Dear derivatives traders: the SEC is watching you

Robert Khuzami, the SEC’s resident bulldog and chief of enforcement, had a warning for participants in the derivatives market on Monday.

As Bloomberg reported:

“The days of insider-trading scrutiny being focused almost solely on the equity markets are now gone,” Khuzami said today at a New York legal conference on hedge-fund regulation. After bringing its first insider trading case tied to credit default swaps in May, the SEC will “roll back the curtain on those markets and look at patterns across all markets,” he said.

The US regulator launched its first-ever insider trading investigation focussing on credit default swaps in May 2009; that case, which is ongoing, involved a (former) portfolio manager at Millennium Partners, a salesman at Deutsche Bank and VNU, the Dutch media conglomerate.

The SEC’s track record of investigating insider trading in non-equity markets is less than stellar, as the exhaustive document dump of exhibits relating to the Bernard Madoff Ponzi scheme made clear. Two of the exhibits — 15 and 18 — released by the Office of the Inspector General for the SEC were particularly interesting, in that they implied the SEC’s investigators hadn’t the slightest understanding of how the options market worked.

But recent hires by the regulator suggest it is working hard to improve the quality of its talent pool, at least as far as derivatives expertise is concerned. In November alone, the SEC has retained the services of Richard Bookstaber – former risk manager, congressional expert witness, author of “A Demon of Our Own Design” and occasional FT Alphaville panelist — and Adam Glass.

Mr Glass was, until October, co-head of Linklater’s US structured finance and derivatives practice. Both he and Mr Bookstaber will be at the SEC’s freshly-minted division of risk strategy and financial innovation. That unit was established in September, and is helmed by Henry Hu, a law professor who knows a thing or two about derivatives.

While that’s quite a lot of brainpower, the success or failure of the SEC to (criminally) prosecute insider trading will ultimately hinge on its ability, working in tandem with the US Department of Justice, to convince jurors of wrongdoing. It is worth recalling the recent and embarrassing failure of the SEC’s brethren at the DOJ to secure any convictions for two former Bear Stearns fund managers accused of, among other things, insider trading.

The world of derivatives is considerably less shadowy and opaque than it used to be, but it is still a complex one, replete with a dizzying array of acronyms. How jurors will respond to the SEC’s lawyers attempting to explain the concept of credit default swaps and why a spike in CDS prices might represent dodgy dealings is anyone’s guess.

FT Alphaville would like to suggest they stick to the clearest, plainest of English, make copious use of charts and avoid any references at all to basis points. Just don’t call it the derivatives for dummies approach – or at least, not out loud.

Related links:
Insider trading scandal
– FT
3Com Trades Before Hewlett Bid Said to Spur SEC Probe (Update1) – Bloomberg

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