Hedge lines
22 July 2014
How will hedge funds react to the changing collateral landscape?
Image: Shutterstock
Hedge funds have long been heralded as an important source of collateral in the financial markets. International Monetary Fund senior economist Manmohan Singh has pinpointed them as a key provider of reusable assets鈥攁long side major custodial agents鈥� securities lending activities鈥攚hich they do through two means, as a pledge against a loan provided by a bank, and repo agreements.
In a 2011 study, Singh found that the total primary supply of collateral from securities lending and hedge funds dropped to $2.4 trillion in 2010 and that velocity dropped to 2.5, resulting in a total amount of collateral received by the considered global dealer banks of only $5.8 trillion.
A recent London School of Economics and Political Sciences study, conducted in conjunction with The Depository Trust & Clearing Corporation, challenged this theory, suggesting that it 鈥渕ay be alarmist鈥�.
The study said: 鈥淭he willingness of long-term investors to make their assets available for yield-enhancing techniques such as securities lending depends on their assessment of risk and reward. In a continuing low-rate environment but with growing con?dence in economic recovery, there may be a renewed tendency for real money investors to reach for yield.鈥�
鈥淪imilarly, the velocity of collateral as calculated [by Singh] is a direct re?ection of the willingness of global banks to over leverage to their clients. Again this tends to be cyclical so that velocity could rise quickly once economic recovery is perceived.鈥�
The study went on to say that the supply of collateral will be sufficient to meet the demands expected as a result of worldwide regulatory reform and evolving market practice, but access to collateral and the ability for collateral to circulate freely across financial systems could become challenging as market participants seek sources of liquidity and assets. How will this situation affect hedge funds, the widely heralded suppliers that they are?
The collateral shortage position was also challenged in the second part of Citi鈥檚 Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization, the resulting report of a survey of hedge fund managers, asset managers, beneficial owners, agent lenders, consultants, fund of hedge funds, pension funds, sovereign wealth funds, endowments and foundations.
The report said: 鈥淭he pool of collateral that hedge funds control is likely to continue to expand at a time when demand for high quality liquid assets (HQLA) hits all-time record highs. This could position hedge funds to begin treating collateral as an asset class with which they can supplement their trading book profits by effective use and pricing of their collateral pool.鈥�
鈥淗edge funds are likely to develop new roles with these competitors and leverage an increasingly interoperable collateral landscape to swap, transform and either upgrade or downgrade collateral to help meet demand from their counterparts or the clients they introduce as agents.鈥�
This comes at a time when hedge funds in particular are experiencing positive quarters. J.P. Morgan鈥檚 Prime Brokerage Insight, released in early 2014, stated that so far this year, 鈥渨ith more volatile markets and downward pressure on equities鈥�, all of the major hedge fund strategies have outperformed their long-only counterparts, 鈥渟howing that hedge funds are able to mitigate drawdowns in down markets鈥�.
鈥淪hould equity correlations continue to break down, 2014 may be a year鈥攗nlike 2013鈥攚hen hedge funds are able to clearly demonstrate their absolute return value proposition.鈥�
Citi鈥檚 analysis of hedge fund assets under management, highlighted in part one of its Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization report, revealed a figure of $1.72 trillion or a post-global financial crisis high of 10.2 percent of the record $16.92 trillion in institutional assets invested across mutual funds and hedge funds.
鈥淭his is up from 9.4 percent, the previous record high level of assets noted in 2012. This increase in hedge funds鈥� share of total institutional investments occurred in 2013 despite hedge funds themselves having significantly underperformed the major equity indices. This illustrates the growing use of these instruments as a risk tool in investor portfolios.鈥�
Citi found that the number of pools of collateral that hedge funds must now consider in administering their daily operations 鈥渋s expanding exponentially鈥�, due in part to new third-party custodial accounts coming into play, forcing hedge funds 鈥渢o step in to manage many of the interactions between their prime brokers, swap dealers and these new counterparts鈥�.
But regulations have also been thrown into the mix, according to Citi. 鈥淣ow there are likely to be a minimum of five types of collateral pools that hedge funds need to consider across prime brokers, swap dealers, cash custodians, third-party custodians and FCMs. Moreover, there are likely to be several types of counterparties in each of these categories and multiple funds that need to be administered. This could result in literally hundreds or even thousands of collateral pools to oversee.鈥�
As a result, costs are likely to increase. 鈥淭he costs of financing are likely to rise as Basel III liquidity coverage ratios and net stable funding ratios negatively impact prime broker balance sheets and force broker-dealers to re-price their offerings.鈥�
鈥淗edge funds that move from a service-based to a relationship-based model with their counterparts are likely to have better access to financing and realise less extreme price increases. Leading firms are likely to concentrate their efforts to achieve financing efficiency with their top prime brokers as a tool in their relationship arsenal. Such efficiency will focus on the placement of debits and shorts. If done with an eye toward the prime broker鈥檚 funding and coverage needs, this will decrease the clients鈥� balance sheet utilisation and increase their return on assets.鈥�
The importance of hedge funds to the collateral system is not to be underestimated. As these studies show, their importance is likely to increase, but the shape and style in which they operate will have ramifications throughout the financial sector.
