Are Your Secrets Safe?

A shift in banks' business model raises questions about conflicts.

The most direct way to regulate hedge funds would be to require them to register with the SEC, as other asset managers must do. The SEC, of course, tried that tack, but was recently stymied by a federal appeals-court decision that held that it was invalid. Chairman Christopher Cox is still formulating a countermeasure. The SEC is the default authority when insider trading is alleged by securities dealers, but concerns about insider trading among hedge-fund advisers don’t seem to be pressing.

An indirect way of preventing hedge fund managers from hurting a bank’s clients is for the Federal Reserve to require at least commercial banks to track and disclose more about their relationships to hedge funds. That type of oversight also makes sense from a macroeconomic perspective, say some, since hedge funds bear so much of banks’ risk and could create a widespread meltdown if they failed along with the banks. “It behooves the lender of last resort to have firsthand knowledge of what’s going on at the institutions that would be at the heart of a crisis,” says Tom Schlesinger, executive director of the Financial Markets Center, a Fed watchdog group.

But the Fed, so far, has shown little interest in getting involved with hedge funds. “Broadly speaking, the best way to make sure hedge funds are not taking excessive risks or excessive leverage is through market discipline,” such as having banks police them and limiting who can invest in them, Federal Reserve Board chairman Benjamin Bernanke told a House committee in late July.

Most other Fed governors agree. One, Randall S. Kroszner, believes commercial banks “are much more aware” of the counterparty risk and that hedge funds are less leveraged after the infamous 1998 meltdown of Long-Term Capital Management.

What You Can Do

Given the resistance at top levels, it’s unlikely that fast action from the government will help keep deals fully under wraps. But there are some approaches CFOs can take now to limit exposure. “At the end of the day, it’s the company’s responsibility to monitor what happens as they bring someone under the tent,” says Freescale treasurer Heinlein.

Number one, experts say, is to build relationships with a few select banks and to be loyal to them. “If you can minimize the number of banks you’re working with and the number of accounts you have, there’s less potential for leakage to happen,” says Dan Carmody of treasury consulting firm TreaSolution Inc. Others suggest finance executives find out how much revenue the bank derives from non-investment-banking activity, and consider using boutique investment banks that focus more narrowly on deals. Heinlein also recommends using commercial banks whenever possible “to help keep the investment banks honest,” since their clients typically do not include hedge funds.

The second key ingredient in keeping secrets secret is to closely track movements in stock, bond, and credit-derivative prices. “Private-equity and hedge funds can always trade in an offsetting product, so that is always a risk,” says Heinlein. “On the other hand, the company always has a right and even an obligation to sniff that out.” He tracks Freescale’s credit-default swaps in part to look for suspicious activity and in part to see how efficiently the company’s bonds are trading.

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