NEW YORK — UBS O’Connor, the $6bn hedge-fund unit in the biggest Swiss bank, risks upheaval as senior traders seek to defect after a clampdown on cash bonuses, two people with direct knowledge of the matter have said.

Traders are contacting other hedge funds and recruiters after UBS moved them to a pay structure used throughout the firm, said the people, who requested anonymity because their plans to leave are not public. That resulted in immediate cash bonuses falling by 50% to Sf1m ($1.06m), and some deferred pay being tied to five-year UBS bonds rather than reinvested in O’Connor funds, the people said.

The potential defections show the struggles the biggest banks may face in retaining top traders at internal hedge funds amid shareholder and regulatory pressure on pay and rules that limit how much of a firm’s capital can be invested in the funds.

"This structure is analogous to working within a bank," said Ilana Weinstein, CEO of New York-based search firm IDW Group. "But what’s the likeness of O’Connor? It’s a hedge fund, and this structure is not competitive with working at another hedge fund."

Departures may hamper CEO Sergio Ermotti’s efforts to rely more on wealth and asset management while cutting expenses by Sf3.4bn in the next three years. O’Connor manages about one-fifth of UBS’s Sf28bn of alternative and quantitative investments, the firm’s highest-margin asset-management group. O’Connor invests only client funds — not the bank’s, the people said.

"We believe our people choose to be here based on a combination of our team culture, access to client capital and UBS distribution," the head of the alternative and quantitative investments business, Bill Ferri, said. "I am … confident that we can credibly compete while aligning with the long-term interests of our clients and UBS shareholders."

O’Connor offers a global multi-strategy fund, a fundamental market-neutral fund, and several long-short equity funds, according to its website. The unit has about 175 staff, including about 90 front-office employees, according to a person with knowledge of the group. Most of the personnel are based in Chicago, with others in New York, London, Hong Kong, Singapore and Tokyo, the person said.

The unit’s core Global Multi-Strategy Fund returned more than 8% to investors last year and more than 10% per year since its June 2000 inception, one of the people said. O’Connor’s trading teams report to chief investment officer Dawn Fitzpatrick and the group’s traders include portfolio manager Kipp Schrage, the person said.

All employees who made more than $250,000 last year had at least 60% of their pay exceeding that amount deferred, UBS said earlier this year. The firm also lowered its cap on immediate cash bonuses to Sf1m last year from Sf2m for 2011. O’Connor traders will get half of their deferred pay in five-year debt that can be cancelled if UBS’s Basel 3 tier 1 common ratio drops below 7%, the people said. The ratio under fully applied Basel 3 rules stood at 9.8% on December 31.

O’Connor staff got 40% of their 2011 bonuses in cash, up to Sf2m, and deferred pay was reinvested in O’Connor funds and vested in equal annual instalments over three years, one person said. There were no caps on immediate cash bonuses before 2009, the person said.

Most hedge funds reward employees based on the performance of the funds, with no limits on cash compensation, and deferred pay most often being reinvested in the funds. Consultants who advise institutional investors on which hedge funds to invest with view pay structures like UBS’s as a risk, said Ms Weinstein. "They don’t like the risk of comp (compensation) being decided by bank CEOs, because you have other competing factors, like driving up the stock and paying other parts of the bank," she said.

"There’s not clear alignment between (incentivising) and rewarding your top-performing investment managers within the fund."

UBS’s asset-management unit cut personnel costs last year by 7.2% to the lowest level since 2003. That helped the division post the highest pretax profit since 2008. The alternative and quantitative unit produced Sf268m of revenue, 14% of total asset management revenue, and the highest gross margin among UBS’s asset-management products.

O’Connor & Associates was founded in 1977 by mathematician Michael Greenbaum, with funding from brothers Edmund and William O’Connor, according to the 1999 book, The Predictors, by Thomas A Bass, who wrote that the firm "made money hand over fist" and "developed a cult of secrecy".

Bloomberg