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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the SIA Compliance and Legal Division Member Luncheon


Annette L. Nazareth

Director, Division of Market Regulation
U.S. Securities and Exchange Commission

New York City, NY
July 19, 2005

Good afternoon. I am delighted to have been invited to speak at another SIA Compliance and Legal Division luncheon. I always welcome the opportunity to discuss the important work we all do to foster compliance in the securities industry. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.1

I thought I would touch on two issues today that may be of interest to you as compliance and legal professionals. The first issue is the age old one of conflicts of interest, and I will offer some insights we have gained through our meetings with firms that have conducted in depth conflicts reviews in their businesses. The second issue relates to emerging risk management challenges when conducting business with hedge funds.

Here in the U.S. we have one of the most robust capital raising and trading markets in the world. The strength of our financial system is attributable, in part, to the confidence that investors have in the fairness and integrity of our markets. It is not enough for broker-dealers to win a new account or garner the lead in an underwriting of securities. Rather, broker-dealers and all market participants must not only earn their customer's trust initially, they must maintain and tend to the investors' trust every day.

The securities industry is fraught with conflicts of interest. Conflicts of interest, when left unaddressed, threaten to undermine investor trust in broker-dealers and confidence in the fairness of our markets. Securities market participants must consider their internal processes and businesses and develop a long-term systematic approach to addressing and resolving conflicts. Many of you, as compliance or legal officers, are well-positioned to observe your firm's daily business dealings and witness first-hand potential conflicts of interest as they may arise. In addressing potential conflicts, you must remember, as compliance and legal officers, that you also serve several masters. You serve the firm, which looks to you to protect its most valuable, albeit off-the-books assets, its reputation; but you also serve the investor, who makes investments based on his or her trust in the firm.

As you all know, in response to a series of scandals in our industry that called into question the vigilance of fines in addressing conflicts of interest, Commission staff called upon financial services firms to undertake a top-to-bottom review of their business operations. Many firms undertook a conflicts review and more than a dozen made presentations to the Commission staff describing their findings. The reviewers, a combination of in-house counsel and compliance personnel, outside counsel and consultants, examined business lines and current compliance policies, and conducted extensive interviews with personnel at all levels of the organization. Through this internal review process, the firms sought to identify significant risks and develop a better understanding of their businesses, thus heightening awareness of potential business conflicts. I cannot over-emphasize the need for firms to continually review their operations for conflicts. The costs of these exercises pale in comparison to the reputational loss and potential fines and settlements associated with a failure to address conflicts of interest.

I'd like to elaborate on a few areas of conflicts that broker-dealers and their affiliated asset managers described in their presentations and where, I believe, conflicts of interest continue to exist. How each firm specifically addressed these conflicts, of course varied, depending upon its specific internal business structure. I present these today to encourage you to review and consider these issues within your own firm's business and internal control structure.

Proprietary Trading

When a financial services firm trades both as agent in facilitating customer orders and as principal for the firm, conflicts of interest may arise in several ways. Obviously, a firm's proprietary desk trading ahead of pending customer orders is probably the first conflict of interest that comes to mind. But the firm may also trade ahead of soon-to-be-released research reports, and/or trade on the basis of knowledge about a customer's portfolio of securities or future underwriting deal. How could these breakdowns occur? Even when a firm is employing customary internal controls, has established information barriers, employed restricted and watch lists, ensured physical separation of research from trading desks and from investment banking, trained its employees and conducted supervisory reviews of front running and employee trading ahead of desk trading and research reports, still instances were found in which information barriers were breached and conflicts occurred. In some instances, the mere inquiry by a research analyst of trading desk personnel about market color, market sentiment, supply, prevailing prices or relative value of an issuer's security could tip off traders, who then may either inform the proprietary trading desk or trade on the information themselves. In other instances, confidential customer information could be overheard because the securities firm's agency and proprietary traders were located side-by side. Elsewhere, the proprietary trading group had access to systems or otherwise received distributions of, say, the equity products group's daily P&L data, which divulged securities positions and trading activity. Where firm personnel identified these problems, the firms took targeted action to bolster information barriers, block access of certain business groups to confidential information in databases about positions held by customers or the firm, and reaffirm, in word and deed, a culture of compliance where individuals who misuse the trust of the customer and firm alike, shall be identified and disciplined.

