Since federal investigators stunned Wall Street by raiding three hedge funds and issuing subpoenas to several others in 2010, all eyes have been on SAC Capital, the $14-billion hedge fund accused this week of insider trading on an unprecedented scale.
The hedge fund has defied investment gravity since it was founded by its star trader, Steven Cohen, in 1992, regularly generating 30-per-cent annual returns and confounding financial theories about the efficiency of markets.
Mr. Cohen also cultivated an interest in modern art, turning heads as he built a stunning collection of work by Picasso, Pollock and Monet to hang on the walls of his $25-million mansion in Greenwich, Connecticut.
Yet Wall Street has a vested interest in SAC beyond the spectacle of its fall from grace. The rapid-fire trading style used by Mr. Cohen turned SAC from a little-known trading house into a hedge fund with offices around the world and more than 1,000 employees – and a prodigious payer of trading commissions to banks.
Such clout made the 57-year-old a feared and admired presence on the trading desks of investment banks, known for his relentless desire for an investment "edge" – the most up-to-date information that would keep him one step ahead of the market – but also a valuable one.
At times responsible for whole percentage points of the daily volume of stock trades made through the New York Stock Exchange, SAC has paid out billions of dollars to the banks and brokers of Wall Street.
Yet the government is now seeking as much as $10-billion in penalties and disgorged profits from the hedge fund, according to people familiar with the matter. SAC said in a statement it had "never encouraged, promoted or tolerated insider trading and takes its compliance and management obligations seriously."
The Securities and Exchange Commission is also seeking to bar Mr. Cohen from managing money for other people as part of a civil action accusing him of failing to supervise his portfolio managers. Mr. Cohen, who has not been charged criminally, has denied any wrongdoing.
SAC's general counsel, Peter Nussbaum, entered a plea of not guilty on behalf of the hedge fund and its units in court on Friday morning. In a document signed "Steve" by Mr. Cohen, he authorized Mr. Nussbaum and Thomas Conheeney, SAC's president, to act on behalf of the hedge fund.
Now that SAC may be forced to hand back its outside capital and operate as a family office, the question is what impact its diminished size would have on the rest of the industry.
Banks that provide credit and trading facilities through their prime brokers to SAC were this week assessing their counter-party risk to the hedge fund, deciding whether to keep it as a client.
Some executives said they had instructed risk management staff to examine derivatives exposure to the hedge fund to determine whether SAC's cash pile was sufficient to safeguard against any potential losses and decide whether it was a riskier credit, potentially pushing up the hedge fund's cost of borrowing. One said the indictment would make it "difficult" to continue providing services to SAC. Others said they had not decided whether it was a red line.
Prime brokers provide the capital that allows hedge funds to leverage their bets. But their most lucrative function is to funnel business to trading desks in other parts of the bank, structure complex derivative positions and lend investors securities to sell short.
Hedge fund assets are far smaller than those of pension funds and other institutional investors, but they make up for that in activity. Brad Hintz, an analyst at Bernstein Research, estimates that hedge funds account for about 25 to 30 per cent of commission revenue paid to banks and brokers, and he says "the lead prime broker would expect to get 25 to 30 per cent of a hedge fund's commission dollars."
According to people familiar with SAC, the fund would typically add two times leverage to its $15-billion of capital, giving it about $45-billion of trading firepower.
SAC has a wide range of prime brokers and bank counterparties, including Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co. and Deutsche Bank AG, which all declined to comment.
However, before the criminal case was announced prime brokers had played down the impact of the fund's assets shrinking from $14-billion to a likely floor of $9-billion, the capital controlled by Mr. Cohen and his staff.
Since the financial crisis, when many hedge funds found they had assets trapped in Lehman Brothers, the bankrupt investment bank, the largest of them have divided their trading among several prime brokers.
Hedge funds routinely fail or shrink, even at the top end of the scale. For instance, Paulson & Co. has seen its assets under management halve from more than $36-billion to $18-billion after huge losses in 2011. Upstarts take their place. "Every year you get a $1-billion client who appears out of nowhere," said one prime broker.
Even if some banks desert SAC, its business is likely to find a home. "There may be nervous prime brokers who would not want to associate with him, but I'm sure he could find a prime broker to trade his capital," said Martin Skylar, a lawyer for Kleinberg Kaplan.
Indeed, a bigger challenge for Wall Street has been the overall reduced appetite for risk-taking since the financial crisis.
Hedge funds, at the insistence of their institutional investors, now park spare capital with custody banks rather than prime brokers. They have also had to act like more staid institutions, as pension fund clients have pushed them to hire a phalanx of compliance staff and administrators.
Even SAC, where the government alleges that compliance programs "failed to detect or thwart insider trading", had hired 10 compliance officers by the end of 2008 as part of an effort to shore up its reputation, and now boasts a team of 38.
Preet Bharara, U.S. attorney in the Southern District of New York, issued a warning on Thursday: "To all those who run companies and value their enterprises, but pay attention only to the money their employees make and not how they make it, today's indictment hopefully gets your attention."
With prosecutors using the techniques of mob investigations, such as wire taps, to search for those pushing the boundaries too far, the message has sunk in. "Nobody wants to be in the position that SAC has been in for the last three years," said the general counsel of another large fund.
Since the start of 2010, hedge funds predominantly trading equities have delivered cumulative profits to their investors of only 14.5 per cent on average, during a period in which returns from the U.S. stock market were 55 per cent.
Lower investor profits mean fewer assets to put to work, less trading, risk-taking and money to go around. Wall Street may eventually mourn the fallen power of one man, if SAC is mortally wounded, but its greater loss is the freewheeling culture that prosecutors have decided is typified by Mr. Cohen's firm.