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Nazareth Discusses Conflicts of Interest and Risk Management at SIA Luncheon

Annette Nazareth, the director of the SEC's Division of Market Regulation, reviewed some of the conflicts of interest that firms have reported after conducting in-depth reviews and some of the emerging risk management challenges in the hedge fund industry in recent remarks to the Securities Industry Association. The securities industry is fraught with conflicts of interest, she said. If left unaddressed, these conflicts can undermine investor trust and confidence in the fairness of the markets, she said. Nazareth 's written remarks were posted on the SEC's Web site.

Nazareth described the conflicts that broker-dealers and their affiliated asset managers revealed in presentations to the SEC and urged others to review and consider the issues in their own firms' internal control structures. One area in which numerous conflicts may arise is where a financial services firm trades both as agent in facilitating customer orders and as principal for the firm. Nazareth warned against trading ahead of the publication of research reports or trading based on knowledge about a customer's portfolio securities or a future underwriting deal. She noted that even a simple inquiry by a research analyst about the market, prevailing prices or the value of a security could tip off traders who may use the information for trades.

Nazareth added that confidential customer information could be overheard where agency and proprietary traders are located next to each other. In some instances, the proprietary trading group may have access to the equity product group's data on securities positions and trading activity. Firms must construct information barriers to block access to confidential information and should identify and discipline any individuals who misuse the trust of the customer or the firm, she said.

Conflicts in the fixed income area differ somewhat because of the manner in which it trades, according to Nazareth . Firms must tailor their internal processes and controls specifically for fixed income to address those key differences, she said. The trading desk for fixed income instruments is a fertile area for market-sensitive information, she explained. Firms and compliance staff must structure and supervise fixed income operations so that the necessary information sharing occurs without eliminating the information barriers that are necessary to preserving customer and proprietary confidential information. Nazareth added that the preservation of information barriers is a primary concern and a source of conflicts in the fixed income area.

Nazareth noted that many of the conflicts that she addressed are not new, but the manner in which they arise may be novel as industry products and services change and new participants enter the markets. Compliance officers must be aware of industry trends and promptly resolve any conflicts that may arise in the course of their business.

Nazareth said that her second topic, prime brokerage for hedge funds, merits legal, compliance and risk operations personnel to consider in connection with their risk management practices. The hedge fund prime brokerage business is highly competitive, she said, and prime brokers are offering an ever-expanding list of services to capture new business or to expand existing relationships. These ancillary activities present numerous conflicts of interest, she said, as well as considerable risk management issues.

Prime brokerage firms are vulnerable to decreases in their primary businesses, according to Nazareth , such as equity and debt trading. Most material risks arise from large exposures to fairly standard products, she said, so even small changes in relevant risk factors can have a major impact. Prime brokerage firms' relationships with hedge funds pose different risk management challenges, she said. Hedge funds' participation in new products has fundamentally affected the market for these products, she advised, which can also affect broker-dealers that trade those products.

Nazareth noted that hedge funds interact with brokers as prime brokerage customers as well as counterparties to OTC derivatives transactions. Broker-dealers increasingly have counterparty credit exposure to hedge funds. Nazareth said that broker-dealers should integrate their risk management practices across business units to avoid undue risk exposure arising from counterparties strategizing how they transact with broker-dealers to avoid margin or collateral requirements.

The size and market activity of the hedge fund industry cannot be ignored, according to Nazareth . She said that risk managers must understand the scope of the firms' relationship across business groups and affiliates to assess their risk exposure. Risk management must create policies to protect against risks where the markets show signs of fundamental changes and market participants are vulnerable.

Finally, Nazareth said that, given hedge funds' lack of transparency, broker-dealers must have the appropriate margin to cover current and potential exposure, particularly if the counterparty is a weak credit.