Banks and brokerages may have heightened their exposure to hedge-fund problems by engaging in a common Wall Street practice: copying the trading of influential money managers.
The practice, known as parallel trading, has received fresh attention following the crisis at Long-Term Capital Management LP, the high-profile hedge fund that had to be bailed out by 14 banks and brokerages last month.
Analysts say banks and brokerage firms that execute trades for prominent managers like Long-Term's John W. Meriwether often mimic the managers' strategies in trading for their own portfolios.
By following Long-Term Capital's strategies, these observers say, banks and brokerages may have realized losses similar to the hedge fund's on their proprietary trading desks.
"If a customer comes in with a big trade, if the trade makes sense, you might put some of your own capital into it," said the head of trading for a major European bank. "Information is the key to the business, and if a guy like Meriwether is doing something you pay attention."
The impact of parallel trading on the 14 banks and brokerages that are bailing out Long-Term Capital could not be learned. But experts say the practice can be troubling for both hedge funds and the firms that trade for them.
"It does create a nasty correlation between a firms' proprietary market bets and its credit exposure to its hedge fund clients," said Jim Wiener, a senior consultant firm Oliver Wyman & Co. in New York. Soon "everybody on the Street has the big idea and it causes real problems when you have to liquidate that idea."
In the case of Long-Term Capital, consultants say, banks and brokerages made similar-but not the same-trades as the hedge fund, or used trading models built to mirror Long-Term Capital's.
For instance, if Long-Term placed an order to sell Russian bonds as part of a pattern of selling emerging market debt, a trading desk might do the same. Or it might institute a strategy designed to lower the offer price of its Russian and emerging-market securities.
The results could harm the traders and the funds, Mr. Wiener said, adding that both may end up getting a lower price for their positions. Even if traders do not sell, their positions could become devalued in the market.
Ronald D. Reading, a managing vice president with First Manhattan Consulting Group and a former currency trading manager at Chase Manhattan Corp., said using order flow information is a common practice on Wall Street. A desk could make parallel trades within minutes of receiving an order from a client.
"You use that information to get out of the way," Mr. Reading said. "You're going to use that information to liquidate that position to not get hammered. It's a matter of shifting your book around during day-trading to go with the tide.
"Market information is massively important if you're a market maker," he added.
Greenwich, Conn.-based Long-Term Capital was rescued two weeks ago in a bailout brokered by the Federal Reserve Bank of New York. A consortium of financial services companies infused a combined $3.5 billion to avoid the fund's collapse, in return for a 90% equity share in it.
The consortium's oversight committee includes David Rogers of Goldman Sachs & Co.; Conrad Volstad of Merrill Lynch & Co.; John Fullerton of J.P. Morgan & Co.; Brian Leach of Morgan Stanley, Dean Witter & Co.; Richard Stuckey of Travelers Group Inc.; and Michael Allen of UBS.
Mr. Wiener said he believes that banks could have avoided some of their trading losses associated with Long-Term Capital by testing their portfolios to see how they would respond in turbulent markets.
On Friday the chairman of UBS and three of its top UBS executives resigned from the giant Swiss bank, citing the $696 million in third- quarter losses related to the hedge fund debacle. (See related story on page 5.) Mr. Wiener said most senior banking executives were unaware of their firms' trading practices.
"If they had known the big risk, some banks would not have been making big proprietary bets on Russian bonds," he said. "What's needed is a greater level of transparency between the trading floor and senior managers."