As the London School of Economics and Political Sciences concluded: 鈥淗istorically, banks have bene?tted from a variety of advantages in assessing and managing credit risks, and their active role in the taking and managing of collateral is a manifestation of this.鈥�
鈥淗owever, regulatory reform and ?nancial innovation may change this going forward. The search for new methods of achieving economical collateral transformation is giving opportunities to market infrastructures and others to provide much needed support for credit creation.鈥�
In a 2011 study, Singh found that the total primary supply of collateral from securities lending and hedge funds dropped to $2.4 trillion in 2010 and that velocity dropped to 2.5, resulting in a total amount of collateral received by the considered global dealer banks of only $5.8 trillion.
A recent London School of Economics and Political Sciences study, conducted in conjunction with The Depository Trust & Clearing Corporation, challenged this theory, suggesting that it 鈥渕ay be alarmist鈥�.
The study said: 鈥淭he willingness of long-term investors to make their assets available for yield-enhancing techniques such as securities lending depends on their assessment of risk and reward. In a continuing low-rate environment but with growing con?dence in economic recovery, there may be a renewed tendency for real money investors to reach for yield.鈥�
鈥淪imilarly, the velocity of collateral as calculated [by Singh] is a direct re?ection of the willingness of global banks to over leverage to their clients. Again this tends to be cyclical so that velocity could rise quickly once economic recovery is perceived.鈥�
The study went on to say that the supply of collateral will be sufficient to meet the demands expected as a result of worldwide regulatory reform and evolving market practice, but access to collateral and the ability for collateral to circulate freely across financial systems could become challenging as market participants seek sources of liquidity and assets. How will this situation affect hedge funds, the widely heralded suppliers that they are?
The collateral shortage position was also challenged in the second part of Citi鈥檚 Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization, the resulting report of a survey of hedge fund managers, asset managers, beneficial owners, agent lenders, consultants, fund of hedge funds, pension funds, sovereign wealth funds, endowments and foundations.
The report said: 鈥淭he pool of collateral that hedge funds control is likely to continue to expand at a time when demand for high quality liquid assets (HQLA) hits all-time record highs. This could position hedge funds to begin treating collateral as an asset class with which they can supplement their trading book profits by effective use and pricing of their collateral pool.鈥�
鈥淗edge funds are likely to develop new roles with these competitors and leverage an increasingly interoperable collateral landscape to swap, transform and either upgrade or downgrade collateral to help meet demand from their counterparts or the clients they introduce as agents.鈥�
This comes at a time when hedge funds in particular are experiencing positive quarters. J.P. Morgan鈥檚 Prime Brokerage Insight, released in early 2014, stated that so far this year, 鈥渨ith more volatile markets and downward pressure on equities鈥�, all of the major hedge fund strategies have outperformed their long-only counterparts, 鈥渟howing that hedge funds are able to mitigate drawdowns in down markets鈥�.
鈥淪hould equity correlations continue to break down, 2014 may be a year鈥攗nlike 2013鈥攚hen hedge funds are able to clearly demonstrate their absolute return value proposition.鈥�
Citi鈥檚 analysis of hedge fund assets under management, highlighted in part one of its Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization report, revealed a figure of $1.72 trillion or a post-global financial crisis high of 10.2 percent of the record $16.92 trillion in institutional assets invested across mutual funds and hedge funds.
鈥淭his is up from 9.4 percent, the previous record high level of assets noted in 2012. This increase in hedge funds鈥� share of total institutional investments occurred in 2013 despite hedge funds themselves having significantly underperformed the major equity indices. This illustrates the growing use of these instruments as a risk tool in investor portfolios.鈥�
Citi found that the number of pools of collateral that hedge funds must now consider in administering their daily operations 鈥渋s expanding exponentially鈥�, due in part to new third-party custodial accounts coming into play, forcing hedge funds 鈥渢o step in to manage many of the interactions between their prime brokers, swap dealers and these new counterparts鈥�.
But regulations have also been thrown into the mix, according to Citi. 鈥淣ow there are likely to be a minimum of five types of collateral pools that hedge funds need to consider across prime brokers, swap dealers, cash custodians, third-party custodians and FCMs. Moreover, there are likely to be several types of counterparties in each of these categories and multiple funds that need to be administered. This could result in literally hundreds or even thousands of collateral pools to oversee.鈥�
As a result, costs are likely to increase. 鈥淭he costs of financing are likely to rise as Basel III liquidity coverage ratios and net stable funding ratios negatively impact prime broker balance sheets and force broker-dealers to re-price their offerings.鈥�
鈥淗edge funds that move from a service-based to a relationship-based model with their counterparts are likely to have better access to financing and realise less extreme price increases. Leading firms are likely to concentrate their efforts to achieve financing efficiency with their top prime brokers as a tool in their relationship arsenal. Such efficiency will focus on the placement of debits and shorts. If done with an eye toward the prime broker鈥檚 funding and coverage needs, this will decrease the clients鈥� balance sheet utilisation and increase their return on assets.鈥�
The importance of hedge funds to the collateral system is not to be underestimated. As these studies show, their importance is likely to increase, but the shape and style in which they operate will have ramifications throughout the financial sector.
As the London School of Economics and Political Sciences concluded: 鈥淗istorically, banks have bene?tted from a variety of advantages in assessing and managing credit risks, and their active role in the taking and managing of collateral is a manifestation of this.鈥�
鈥淗owever, regulatory reform and ?nancial innovation may change this going forward. The search for new methods of achieving economical collateral transformation is giving opportunities to market infrastructures and others to provide much needed support for credit creation.鈥�
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