ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

15
Since the hedge fund’s gain or loss under the option was determined by the gain or loss in the
managed account, as long as the bank executed all of the trade orders made by the hedge fund as
the Investment Advisor, the value of the holdings in the managed account would match and
cover the cost of any gain due to the hedge fund when the option was exercised. 42 Both
Deutsche Bank and Barclays told the Subcommittee that they always executed the trades directed
by the hedge fund acting as the Investment Advisor to ensure sufficient funds to pay off the
option when exercised and to ensure the banks remained economically neutral with respect to the
trading activity conducted by the hedge fund, acting as both Investment Advisor and option
holder. 43
In addition, in many of the basket options examined by the Subcommittee, the option
buyer, the hedge fund, paid a cash premium equal to about 10% of the funds intended to be
invested from the managed account and the bank then provided financing for the remaining 90%,
charging interest on the funds provided by the bank. In other words, if the hedge fund paid a $1
million premium into the basket option account, the bank could deposit another $9 million into
the account, giving the hedge fund, as Investment Advisor, a total of $10 million to invest, while
charging interest on the $9 million loaned to the account. This financing arrangement greatly
increased the amount of funds that the hedge fund, as Investment Advisor, had available to
invest. It also magnified the potential investment profits or losses from the managed account.
Upon exercise, the hedge fund benefited from the option if the value of the securities in
the managed account increased during the option period, while its risk of loss was limited to the
amount of the premium it had paid to the bank. In other words, to continue the earlier example,
if the account began experiencing losses, the hedge fund’s losses would be limited to the $1
million premium it had deposited into the account. In contrast to the hedge fund which
conducted the trades and benefited from the resulting profits or losses, the bank benefited from
the option transaction primarily from fee revenues generated from the financing and trading fees
it charged to the option holder for the trading activity in the managed account. The bank also
benefitted from the revenues generated from its ability to lend out securities contained in the
managed account.
The hedge fund also supposedly benefited from a certain amount of compensation paid
by the bank for performing investment advisory services for the managed account. That
compensation in at least one case was substantially below the standard hedge fund fees charged
in the market for years, presumably because the hedge fund was investing on behalf of itself and
the Subcommittee that, “as a first order” he assumed that “they [the banks] hedged every single transaction.”
Subcommittee interview of Peter Brown, RenTec (6/3/2014).
42 According to RenTec Co-CEO Peter Brown, the option was a “delta 1” option, meaning that its value perfectly
tracked the value of the underlying assets. Subcommittee interview of Peter Brown, RenTec (6/3/2014). Barclays
risk management personnel also confirmed that this was a “delta 1 option” and explained to the Subcommittee that
basket options did not pose either “market risk” or “credit risk” for the banks. Subcommittee interview of Lansford
Dyer, Barclays (4/3/2014). In addition, Barclays represented to its regulator, the Financial Services Authority, that
the COLT structure “does not give rise to market risk within Palomino Limited. As such it is equivalent to a
forward sale.” 12/19/2005 “Collected documents submitted to the Financial Services Authority relating to Project
COLT,” produced by Barclays, BARCLAYS-PSI-005215, at 260.
43 See “Renaissance Technologies: MAPS Restructuring Highlights,” prepared by Deutsche Bank, RT-PSI-
00068592-599, at 594; Subcommittee interviews of Eamon McCooey, Deutsche Bank (5/2/2014) and Martin
Malloy, Barclays (5/1/2014). See also Subcommittee interview of Jonathan Mayers, RenTec (5/28/2014).