Renaissance Technologies LLC’s desire to limit market risk drove it to use financial products now under scrutiny by a U.S. Senate panel for their potential tax benefits, said co-Chief Executive Officer Peter F. Brown.
The products also let the hedge fund borrow more money to bet on stocks, Brown said at a hearing today held by the Senate Permanent Subcommittee on Investigations. A report by the subcommittee said the instruments may have helped Renaissance avoid more than $6 billion in taxes.
“The world is littered with financial institutions that failed after putting too much trust in their models,” Brown said. “We are determined that Renaissance not suffer such a demise. The barrier options we use provide precisely the protection we need.”
The computer-driven trading firm routed more than $34 billion in profits through financial products known as basket or barrier options, the subcommittee said. The panel said Renaissance contended the profits from most of the options could be taxed at a preferential lower rate.
Renaissance’s Medallion fund bought the options from Barclays Plc (BARC) and Deutsche Bank AG (DBK) over the past 14 years. The options provided Renaissance with profits from a basket of securities owned by the banks. The banks paid Renaissance to manage the securities.
If the options were held for more than a year, Renaissance would pay taxes at the preferential lower rate on long-term capital gains, even when the options’ value was linked to millions of rapid trades in the basket of securities.
Under current law, profits from short-term capital gains are taxed at marginal federal rates of as much as 44.4 percent, compared with a 23.8 percent top rate for long-term gains. For some earlier years, the rates were 35 percent and 15 percent.
Compared with a prime brokerage account with a bank, the options offered two main benefits, Renaissance said today in a separate statement. It could get more borrowed money, or leverage, from the banks to bet on stocks, Renaissance said, and its losses were limited to the up-front purchase price of the option.
“These go hand in hand, because when trading with leverage, a single mistake can be disastrous for our firm,” Brown said.
Brown said he learned a lesson in market risk in March 2000, during a stock-market rout driven by the collapse of technology stocks.
“In a very short period we took very large losses,” he said. “Not having slept for days and being incredibly distraught by the losses, I offered to resign, but my boss at the time rejected my offer, telling me, ‘You are now far more valuable, because you now know never to put your full faith in a model.’”
Renaissance’s Medallion fund, with more than $9 billion under management, uses computer algorithms to identify small discrepancies in markets and profit from them. The fund is open almost exclusively to fund employees.
Renaissance was founded by the mathematician James H. Simons, whose fortune is now estimated by Bloomberg Billionaires Index at about $15.5 billion.
Brown became co-CEO with Robert L. Mercer in 2010 after Simons retired and became non-executive chairman. Before joining the firm in 1993, he was a language-recognition specialist at International Business Machines Corp.
In other testimony before the panel today, Barry Bausano, the co-head of global prime finance at Deutsche Bank, said his bank’s products weren’t tax-motivated and that it stopped selling versions that offered potential tax benefits after the IRS publicly challenged them in 2010.
Gerard LaRocca, Barclays’s chief administrative officer for the Americas, said his bank made that decision in 2013. It’s still not certain that the law doesn’t allow the tax benefit, LaRocca said.
Barclays decided to stop selling the options because they didn’t meet the “expectations of the relevant taxing authorities,” he said.
LaRocca said Barclays continues to have three options with Renaissance that were created before the policy change and that have potential tax benefits. Asked by Levin why Barclays doesn’t unwind the trades, he said the bank hadn’t considered doing so and would “take that under advisement.”