Another Sell-Side Conflict: Tipping Off Hedge Fund Clients

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New York, NY – In recent years, sell-side investment banks and brokerage firms have been accused of mishandling various conflicts of interest that plague their business, including providing optimistic research in order to win lucrative investment banking business and enabling their proprietary trading desks (and favored clients) to front run their own reseach reports.

However, in the past few months a new conflict of interest concern has arisen — that of investment banks tipping off important hedge funds with knowledge of large customer trades to curry favor with these profitable clients.

Historically, some mutual funds have complained that investment banks and brokerage firms were using information about their clients’ trading activity to help them generate exhorbitant profits from their proprietary trading desks — a practice known as “front running”.  However, some suggest that investment banks have begun to leverage their knowledge of client trades in different way.

In fact, in January of this year, the Securities Exchange Commission initiated a broad-based investigation into this issue when it sent out letters to a number of Wall Street investment banks, including Deutsche Bank, Merrill Lynch, Morgan Stanley, and UBS, requesting a great deal of data about their clients’ and their own trading activity for the last two weeks of September, 2006.

Experts suggest that this request is not part of a specific SEC investigation into the problems at any one firm (or group of firms), but rather it is part of a process to better understand the relationships hedge funds have with their brokers, and to see if those contacts could have led to insider trading.  In other words, the SEC is trying to identify patterns that could point to potential leaks of insider information.

The move by the SEC in January is also a reaction to complaints the regulator has received from some mutual fund managers.  These mutual fund firms explain that this information leakage is hurting them as these hedge funds’ trading is negatively impacting the prices their funds receive on those trades.

Unfortunately, obtaining concrete evidence of this type of “insider trading” activity is extremely difficult to find — particularly if the hedge fund uses information of a large trade to conduct a trade away from the source of the information.  It becomes even more difficult to detect if the hedge fund uses the inside information by placing a trade using derivatives instead of cash securities.

The concerns over the misuse of customer trade information to benefit hedge fund clients has arisen as these opaque investment pools have grown in size and profitability.  Hedge funds are often an investment bank’s most profitable clients given the sheer volume of commission business they do (some estimates put hedge fund volumes at 30% to 40% of the average daily trading volume on many major exchanges).  In addition, these firms also generate profit for a bank through their borrowing and financing activity.

Of course, the hedge fund industry has argued that they have been unfairly characterized by the insinuations that they are involved in insider trading.  Indeed, a cynic might conclude that the complaints by the mutual fund industry could either be “sour grapes”, or a way to excuse their consistent under performance when compared to their hedge fund competition.

However, mutual fund executives explain that their concern over insider trading by hedge funds has arisen because the increase in the number of hedge funds, and the rapid influx of money into these funds in recent years, has made it extremely difficult for hedge fund managers to make money without access to sensitive information.

As a result, some mutual fund professionals have begun to openly question the rather cozy (and profitable) relationship between hedge funds and the investment banks and brokerage firms that support them.

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