Fixed Income

Conflicts of interest in the fixed income area, while similar to conflicts arising in trading, research and underwriting of equities, differ in some ways because of the very nature of fixed income itself and the manner in which it trades. These differences, therefore, have led firms to tailor internal processes and controls specifically for fixed income to effectively address the conflicts. There are, indeed, some key differences in fixed income such as: (i) the content of fixed income research, which often focuses on macroeconomic trends and issuer's debt capital structure; (ii) the manner in which fixed income products are priced - on the basis of spreads to treasuries, which reduces the likelihood that issuing research will materially impact the price of individual securities; (iii) the existence of credit rating agencies and sources other than securities firms that provide independent information to the market about the credit worthiness of debt securities and issuers; (iv) the fact that underwriting of debt often involves an auction process rather than traditional book building; and (v) the fact that institutions play a dominant role in the market for fixed income securities.

This being said, the trading desk for fixed income instruments still is a fertile venue for market sensitive information. A critical aspect to understanding any fixed income issuance is to know the issuer's ability to service its debt as well as to maintain current coverage ratios. For non-investment grade companies, the ability to project future revenues, cash flow and earnings are equally relevant. At any financial services firm, then, various groups within the firm, particularly sales and trading personnel and research analysts, gather, synthesize and interpret prevailing market information. This information may include yields, spreads and data concerning comparable fixed income securities, in order to determine valuations of and pricing information for many debt securities. Fixed income trading requires a wealth of information and continuous analytic support of trading desk operations in order for traders to perform executions, make markets, and provide liquidity and information flows in an open and fluid manner on and near the trading desk. This means that firms and compliance staff must structure and supervise fixed income operations with great care, in order to permit the necessary information sharing to take place, without breaking down the information barriers needed to preserve customer and proprietary confidential information.

Indeed, firms we spoke to observed that preserving information barriers was a primary concern and source of conflicts in the fixed income area. Because of the interaction of research, sales, trading, and banking, confidential information may get shared, providing firms or their personnel with opportunities to trade ahead of customers, research or the proprietary desk. While physical separation of these groups is useful, more needs to be communicated by compliance and legal staff about limiting what can be said by research or banking personnel in the presence of traders and vice versa. Moreover, firms may consider that when such personnel must be on the trading desk to offer trade ideas or insights on an issuance to a counterparty, that these conversations occur in a segregated space on the desk, so that only the necessary participants converse and otherwise may not overhear other activity or trading interest taking place at the desk. Further, supervisors should be observant at critical locations, such as trading desks, and closely review trading activity reports and firm surveillance for signs of front running and other inappropriate practices.

Many of the conflicts I have spoken of today are not new, but the manner in which they arise may be novel as industry products and services change and new participants enter the markets. It is incumbent on legal and compliance officers at broker-dealers, investment advisers and other industry participants to be aware of industry trends and then look carefully within their firms - at their firms' business practices, their internal controls and policies - and promptly resolve actual and potential conflicts that arise in the ordinary course of their business.

Broker-Dealers and Hedge Funds: Risk Management Challenges

I would like to shift gears now and discuss another topic - prime brokerage for hedge funds. This is an issue that I think it well worth legal, compliance, and risk operations personnel at firms to consider in light of their current risk management practices. Prime brokerage is a fast growing, and highly lucrative, business for broker-dealers. At a time when profits from secondary trading have been squeezed of late, the spread prime brokers earn on lending money and securities to hedge funds is substantial. The rise in prime brokerage has also been propelled by the proliferation in hedge funds and growth in assets under management, which now tops $1 trillion. However, hedge funds could not successfully execute their investment strategies without prime brokers lending them securities and capital. The two, prime brokers and hedge funds, are inextricably related.

Hedge fund prime brokerage business is highly competitive. As a result, prime brokers now offer an ever expanding list of services to capture new hedge fund business or expand existing relationships - for example, by helping managers raise capital through introductions with potential investors, and even providing office space, phones, data feeds and trading systems. These ancillary activities present numerous conflicts of interest. For instance, prime brokers have knowledge of hedge funds trading, strategies and positions, that could be misused by the prime broker. Also, making capital introductions may appear as if the prime broker is recommending the hedge fund to the potential investor when it, in fact, is not. Also prime brokers will benefit from the growth of hedge funds that it recommends (or may be a direct investor in the fund), which is likely not known by the prospective investor.

Prime brokerage also poses some considerable risk management issues for the prime brokers. As new entrants into the prime brokerage space compete aggressively with incumbent firms, such intense competition may foster an environment within prime brokers where the exercise of prudence, particularly in their risk management practices, is secondary to gaining or maintaining market share.

