BlueCrest Capital Management was, in the early 2010s, one of Europe's largest hedge fund firms, with assets approaching $40 billion. The snag - the flagship fund, BlueCrest Capital International ("BCI") - was not performing well. What may well have been the reason? Well, unknown to investors, many top traders in the firm had been transferred from BCI to a proprietary trading fund accessible only to insiders, BSMA - or the BlueStar ("BS") Master Account.
The SEC's Order lists a lengthy series of decisions by the BlueCrest's senior executives which benefited BS: aside from transferring traders to the proprietary BS vehicle, the SEC states that BlueCrest replaced some of that trading capacity in BCI with an automated algorithm, called Rates Management Trading ("RMT"). RMT was not only inadequately disclosed, but persistently generated negative tracking error as compared to "live trades".
Are you sitting comfortably? Then, per the SEC:
- BS was launched in October 2011 with initial assets of $500 million. These assets were 93% owned by the senior management of BlueCrest who sat on the firm's Executive Committee, or ExCo.
- On launch, BlueCrest transferred 6 traders from BCI to trade 100% for BS, hence transferring their trading (and profits) from external investors in BCI exclusively to the house BS vehicle.
- After BS’s launch, BlueCrest continued transferring high-performing Rates and RV traders from BCI to BS, and assigned many of its most promising newly hired traders to BS throughout the Relevant Period (October 2011-December 2015) while others went to BCI. From October 2011 through June 2015, BlueCrest reassigned 21 Rates and RV traders from 100% BCI to 100% BS; split the capital allocations of 5 Rates and RV traders, who previously traded only for BCI, 50:50 between BCI and BS; and allocated 21 newly hired Rates and RV traders, who were eligible to trade for BCI, exclusively to BS.
- Meanwhile, BlueCrest replaced traders transferred from BCI to BA with a new semi-systematic, algorithmic trading program – RMT – that sought to replicate the risk profile and profits of live Rates and RV traders across the entire BlueCrest platform on a T+1, i.e., next-day, basis. RMT had lower P&L and greater volatility than the corresponding live traders and, therefore, underperformed them.
- Without RMT, BlueCrest likely would not have been able to move as many traders in so short a time period while maintaining BCI’s overall level of allocated capital. BlueCrest decreased the overall amount of capital allocated to live BCI traders while increasing the amount of capital allocated to RMT in BCI over the Relevant Period. Specifically, the capital that BlueCrest allocated to live BCI traders decreased from $12.5 billion in January 2012 to $7.4 billion in June 2015; and the capital that BlueCrest allocated to RMT increased from $0 to $7.2 billion during the same period. At the same time, BlueCrest increased the capital allocated to live BS traders from $4.45 billion in January 2012 to $22.1 billion in June 2015.
- BlueCrest initially deployed RMT exclusively in BCI. Starting in July 2012, BlueCrest allocated one-third to half of new RMT trading risk to BS. June 2013 was the market event widely known as the “Taper Tantrum” in which U.S. Treasury yields surged following the Federal Reserve’s announcement of future tapering of its quantitative easing policy. After RMT incurred significant losses during the “Taper Tantrum,” BlueCrest ceased deploying RMT in BS and allotted 100 percent of new RMT trading risk to BCI from July 2013 through December 2015.
- Throughout the Relevant Period, RMT was BCI’s largest capital allocation with limited exceptions. BCI’s capital allocations to RMT ranged from approximately $1.87 billion to approximately $7.89 billion which represented 17 percent to 52 percent of BCI’s total allocated capital.
- RMT gave rise to a conflict of interest because BlueCrest could retain a greater percentage of performance fees generated by RMT than performance fees generated by live Rates and RV traders. Whereas BlueCrest paid its live traders incentive compensation out of the performance fees it earned in the amount of 15 to 18 percent of the P&L that the traders generated, less salary and certain costs, it did not pay incentive compensation to traders based on the P&L that RMT generated by replicating their trades. Compensation to RMT Desk personnel, which included a smaller amount of discretionary compensation, was substantially less than that to live traders.
