* Hedge funds carry out internal probes
* Advance knowledge of rates could give trading advantage
* Some funds bets based on tiny movements in benchmarks
By Tommy Wilkes
LONDON, July 26 (Reuters) - Investors are pushing some of the world's biggest hedge funds to show that their traders played no part in the interest rate rigging scandal plaguing major banks.
These hedge funds have responded with in-depth internal probes which they hope will assure investors that they did not collude with the banks, are completely clean and will not become embroiled in the affair, people familiar with the funds said.
Regulators across the globe are investigating whether banks tried to rig the London interbank offered rate, a benchmark used to set the price of trillions of dollars of financial products.
None has publicly confirmed they are looking into the activity of hedge funds or alleged any wrongdoing by them.
However, some investors are so concerned about the reputational damage and the difficult questions their own clients would pose if hedge funds they had invested in were to be implicated that they are demanding the managers show they have a clean record.
"It's something they have to investigate and something we've been talking to our managers about to make sure they didn't do anything untoward," said one source who works closely with investors in hedge funds.
Hedge funds play no part in setting the benchmarks, which are determined by a group of major banks, but even knowing in advance how the rates would change could be profitable for funds employing a range of trading strategies.
The calls from investors for funds to show they are clean spotlight just how dramatically the relationship between hedge fund manager and investor is changing.
Long-renowned for their secrecy, the largely unregulated sector has sucked in billions of dollars of cash from big, mainstream institutions such as pension funds in recent years. These investors demand much more transparency than the high-rolling wealthy individuals who were once their primary backers.
Hedge fund managers are not the only ones facing investor pressure to come clean. Shareholders are also clamouring for big banks to conduct Libor-related due diligence so that they can provide guidance on the size of potential fines and legal costs.
Declining to name specific managers, the source said he had approached the funds in which his clients invest for assurances they were not implicated. Those funds are global macro funds, which bet on major trends and invest in different assets.
He found that they had spent at least the past six months trawling through emails, voicemails and phone calls their traders made during the relevant periods.
At least one fund has employed a sophisticated computer algorithm: to discover whom its traders talked to and whether, during the course of those conversations, they discussed Libor fixings with traders at banks.
Britain's Financial Services Authority (FSA) said traders at Barclays, which last month reached a $450 million settlement with U.S. and British regulators over attempted manipulation, sought to rig rates as far back as January 2005.
Some hedge funds - such as macro funds and those with so-called relative value fixed income strategies - make bets on "spreads" related to Libor. Knowing where the rates were set before publication would have been a trading advantage.
"Yes, people are looking into the matter," one hedge fund of funds executive said, when asked whether the hedge funds he had invested in were conducting internal probes on Libor.
However, the investor cautioned that because it is unclear about the extent to which Libor was successfully manipulated "things are fairly up-in-the-air at the moment."
A third source, who invests directly in macro funds, said he has been comforted by reassurances from managers that they had robust compliance systems in place and would be surprised to learn of any collusion with traders at banks.
An ex-trader for Royal Bank of Scotland has alleged that Brevan Howard, one of Europe's biggest hedge funds, asked his former employer to change the Libor rate in 2007, court documents filed in Singapore in March show.
Brevan declined to comment. The fund is not a named party in the court case and is not being sued for any wrongdoing. RBS declined to comment.
In documents released last month, Britain's regulator published a communication from March 2007 between a hedge fund trader and a Barclays staff member known as "Trader E" which suggested the hedge fund employee was aware Barclays tried to manipulate the Euribor rate, another global benchmark.
The hedge fund trader appears to warn Barclays about setting the three-month rate very low, saying it made trading in the three-month International Money Market - where interest rate futures contracts are bought and sold - dangerous.
"It does draw attention to you guys. It doesn't look very professional," the hedge fund trader said.
It was not clear whether this knowledge helped the hedge fund trader to make any financial gain.
Bank rate-setters may have attempted to rig Libor to paint a better picture of their bank's health, or because derivatives traders requested specific rates to help their positions.
Many hedge funds have hired former interest rate traders from banks to help manage their portfolios in recent years.
Japanese regulators last year found that two Citigroup employees were involved in attempted manipulation of the yen-denominated Libor rate. It did not identify the traders but sources familiar with the situation named one of them as Christopher Cecere, who now works at Brevan Howard in Switzerland.
In an interview with Reuters in February, Cecere said he left Citigroup voluntarily with full bonus and that he has not been questioned by regulators. Japan's Financial Services Agency declined to comment.
The Financial Times newspaper reported last week that regulators are looking at possible links between Christian Bittar, who worked at Deutsche Bank at the time and now works at hedge fund firm BlueCrest, and an ex-Barclays employee who tried to rig Europe's benchmark interest rate.
BlueCrest, a $30 billion-plus firm run by ex-JP Morgan trader Mike Platt, confirmed Bittar works there but declined to comment further. Bittar could not be reached for comment.
For most traders, a small move in Libor might make little difference.
But advance knowledge of changes to the rates could have meant big gains for so-called fixed income relative value traders.
Their strategy involves betting that tiny price dislocations in markets will correct themselves over time. The traders boost returns with huge levels of borrowing.
But the strategy, once likened to picking up nickels in front of a steam roller, is best known for helping bring down the Long Term Capital Management hedge fund in 1998.
Funds using the strategy were big players in trading Libor-linked spreads in the run-up to the 2008 financial crisis, industry sources say, before many crashed out from the high-rolling game.
One of the more common Libor-linked instruments traded by hedge funds is the so-called Libor/OIS spread.
This typically measures the difference between the three-month Libor interbank lending rate and expected central bank lending rates, as measured by overnight indexed swaps. The spread is a common gauge of credit risk and market stress.
The spread usually trades around 10 basis points but it spiked to a record high of around 365 basis points at the height of the financial crisis in October 2008, handing a healthy profit to hedge funds that bet it would widen.
Last month Britain's FSA said Barclays' "Trader E" indicated as early as December 2006 that he would benefit from a particular spread between three month Euribor and the EONIA rate, also an indicator of financial stress.
Barclays declined to comment.
The difference between three month Euribor and EONIA rates was less than 25 basis points in early 2007. It had reached more than 170 in late 2008.
Libor rates submitted by banks are compiled by Thomson Reuters, parent company of Reuters, on behalf of the British Bankers' Association (BBA).
Despite the calls for hedge funds to investigate possible involvement, investors know there is only so much they can do to ensure managers were not caught up in the scandal.
"We spend a lot of time with managers to make sure that we are comfortable with them," Guy Davies, head of European equity at FundQuest, the multi-management unit of BNP Paribas Investment Partners, said.
"We hope we are dealing with good quality people from both an investment and ethical perspective. Other than that, there's not much more that a multi-manager can do," he added.