The challenges facing hedge funds and the movement of their collateral are set to increase for a number of reasons. Firstly, the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR) are pushing more over-the-counter (OTC) derivatives into centralised clearing through central counterparty clearing houses (CCPs). Uncleared OTC derivatives, which are those considered too esoteric or high-risk to be cleared, will be traded bilaterally albeit with far higher margin costs. And finally, Basel III capital requirements will facilitate limits on how much financing prime brokers can provide their hedge fund clients. As such, it is inevitable the collateral prime brokers demand for this financing is going to have to be of higher quality and quantity. All of this leaves hedge funds in something of a bind.
The sheer volume of swaps that will migrate onto CCPs puts hedge funds in a challenging situation. The systemic nature of CCPs requires these market infrastructures to accept only high-quality collateral in the form of initial margin such as cash or government bonds. CCPs will most likely only accept cash collateral as variation margin, which of course can be subject to multiple calls per day depending on market volatility. Collateral costs for bilateral OTC derivatives will also increase substantially. “The challenges clearing and bilateral trading of esoteric OTC products and what it means to obtaining collateral is still in their early days. I think we need to wait and see what the impact will be,” says one director of operations at a newly launched hedge fund in London.
Some prophesise the increased collateral demands could facilitate a shortfall in eligible collateral. Such a scenario could potentially make it difficult for fund managers to obtain collateral and subsequently clear their trades. A paper published by the London School of Economics (LSE), in conjunction with the Depository Trust & Clearing Corporation (DTCC) warned firms may struggle to obtain collateral. Market fragmentation insofar as banks clearing across five markets could see a 10-fold increase in margin movements if transactions are being cleared through five CCPs, for example. This raises the question as to whether CCPs should ease the eligibility criteria for collateral posted as margin. Some have suggested high-grade corporate bonds could suffice if CCPs applied haircuts.
Regulators have made it no secret of their disapproval if such an outcome were to materialise. Hedge funds have also taken note. “We are unlikely to be allowed to post corporate bonds as collateral to CCPs. If a blue-chip company’s bonds were being posted as collateral, then it is likely that nearly every market participant will be posting those same bonds as collateral. Were a market event to occur, and those bonds to depreciate in value, the repercussions would be significant,” comments the hedge fund operations director.
Collateral T’s & C’s
It is not just the migration to centralised clearing that will affect hedge funds’ collateral requirements, but the inevitable changes in terms and conditions of prime brokerage financing. Basel III capital requirements are going to push up the cost of hedge fund financing with prime brokers being forced to scale back their financing. White papers published by Citi and J.P. Morgan highlight that restrictions on re-hypothecation of client collateral and liquidity coverage ratios are also putting pressure on prime brokers’ financing operations. This will be disproportionately felt by hedge fund managers running illiquid or highly leveraged strategies.
A study by Barclays estimated this reduced financing would impede the average hedge fund manager’s returns by around 10 to 20 basis points. Highly leveraged strategies, such as fixed income arbitrage which is leveraged at 13 times its Net Asset Value (NAV) on average, could see returns diminish by as much as 80 basis points, said the Barclays study. A handful of bulge bracket prime brokers have culled smaller, less profitable hedge funds. As such, those select hedge funds that retain financing are going to have to post more high value collateral so as to ensure banks are compliant with the Basel III capital rules.
“The impact of Basel III, which forces banks to raise the quality and quantity of tier-1 capital on their balance sheets, is that some banks and prime brokers are becoming more sensitive towards hedge fund financing. A handful of smaller hedge fund managers may eventually have prime brokerage relations unilaterally severed, while others will face higher financing costs. Collateral costs are going to go up a few percentage points I suspect. Prime brokers will also demand higher quality collateral from clients and take additional hair-cuts on less credit worthy collateral,” says Robin Grant, chief operating officer at RS Platou Asset Management in London.
The key to reducing risk: better management
One mechanism by which hedge funds can reduce the risk of a collateral shortfall is by better managing their collateral. A paper by Citi advised hedge funds to streamline their collateral management instead of viewing it in multiple silos. Through improved internal management of collateral, hedge funds can improve the efficiency of the whole process. Some even argue that collateral could become an asset class in its own right with the Citi paper suggesting hedge funds could swap, transform, upgrade or downgrade collateral. The hedge fund operations director is not wholly convinced. “I think hedge funds will continue to look to their banks to offer those sorts of services,” he says. Another method by which collateral could be managed more efficiently would be if managers were to increasingly embrace the Investment Book of Record or “IBOR.” IBOR is a single source of truth which gives fund managers a full view of front, middle and back office data in what many argue help managers identify reconciliations of positions in a timely and accurate manner. IBOR provides managers with position level data on collateral in near-real time, and helps them identify the collateral pledged. This helps firms post collateral far more efficiently, although take-up of IBOR has so far been muted.
Collateral costs are certainly going to increase for fund managers, and while it is unlikely a collateral squeeze will ensue, obtaining eligible collateral will become a major challenge once mandatory clearing begins in earnest and Basel III capital rules bite.