These firms are always vulnerable to decreases in their primary businesses, such as equity and debt trading. And most material risks at securities firms arise from large exposures to fairly standard products. Even small changes in relevant risk factors for these products can have a major impact, for instance where firms are structurally long investment grade spreads (through cash and derivatives instruments) and long mortgages. However, securities firm relationships with hedge funds pose altogether different risks and therefore risk management challenges.

The hedge fund industry has seen enormous net cash inflows, which in part has attracted new managers to start up new hedge funds. With so much cash available, hedge fund managers, and particularly inexperienced managers, may invest in asset classes outside their area of expertise and consequently distort market fundamentals, for example, in the credit trading market. Their presence, in turn, may squeeze margins of the more established players in the market and lead to additional drift in investment strategies. At some point, either because of an event in the markets or substantial losses at hedge funds, the trend will reverse. With assets flowing out of hedge funds, the parties left standing, that is, the broker-dealers, will likely have legal exposure and suffer reputational damage. This may also come at a time when smaller institutions and retail investors, often the last to participate in a new product, will have invested substantially in hedge funds.

Certain trading strategies followed by hedge funds are difficult in terms of measuring risk exposure. For several years, convertible arbitrage was a predominant trading strategy that has since waned as volatility in equities has fallen to historically low levels. What has emerged are trading strategies involving positions in multiple asset classes, such as capital structure arbitrage. For prime brokers, strategies that span multiple asset classes pose significant systems challenges for measuring and offsetting risks of different types. In addition to new investment strategies, hedge funds participation in new products has fundamentally affected the market for these products, and turns conventional wisdom about risk exposure in these products on its head. One example of this is energy, where the high volatility in the markets for oil, natural gas and electricity has attracted hedge fund investment. The entry of hedge funds, which cannot take physical delivery and have limited capacity to hold positions in the face of losses, has contributed to dramatic spikes in front month energy contracts, the most liquid contracts in these markets that should experience less volatility. Observers note that the statistical properties of returns in these markets has changed, as evidenced by several "thirteen sigma" moves in energy markets over the last year, that once were estimated to have a probability of occurrence of zero. This in turn poses risk management challenges to, and has caused losses at, some broker-dealers who trade actively in energy.

Another development posing risk management challenges is that hedge funds not only interact with brokers as prime brokerage customers, but also as a counterparty in OTC derivatives transactions. Broker-dealers, then, increasingly have counterparty credit exposure to hedge funds. Hedge funds can achieve the same leverage through derivatives as they do through margin. This trend, termed synthetic prime brokerage, may potentially displace the broker-dealer's relationship with the hedge fund from the prime broker business unit most familiar with evaluating hedge fund credit risk and making margin determinations to other business units within the firm. Broker-dealers should carefully integrate their risk management practices across business units to avoid undue risk exposure arising from counterparties strategizing how they transact with broker-dealers to avoid margin or collateral requirements.

Similarly, fund of funds offer additional opportunities for hedge funds to leverage. The leverage, both at the fund of fund and hedge fund, is generally not transparent to the investor. Also, the lock-up periods for fund of fund investments in other hedge funds typically are shorter than lock-up periods for direct investments in hedge funds. The combination of added leverage and shorter lock-ups could lead to rapid withdrawal of assets from other funds or a class of assets, should fund of funds experience outflows. This dynamic occurred in late 2004, when convertible arbitrage lost favor and assets flowed from convertible arbitrage funds. Where liquidity issues arise in markets or with market participants, broker-dealers must ensure that they maintain enough of a cushion that permits them time to evaluate the market and sell, if needed, into a declining market.

The size and market activity of the hedge fund industry is a force risk managers at broker-dealers and other market participants cannot ignore or treat lightly. Risk managers must understand the scope of the firm's relationship across business groups (and even affiliates) to assess their risk exposure. Risk managers also must observe the trends in the markets and create risk management policies to protect the firm against risk, particularly where markets show signs of fundamental change and market participants are vulnerable. Finally, while broker-dealers should strive to learn as much about their counterparties as possible, given hedge funds' lack of transparency, broker-dealers must ensure that they obtain the appropriate margin to cover current and potential exposure, particularly if the counterparty is a weak credit.

I hope my remarks today focus your attention on identifying and managing emerging issues in the areas of conflicts of interest and risk management and provide some insights into promoting a culture of compliance in your organization. The Commission staff remains committed to helping you address these challenges.

Thank you.



Modified: 07/21/2005