The bankruptcy of investment bank Lehman Brothers has prompted hedge funds to reassess their counterparty risk exposures when trading over-the-counter (OTC) derivatives, according to Ian Mainwaring, head of the alternative investments practice at investment management consultancy Citisoft.
“The collapse was a wake-up call, and made people think, ‘If it can happen to Lehman, we have got to think carefully about our exposure to other so-called safe counterparties’.” he says.
While counterparty risk has become a growing concern for hedge funds and long-only managers across all instruments and asset classes since Lehman’s demise, it is particularly pressing in OTC derivatives. Unlike exchange-traded instruments, where clearing and settlement usually takes place through central counterparties and central securities depositories, OTC derivatives transactions are cleared and settled bilaterally between broker and client. This means clients are exposed to brokers for all parts of the transaction lifecycle, not just trade execution.
OTC derivatives also have long maturities, with counterparties remaining exposed to each other throughout the life-span of the contracts. “Interest-rate swaps and credit default swaps can have durations of five, 10 or 15 years,” says Mainwaring. “In today’s environment, it is a brave man who says, ‘I can guarantee that my current counterparty is still going to be in business in 10 years’ time’.”
Hedge funds are trying to reduce counterparty exposure in OTC derivatives transactions by demanding more collateral from brokers to protect against default, reversing the trend seen before Lehman went bankrupt.
“Before Lehman, a fund would typically look at the credit rating and risk profile of a counterparty, decide it was safe, and reduce the collateral,” says Mainwaring. “But now, funds’ ideas about the safety of counterparties have changed and they want more collateral on the table.”
There are also industry-wide moves afoot to reduce counterparty risk in the OTC derivatives market. Although establishing central counterparties for OTC derivatives has been discussed for several years, Lehman’s collapse has given regulators a new sense of urgency. On October 31, the Federal Reserve Bank of New York issued a statement listing the formation of a central counterparty for credit default swaps in the US as one of its central priorities for addressing concerns about OTC derivatives.
Mainwaring suggests regulators could introduce an intermediation model in which a third-party bank would sit between the client and broker and assume the counterparty risk for the transaction. The third-party bank would in turn receive backing from the relevant regulators. “My gut feeling is that the ultimate solution will be a mixture of third-party mediation and a central counterparty model,” he says.
As well as changing their approach to OTC derivative trading, hedge funds are increasing the number of prime brokers they use to spread their counterparty risk. However, this approach can create new problems as well as solving existing ones, according to Mainwaring. “For a hedge fund, maintaining an increased number of broker relationships potentially costs them more from an operational and technology perspective,” he says.
Hedge funds may also find prime brokers less accommodating as they cut the volume of business they send to individual firms. “Prime brokers are recognising that they are going to get less business, and therefore they can’t offer all the services they did previously,” says Mainwaring.