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Money managers under the microscope

Should hedge funds worry about porous Chinese walls?

August 10, 2009

Nowadays most hedge fund managers who use leveraged trading strategies such as relative value to exploit pricing inefficiencies employ multiple prime brokers.

If you ask them why, they will generally answer that, post Lehman, having multiple prime brokers is seen as a fundamental part of managing counterparty risk.rtxdru2_comp

However, many hedge funds, especially the high-frequency traders who have come under the spotlight recently, already used multiple prime brokers before the collapse of Lehman.

But two years ago, hardly any of them mentioned counter-party risk. It was almost a non-issue, since virtually no one was expecting a major bank to go down the tubes.

At that time, the most common explanation for having multiple prime brokers was that “we don’t want one broker to know all our trades”.

But why? There is by law a Chinese wall, or a series of them, between a bank’s prime brokerage and its proprietary trading desk.

Surely the hedge funds know that? So the question of the bank’s prop desk potentially front running their trades should not arise, should it?

So why were, and are, some hedge funds anxious to ensure no single prime broker can keep tabs on all their trades? Are they worried about Chinese walls being porous?

Comments

Which law demands chinese walls, why would it not be possible from a legal point of view to combine prop and PB business – besides the ovious reasons of client confidentiality?

Posted by AMW | Report as abusive
 

There are chinese walls between the businesses because otherwise the prop traders could see the order book of the prime brokerage, which would be an enormous advantage for the prop traders as compared to the brokerage’s clients.
In simple terms, if you see a pile of sell orders in the prime brokerage waiting to be executed, it gives you a good idea of which way the market should go, right?

 

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