- During the Relevant Period, RMT generally performed worse than BlueCrest’s live Rates and RV traders. RMT was not configured or intended to capture all of the trading activity of all of BlueCrest’s live Rates and RV traders because certain strategies and asset classes were unsuited to algorithmic strategies and next-day execution....RMT excluded or underweighted some profitable traders, including several who had been reassigned from BCI to BS, and many profitable trading activities, including intraday, illiquid, and certain option, equity, and inflation linked strategies and asset classes because of their unsuitability to this strategy and the RMT process.
- Initially, BlueCrest’s internal reports estimated that RMT’s Target Portfolio would seek to capture 70 to 80 percent of the P&L of the live Rates and RV traders included in RMT. In fact, RMT’s Target Portfolio generally captured a lesser percentage. From September 2013 through May 2015, for example, RMT’s Target Portfolio captured approximately 53 percent of the P&L of the live traders whom RMT tracked.
- RMT was also subject to ongoing model and operational errors. In January 2015, for example, BlueCrest discovered two errors in which RMT’s algorithms failed to capture certain FX and bond options, while they did capture the FX and bond futures used to hedge the options. This resulted in a $28 million reduction in BCI’s P&L.
- In 2014 and 2015, BlueCrest continued to make large capital allocations to RMT despite internal BlueCrest analyses of RMT’s underperformance. For example, in June 2014, an internal BlueCrest report showed that RMT’s “historical slippage” was between 60 to 75 percent since inception, and more than $198 million from January through June 2014. A May 2015 monthly P&L report for RMT indicated that RMT’s YTD actual P&L underperformed its Target P&L by more than $116 million. Nonetheless, from June 2014 through May 2015, RMT’s allocated capital in BCI ranged from approximately $7.6 billion to almost $7.9 billion, representing 39 percent to 52 percent of BCI’s total allocated capital.
- BlueCrest also failed to disclose material facts about RMT to BCI’s independent directors. As late as July 11, 2012, BlueCrest told BCI’s independent directors that RMT was a “project” that was “in the early stages of development,” whereas BlueCrest had in fact been using RMT in BCI since January 2012. Similarly, in July 2013, BlueCrest described RMT to BCI’s independent directors as a “discrete rates trading strategy” when, in that month, RMT’s allocated capital in BCI was approximately $2.8 billion. In fact, BlueCrest failed to provide any information to BCI’s independent directors concerning RMT’s allocated capital in BCI until October 2015. Moreover, during the Relevant Period, BlueCrest never informed the independent directors about BlueCrest’s conflict of interest in deploying RMT or the fact that RMT underperformed the live traders whom it tracked.
The SEC concludes:
“BlueCrest repeatedly failed to act in the best interests of its investors, including by not disclosing that it was transferring its highest-performing traders to a fund that benefitted its own personnel to the detriment of its fund investors,” said Stephanie Avakian, Director of the SEC’s Division of Enforcement. “This settlement holds BlueCrest responsible for its conduct and furthers the SEC’s goal of returning funds to harmed investors.”
“An adviser’s disclosures to investors and prospective investors in funds they manage must be accurate,” said Adam Aderton, Co-Chief of the SEC’s Asset Management Unit. “BlueCrest investors were marketed a fund with exceptional trading talent but instead got a fund with an undisclosed algorithm that performed worse than those touted traders.”
The SEC’s order finds that BlueCrest willfully violated antifraud provisions of the Securities Act of 1933 and Investment Advisers Act of 1940 as well as the Advisers Act’s compliance rule. Without admitting or denying the SEC’s findings, BlueCrest agreed to a cease-and-desist order imposing a censure, and must pay disgorgement and prejudgment interest of $132,714,506 and a penalty of $37,285,494, all of which will be returned to investors.