By Lauren Tara LaCapra and Emily Flitter

Dec 3 (Reuters) - Morgan Stanley hired former Goldman Sachs trader Edward Glenn Hadden to run its Treasury bond desk last year, even though his former employer had placed the trader on paid leave for about a year following an internal inquiry, said three people familiar with the situation.

The inquiry by Goldman involved a matter separate from an ongoing investigation by exchange operator CME Group into a December 2008 trade that involved U.S. Treasury futures.

Neither Hadden nor Goldman has been accused of wrongdoing in the 2008 trading incident. But the decision by Morgan Stanley to hire Hadden even though some of his activities had raised questions within Goldman could put the firm in an uncomfortable position in light of the revelations of the CME Group investigation.

Hadden was a partner at Goldman Sachs when the 2008 trade drawing scrutiny occurred. The incident that led to the Goldman internal inquiry took place the end of 2009 and involved profits Hadden is said to have made ahead of the launch of a new Treasury futures contract introduced by the CME Group in early 2010.

Morgan Stanley and Goldman Sachs both recently learned of the CME investigation into the 2008 incident. But sources said Morgan Stanley was aware Goldman had put Hadden on paid leave when it hired him in March 2011.

Hadden's lawyer said his client did nothing wrong with the 2008 trade and expects the CME to reach a similar conclusion when it completes its investigation.

"There is no legal or factual basis for any suggestion of market manipulation," said James Benjamin, who defended his client in response to a recent regulatory disclosure by the firm that Hadden is being investigated by CME over a 4-year-old trade.

Benjamin had no comment about the incident that led to Goldman putting Hadden on paid leave that effectively barred him from trading at the firm for about a year.

Hadden, who goes by his middle name "Glenn," officially left Goldman in late 2010. A few months later, Hadden, who had been a partner at Goldman, joined Morgan Stanley with much fanfare to run the Wall Street firm's Treasury bond and interest rate derivatives trading desk.

Hadden is one of the most successful traders in the market for Treasury bonds and interest rate derivatives, whose value stands at $531.6 trillion, according to the Securities Industry and Financial Markets Association. He had worked for Goldman Sachs for about 11 years before voluntarily leaving the firm at the end of 2010.

Trading in Treasuries and interest rate derivatives is an important part of Morgan Stanley's bond trading business, as it focuses on high-volume trading that can be easily automated and cleared under new regulations, rather than riskier and more complex over-the-counter trades.

Benjamin, a defense attorney with Akin Gump, said the CME investigation involves a "technical risk management activity" that occurred "in a one-minute period four years ago." While Benjamin declined to discuss the specifics of the allegation against Hadden in his statement, the lawyer said his client had "acted properly and followed established market practice."

CME Group declined to comment.

Morgan Stanley spokesman Mark Lake said Hadden is still employed by the firm, and in good standing.

News of the investigation broke on Sunday evening when The New York Times posted a story on its website about Hadden with the headline "Morgan Stanley Trader Faces Inquiry on Possible Manipulation."

The paper, citing a regulatory filing and sources familiar with the matter, said the CME was investigating Hadden over whether his Treasury futures trading had manipulated prices.

Hadden's file with the Financial Industry Regulatory Authority cites a pending CME investigation of his Treasury futures orders placed on the expiration date in December 2008.

The trades being probed by the CME pertained to programs set up by the Federal Reserve during the height of the financial crisis to help support Wall Street and the banking system, a person familiar with the matter said.

The New York Times reported that some at the Fed had suspected that Goldman was trying to improperly profit from one of the government's bond-buying programs, and complained to Goldman about Hadden.

The 2009 incident that led to the Goldman internal inquiry also involved Treasury futures but had nothing to do with the U.S. government's efforts to prop up the financial system.

Instead, the 2009 matter involved a new Treasury futures trading product the CME was developing and one which Hadden had advised on, said those people, who were not authorized to speak publicly on the matter.

Hadden had found a way to structure a Treasury trade ahead of the CME's official announcement in September 2009 that it was going to launch in early 2010.

That incident moved his superiors at Goldman to put him on leave, keeping him on the payroll but preventing him from actively trading for about a year.

Indeed, even as the CME investigates Hadden over the 2008 incident, its product development team has continued to turn to him for help in devising new Treasury futures products. CME Group quoted Hadden in a Sept. 18 press release highlighting a new interest rate swap futures product. 

(Additional reporting by Ann Saphir)

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