Citigroup May Move Prop Traders to Hedge Funds for Volcker Rule

Paul Volcker, former chairman of the U.S. Federal Reserve
Paul Volcker, former chairman of the U.S. Federal Reserve, testifies at a Senate Banking Committee hearing in Washington. Photographer: Joshua Roberts/Bloomberg

Citigroup Inc. may move a team of proprietary traders into its hedge-fund unit, one of at least three alternatives the U.S. bank is studying to comply with the Dodd-Frank Act, people briefed on the matter said.

Traders in the Citi Principal Strategies unit, led by Sutesh Sharma, would be reassigned to Citi Capital Advisors, which mostly oversees money for outside investors, said the people, speaking anonymously because the talks are preliminary. The bank would set up the traders as hedge-fund managers and seed their funds, then raise money from outside investors to redeem its stakes, the people said.

“This may be a way of keeping a high-margin capital- markets business in the fold, within the language of the law,” said David Hendler, a senior analyst at New York-based research firm CreditSights Inc. “They would be transforming it from an-interest-plus-capital-gain business into a fee business.”

Citigroup and Goldman Sachs Group Inc. are among U.S. firms grappling with provisions in the law signed last week requiring banks to stop using their own money to wager on securities and markets. The changes were advocated by former Federal Reserve Chairman Paul Volcker, who said banks supported by federal deposit insurance shouldn’t be allowed to speculate.

Fraction of Revenue

Many banks say proprietary trading is a fraction of their total business and that most trades are done on behalf of customers. Such trading accounted for about 2 percent of New York-based Citigroup’s total 2009 revenue, or about $1.6 billion, a person close to the bank said in May. New York-based Goldman Sachs has said it gets about 10 percent of its revenue from proprietary trading.

The traders make money from returns on the stocks and bonds they buy. Hedge funds do so by charging investors fees.

Under another scenario considered by Citigroup, members of the Principal Strategies team would be distributed across the bank’s main client-facing trading operations based on their specialties, the people said. For example, proprietary traders who specialize in stocks in specific industries would join the single-stock trading team, one of the people said.

Danielle Romero-Apsilos, a Citigroup spokeswoman, declined to comment.

Citigroup’s trading chief, James Forese, is among executives trying to gauge whether proprietary traders, many of whom came from hedge funds and enjoy their independence from client duties, would be willing to return to the main trading desks, the people said.

Dorfman, O’Brien

The executives are also evaluating whether the proprietary traders have strong enough records to entice outside investors, the people said. Citigroup would need the outside money to redeem its stakes because the Volcker rule prohibits banks from holding more than 3 percent of total investor contributions in any given hedge fund.

Sharma, who’s based in London, has discussed options with Jonathan Dorfman and James O’Brien, who co-head the Citi Capital Advisors unit, one person said. Citi Capital Advisors oversees about $14 billion.

Traders within Principal Strategies have been briefed on the options, another person said. They include members of a stock-trading unit known as the Long-Short Equity Group. Earlier this year, the unit’s former leader, Matt Carpenter, and a dozen proprietary traders quit rather than wait for the Volcker rule-mandated changes.

In 2007, Goldman Sachs started a hedge fund with about half of the members of its Goldman Sachs Principal Strategies team, which trades stocks with the firm’s own money. That fund, Goldman Sachs Investment Partners investors, remains with the bank and is housed in the money-management division. Some traders who stayed in the principal-strategies unit, including Pierre-Henri Flamand and Ali Hedayat, left Goldman Sachs earlier this year.

Operations Under Review

Lucas van Praag, a spokesman for Goldman Sachs in New York, declined to comment on whether the firm plans to turn its prop traders into hedge-fund managers.

“Given the changes coming to financial regulation, we are as you would expect reviewing those operations likely to be affected,” van Praag said.

The Dodd-Frank law allows banks at least four years to bring their proprietary trading into compliance, with a potential extension of as many as three years, according to a timeline prepared by Davis Polk & Wardwell LLP, Citigroup’s lead outside law firm.

While the extensions might push full compliance to 2017, giving the banks time to evaluate options, Citigroup wants to settle its plans for the Citi Principal Strategies unit before traders get nervous and look elsewhere for employment, the people said.

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