Hedge Funds Restructure In Wake Of Regulation Implementation

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Opportunities to rethink business approach

New regulations are being implemented soon. Hedge funds need to be prepared for taking advantage of related opportunities including:

  1. More market prevalence: Proprietary trading divisions are waning at investment banks like Goldman Sachs Group Inc (NYSE:GS) and Morgan Stanley (NYSE:MS) as a result of implementation of Volcker rule and Liikanen proposal. As a result, some functions including market making, security inventory management and direct lending are shifting from investment banks to hedge funds. The latter have also used their relationships with institutional investors to co-invest or even invest directly in proprietary trades.
  2. More demand for high quality liquid assets (HQLA) collateral: Hedge funds hold an expanding share of HQLA. They could use HQLA as another way to generate profits by letting other asset managers (hedge funds or traditional long-only) use their collateral pool and price such use effectively. Hedge funds could also work with their counterparts or clients to customize collateral.
  3. Potential financing efficiency: Lending costs will probably rise as Basel III is implemented. Prime brokers will be required to have higher liquidity ratios and less leeway in their balance sheets. Loans will need re-pricing making it more expensive for some hedge funds to borrow. Hedge funds that focus on building relationships, however, will be able to work with their prime brokers to control financing costs. Shorting and debits can be used to lower balance sheet use by prime brokers and increasing their return on assets.

The global financial crisis (GFC) resulted in institutional investors expanding their role in funding hedge funds. Institutional investors became the largest investor group. Hedge funds became an integral part of alternative investments allocation for institutional portfolios. This shift created the opportunities listed above. Combined with regulatory developments, an expanding institutional investor base also creates new challenges.

Regulations place higher demands on hedge funds

Rules to track collateral pools call for more categories. Regulators are paying more attention to counterparties and leverage used, which means hedge funds will need to track these items.

Hedge funds work with swap dealers, cash custodians, futures commission merchants (FCMs) and prime brokers. Post GFC, regulators added third party custodians. Hedge funds need to house fully paid long positions with the latter. GFC highlighted risks of keeping all assets with the same prime broker after Lehman Brother’s collapse. Having a third party custodian aims to reduce risks in dealing with prime brokers by reducing their role. Hedge funds now work with five institution category. Within each category, there are different counterparties increasing difficulty of collateral pool tracking. There could be thousands of collateral pools to oversee.

Most hedge funds still segment their collateral management according to investment type. Securities team works with HQLA that results from firm’s financing activities and try to improve returns. Over the counter (OTC) and listed derivatives teams manage collateral and margin with swap dealers and FCMs. Hedge funds currently are in need to consolidate their view of their collateral as there are more pools to track. A consolidated view will also allow hedge funds to improve liquidity management and return on assets. Considering collateral pools together will allow firms to model impact of trades on their portfolios and collateral needs.

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