The US Senate Permanent Subcommittee on Investigations called Peter F. Brown, Co-Chief Executive Officer and Co-President of Jim Simons’ Renaissance Technologies LLC, among others, to testify on the use of basket options accusing the hedge fund of trying to evade taxes. But according to Brown, the basket options were a practical solution to a strategic problem and the tax implications were more of an afterthought.
“Deutsche Bank proposed a basket option transaction to Renaissance in the late 1990s. It did not do so with a focus on tax benefits. The basket options that Deutsche Bank AG (NYSE:DB) (ETR:DBK) proposed allowed Medallion to obtain leverage on a non-recourse basis that could not be obtained through any other product,” Brown wrote in his statement to the subcommittee.
Renaissance: Basket options were used for leverage with a safeguard, not tax evasion, says Brown
Renaissance’s Medallion fund uses algorithmic trading which, according to Brown, is right very slightly more often than half the time. It makes money, but slowly, and to get the kinds of returns that Renaissance’s clients expect the fund has to use a lot of leverage. The problem, of course, is that so much leverage risks enormous losses to the fund if something goes wrong.
The basket options set up accounts held by Deutsche Bank AG (NYSE:DB) (ETR:DBK) or Barclays Plc (NYSE:BCS) (LON:BARC) and operated by Renaissance, which paid a premium for the deal. If the balance of the account was high enough Renaissance would exercise the option and claim the difference, and if the balance went below a specified amount the banks closed the account, preventing Renaissance from benefiting from a rebound.
This option has the unique property of providing leverage while limiting losses to the initial premium paid by Renaissance. That’s not to say that Renaissance never took tax considerations into account when deciding whether to exercise an option, but that taxes weren’t the main reason to use basket options.
Enormous leverage might also be illegal
Even if the subcommittee accepts Brown’s explanation for the rationale behind basket options, it’s still not clear if the amount of leverage that Renaissance was able to achieve was actually legal. Brown points out that higher amounts of leverage are allowed when trading options, which is true, but in some cases basket options let hedge funds push their leverage to ten times the legal limit. If Medallion can’t produce decent returns without such high amounts of leverage, Renaissance may have to find a different strategy in the future.