Hedge Funds - Big Brother is Watching

If doubling the tax rate for carried interest was a blow to private equity funds, now it is hedge funds turn with the FSA announcing that it is launching a formal 'assessment' (code for 'investigation') into the system hedge fund managers have in place to guard against market abuse. This after an initial review showed that some managers don't have adequate controls.

This review lead the FSA to be 'disappointed' with some companies internal controls and said that market abuse training, in some cases, was 'non-existent'. This review took in smaller firms and larger firms alike and is has prompted a wider initiative by the FSA to ensure good practices are developed within hedge fund management companies.

"We will be following up with the firms visited and are also launching a program of visits to a wider cross section of (hedge fund managers) over the coming months to formally assess their market abuse systems and controls," the FSA wrote in its markets division's monthly newsletter.

The FSA has wide reaching powers which can included sanctions on firms, expulsion or even legal action.

The review comes after the FSA found that nearly one-quarter of U.K. takeover deals were preceded by possible insider trading in 2005, the most-recent period studied, though there is little to suggest that hedge fund managers are more likely to engage in insider trading than any other market participant.

"Some (hedge fund managers) had a high level of awareness and appropriate controls in place, whilst others were less aware, had fewer controls and demonstrated a complacent attitude to the risks," the FSA said.

This latest initiative by the FSA is due to a growing belief by regulators that insider trading is rife in the markets present both in the UK and US.

In March, the SEC caught a 14-person insider-trading ring that netted more than $15 million in profits and included a UBS research executive, a Morgan Stanley compliance lawyer, a Bear Stearns stockbroker, three hedge funds and a day-trading firm. In May, the SEC froze brokerage accounts owned by a Hong Kong couple it accused of turning an $8 million profit on Dow Jones & Co. shares after allegedly receiving insider information on News Corp.'s $5 billion offer for the group.

To catch rogue traders, regulators and banks increasingly are employing technology, such as complex event processing (CEP) and remote-control software, to monitor insider trading.

Investment banker Hafiz Naseem's last move before boarding a plane from Pakistan back to his Madison Square Park office in New York was to take out his Blackberry and, just like millions of users worldwide, add a telephone number to his contact list. What Naseem didn't know was that the move, like every single keystroke on his mobile device and laptop, was being monitored and logged in real time by an FBI agent back in the U.S.

When the 37-year-old banker landed in New York, he was arrested on insider trading charges in what proved to be the culmination of four months of investigation harnessing both traditional methods and new technology.

We have said it before on this blog, the regulators are getting tough and are probably being backed by a political will to catch the big guys. Someone's scalp will be on the mantle of an ambitious politician soon, we are sure of it.

What of the algorithmic traders? Although a technological Bermuda Triangle myself, others in the industry are not so unskilled. Looking at charts and market movements in securities with the benefit of hindsight, it is fairly easy to spot inside trading patterns, but what of those computer trading programs that search out these anomalies and benefit from that trading pattern. In other words computer programs that are specifically geared to spot insider action and trade on it? Is that market abuse?

I understand that it is. Spies on your Blackberry, keystroke finders on your laptop and computer systems seeking out computers systems... It is all getting a bit 1984 for me.. and I don't mean the dodgy hair do's and the fluorescent socks, more an Orwellian nightmare.