Should hedge funds worry about porous Chinese walls?

Date: Tuesday, August 11, 2009
Author: Blogs.reuters.com

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.

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?