do regulators take this that banks have been fined, not because they have been guilty of trading on inside information, but because lapses in risk management could have led to this - as happened to Morgan Stanley in June 2006 when it was fined $10 million by the US Securities and Exchange Commission (SEC). The dealer was charged with failing "to maintain and enforce adequate written policies and procedures to prevent the misuse of material non-public information, commonly referred to as inside information", which included monitoring the trading accounts of its employees.

The majority of hedge funds, however, are not under the same regulatory obligations to have specific compliance procedures in place and are not monitored by regulators over the quality of their controls. That's because they remain outside of the jurisdiction of national supervisors. Instead of being guilty until proven innocent (as in the case of Morgan Stanley), dealers complain that hedge funds have the luxury of being innocent until proven guilty.

Nonetheless, some of the larger funds are beginning to take the issue of compliance more seriously. Some managers have set up internal Chinese walls to restrict information, separated trading rooms, restricted access to parts of the building via the use of key passes, and have set up dedicated computer servers, telephone lines, fax machines and legal compliance procedures to ensure those involved in trading public securities do not receive sensitive information from other non-public parts of the business.

Oak Hill Capital Partners, a Connecticut-based investment vehicle, is one fund that has set up new compliance procedures because of possible public-private conflicts. The investment company manages $20 billion of capital through its subsidiaries across a variety of asset classes. The fund originates loans and has portfolios covering the equity and credit markets - areas that throw up potential conflicts of interest were the firm to receive non-public information on a company in its investment portfolios.

"We take a very conservative approach," says one source at Oak Hill, who asked not to be identified. "We haven't even tried to put up a Chinese wall. Instead, if anyone receives any non-public information, we just restrict everyone."

If the fund receives non-public information, managers are not allowed to trade on securities in the relevant company until the material becomes public. So as not to affect current investments, the fund will not take non-public information on a company in which it has securities outstanding.

But, despite the efforts of some funds, recent reports indicate that the problem of insider trading is more acute than ever - and hedge funds are being fingered as the main culprits. A report from measuredmarkets.com, a Toronto-based website that offers equity price-monitoring tools, alleged in August last year that some 40% of scrutinised US mergers with a value of $1 billion or more in the 12 months to July 2006 had indicated "deviant trading behaviour", which included credit default swaps (CDSs) jumping up in the days before an offer had been announced - a possible indicator of insider trading.

Regulator involvement

Even some within the fund community have begun to call for greater oversight to prevent front-running in the credit derivatives market. "You have to be shocked at the speed CDS prices move in advance of an announcement of a company event. It has become the market that moves first, even ahead of the equity markets," said Bart Broadman, founder and head of Singapore-based hedge fund Alphadyne Asset Management, speaking at the second annual Asia Risk conference in Hong Kong in November. "There may be no Eliot Spitzer for the credit markets, no overarching regulator, but front-running or potential insider trading is going to get a lot of scrutiny."

Indeed, regulators have been talking more urgently about the need to clamp down on insider trading. The problem is that these cases rarely lead to a prosecution. Figures obtained by Risk from the Federal Bureau of Investigation (FBI) illustrate that despite the alleged prolific nature of insider trading, US authorities have not found it easy to bring any prosecutions.

Generally, the SEC refers insider-trading cases to the FBI for prosecution and, although the number of referred cases did increase by more than a quarter between 2004 and 2005 (see figure 2), the ratio of convictions to cases has remained steady over the past five years, at around one conviction for every four referrals to the FBI. The FBI's record against those it eventually decides to charge is good, however, and in 2005 won all 19 cases.

May 2006 saw one high-profile success case. Hillary Shane of the hedge fund FNY Millennium Partners paid a $1.45 million fine in May for trading in a security - CompuDyne Corporation - that she had previously received insider information on through a call about a proposed private placement.

The difficulty is bringing these cases to the prosecution stage. "Insider-trading cases are rarely proved with a smoking gun," Ron Tenpas, Washington, DC-based US associate deputy attorney-general, told the Senate hearing in September last year. "These cases almost universally turn on circumstantial evidence and insider traders frequently proffer a number of alternative explanations for their conduct. These cases are difficult and risky, and the investigations are often protracted and complex."

