Hedge funds entering credit-default swaps need to investigate whether commercial bank counterparties could have inside information through their lending business, according to lawyers. The problem, said lawyers, is hedge funds sell credit protection based on publicly available information, while commercial banks may have inside information.
Citigroup has settled Securities and Exchange Commission charges it reduced its exposure to Enron by buying default swaps while having knowledge--through its role as underwriter of Enron's debt--that the Houston-based company would have problems meeting debt payments. Yet many hedge fund compliance officers still do not perform due diligence in this area, said Walter Pollard, partner at Goodwin Procter in Boston. Pollard said he had seen cases in which compliance officers had "absolutely no idea" if the bank had a relationship with the entity whose debt underlay the CDS transaction.
Pollard, who has negotiated credit-default swaps on behalf of hedge funds, said if compliance officers see documentation for CDS trades, it is their job to follow up to assure there are no relationships that might be exploited for insider information. By doing so, hedge fund compliance officers provide a valuable service to their firm, said Pollard.
"Banks are sensitive to these issues and have in place controls that were reinforced in an initiative completed last October, in which [the International Swaps and Derivatives Association] and its members participated," said Bob Pickel, ceo of ISDA. Louise Marshall, ISDA spokeswoman, said the NASD issued a report on the retail side of the bond market business in September, which focused in part on the interrelationship of the bond and credit derivatives markets. The report states, "market forces were already improving the initial areas of concern."
