Senate Homeland Security and Governmental Affairs Subcommittee on Investigations Hearing
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Testimony by
Chairman Levin, Ranking Member McCain, and members of the Subcommittee, we appreciate the opportunity to be here today to speak with you and to answer your questions on behalf of
Below we discuss the topics you have asked us to address. As you know, we have also supplied your staff with information that further addresses these topics in document responses and in interviews over the last year and a half. We appreciate having had the opportunity to meet with your staff on a number of occasions to discuss this matter, and we hope that you have found our engagement cooperative and responsive.
We want to be clear: Renaissance's Medallion fund entered into barrier options with
The
Renaissance -- Background and Business Model
Renaissance was established for the purpose of producing superior financial results for our investors by adhering to mathematical and statistical methods in the design and execution of trading strategies. We were founded and are principally owned by scientists and we generally hire physicists, mathematicians, astronomers, and computer scientists.
Renaissance's equity trading and advisory activities bring added liquidity to the equities markets, reduce inefficiencies, and improve capital formation. We collect all the publicly available data we can find that we believe might bear on the movement of the prices of tradable instruments-- news stories, analysts' reports, energy reports, crop reports, weather reports, regulatory filings, accounting data, and, of course, quotes and trades from markets around the world. Our models use this data to make predictions about future price changes. Although we use different strategies in managing our different funds, all of our strategies depend on the output of our data-driven models. Of particular note for today's discussion is the fact that our models do not factor in tax rates when making trading recommendations.
Medallion has achieved exceptional returns over the years, but we are mindful that past success is no guarantee of future performance. We also understand the need for thoughtful regulation and laws to govern the operations of the financial system as a whole, and we are committed to being a constructive participant in the dialogue about what those regulations and laws should be.
The Use of Barrier Options by Medallion
The model developed by Renaissance for Medallion makes predictions that are profitable only slightly more often than not. Moreover, the predicted price movements can be easily overwhelmed by external events. To compensate for these factors, the model generates a large number of recommendations, so that by virtue of the mathematical principle known as the law of large numbers, the variability of the returns produced by the model is greatly reduced.
However, because the model's recommendations are expected to be profitable only slightly more often than not, the rate of return obtained by applying the recommendations to an unleveraged portfolio would be very small. Leverage magnifies the effect of positive changes in the overall value of the portfolio on the rate of return, and this effect is greater the higher the level of leverage employed. Medallion's barrier options with
In addition to leverage, a key benefit of these barrier options is that they provide Medallion with protection against losses that might occur when trading at high leverage. Models often work well, but the markets have many times taught participants the lesson of humility.
The barrier options offered by
Our decisions to exercise the barrier options were driven by business imperatives. For example, the average holding period of the
We are prepared to discuss issues of tax policy during the hearing in more detail.
How the Barrier Options Work
Each barrier option references the performance of a notional basket of securities, called the reference portfolio, generated by Medallion's trading model. There are other, publicly available options today that reference changing baskets of securities, such as options on the "Dogs of the Dow" or the S&P 500. When our model performs well, the fund profits, aided by the superior leverage available through these options. Upon exercise of the option, Medallion is entitled to a cash settlement payment generally equal to the net positive performance of the reference portfolio. If the model performs poorly, the option limits Medallion's downside risk, because Medallion's maximum possible loss is the amount of premium paid to purchase the option. We know of no other way to obtain this combination of leverage and loss protection.
Each option contains a barrier provision, pursuant to which the option automatically terminates if the value of the reference portfolio falls below a specified level, even momentarily. Thus, the barrier provision prevents Medallion from benefiting from a rebound in the value of the reference portfolio after such a decline. The barrier feature of the options helps the banks manage their risk; without this feature, the banks likely would not enter into the options. The U.S. Tax Court has specifically said that options with barrier provisions, such as ours, are taxed as options. n4
The barrier options provide Medallion with critical loss protection and superior leverage, but these benefits come with a price. Because Medallion does not own the underlying instruments that make up the reference portfolio, it would have no claim to any of the assets its counterparty might hold to hedge an option should that counterparty suffer a
It is common for banks that enter into derivatives contracts to hedge against risk of loss by taking offsetting positions in the referenced instruments. Although nothing in the option agreements with either
How the
Although the details of the barrier options have been modified slightly over the years to adapt to the unique demands of each bank, the
The 2007 "Quant Quake" demonstrated convincingly that the strategies of different quantitative funds were correlated, and thus that the risk faced by even the best-run funds was significantly greater than previously thought. In particular, a forced liquidation by any fund could have cascading effects on other funds, resulting in greater losses for all. Newly sensitized to these concerns about risk, from 2007 until late 2008,
In the wake of the "Quant Quake," we also modified prospectively our barrier options with
Tax Treatment of the Options
You have also asked more broadly about the tax treatment of barrier options. Renaissance has historically consulted with outside advisors on the tax treatment of the options at issue here and is comfortable that its tax treatment of the options is correct under current law. As noted above, the
It is common for parties to an agreement to allocate between themselves the burdens of various risks, including tax risk. Medallion's agreements with
In 2010, the
Conclusion
Medallion enters into barrier options to address the business imperatives discussed above. We believe we have reported the income from these options in accordance with current law, and are eager for a speedy resolution of the matter now before the
n1
n2 The first
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n4 Garcia v. Commissioner, 101
Read this original document at: http://www.hsgac.senate.gov/download/?id=7d5e98ba-5d83-4a84-8dc1-d57106fe6819
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