In particular, regulators have been fighting an uphill struggle to analyse trading patterns on the platforms they oversee. That is because of the sheer amount of data that needs to be analysed: the New York Stock Exchange alone has seen the number of daily executed trades grow from around one million in 2000 to six million by the end of 2005, in part because of an increase in the use of algorithms that spot minute arbitrage positions in such markets.

The migration of hedge funds into new asset classes has brought an added challenge. The capital markets are being redefined, with directional bets taken by fewer and fewer investors. Instead, hedge funds are employing more complex strategies, such as volatility trading and capital structure arbitrage.

Dealers have expressed the difficulty of analysing market behaviour using traditional proxies because of these newer strategies. That poses the question: if the markets are becoming less and less predictable, how can regulators spot extraordinary and possible insider trades?

Building a case

"It is important to understand how difficult it is to build an insider-trading case," says Linda Thomsen, director of enforcement at the SEC in Washington, DC. "They are unquestionably among the most difficult cases we are called upon to prove and, despite careful and time-consuming investigations, we may not be able to establish all of the facts necessary to support an insider-trading charge."

The lack of litigation has led to some hedge funds becoming complacent about compliance - something they themselves readily admit. The worst of these are the smaller firms, where managers have to weigh up compliance costs against the perceived protection this might bring, with the result that too little attention is spent on establishing Chinese walls.

"The smaller players may not have such adequate compliance resources," says Ian Mason, a partner at the London-based law firm Barlow Lyde and Gilbert, and former head of the wholesale group in the enforcement division of the FSA until 2005. "Often, they just try to externalise the problem through a compliance consultancy firm and, although that can be effective, senior management need to be responsible day to day. Some just outsource without top management actually taking on responsibility."

Sources say these smaller funds are balancing the probability of a case being brought against them - and if it is, the low fines that have been levied so far - with the perceived high costs of introducing new compliance procedures. This cost analysis is prompting some to feel that it's worth the risk.

However, while many funds would be able to stomach a fine of the same proportions as GLG, the reputational risk involved is prompting others to take a similar approach to Oak Hill - trying to avoid public-private conflicts in the first place.

"For us, it just isn't feasible to set up Chinese walls," says James Starky, chief legal officer at London-based Cairn Capital. The $17.6 billion fund concentrates on opportunities in the credit market and has been active in the collaterised loan obligation (CLO) area. Managing both public and private information in a fund the size of Cairn - which employs around 30 people in a single open-plan office - would be nigh on impossible, says Starky. Instead, a decision is taken on a name-by-name basis whether the fund wants to remain entirely public.

"If we go private on a name, we go private across the firm; if we decide we want to stay public, then that's across the firm too," he says. "For one, our traders on the hedge fund sit next to the portfolio managers who might be ramping up a CLO and we've just taken the view that given that physical proximity we can't have Chinese walls. But, even if we moved people to the other side of a wall, we still don't believe it would be an effective Chinese wall."

The system can be constraining, admits Starky. The fund sometimes decides not to get involved with a certain CLO because that would involve going entirely private - but he believes that, rather than shutting out opportunities, not having a Chinese wall actually adds value because colleagues can bounce ideas off each other without fear of wall-crossing.

However, those funds without compliance policies in place are leaving themselves open to regulatory scrutiny - and that could seriously put their reputations on the line. The thinking at some dealers is that the smaller funds that are choosing to operate on both the public and private sides of the market - whether they are actually acting illegally or not - would not have the risk infrastructure in place to convince regulators of their innocence should it be alleged that they have performed an insider trade.

Some funds could be opening themselves up to the risk of regulators misinterpreting a seemingly overly successful trade - or of a competitor possibly implicating it in unfounded allegations of insider trading. That could spark a flurry of investor capital walking straight out the door.

"You don't want you name plastered across the front page of the newspapers," says Starky. "Even if you can sit there and say that you are innocent, you just don't want that kind of thing to happen. You don't want that kind of publicity, and we can't take that kind of risk."