Citi paper warns hedge funds on collateral management and rising financing costs
Hedge funds must optimise the way in which they manage their collateral following reforms of the over-the-counter (OTC) derivatives markets while the cost of financing is going to rise exponentially in light of Basel III capital requirements, a new study from Citi Prime Finance has said.
There is widespread speculation that a collateral shortfall could emerge as more OTC derivatives are increasingly cleared through central counterparty clearing houses (CCPs) as mandated under Dodd-Frank in the US and the European Market Infrastructure Regulation (EMIR). CCPs are only allowed to accept high quality collateral – usually cash or government bonds – for initial margin while firms can typically only post cash collateral for variation margin. A paper published last week by the London School of Economics (LSE) in conjunction with the Depository Trust & Clearing Corporation (DTCC) warned firms may struggle to obtain collateral.
Sandy Kaul, head of business advisory services at Citi, said EMIR and the implementation of bilateral margining for non-cleared derivatives in 2015 would lead to a steady increase in collateral demands but remained hopeful the challenge was not insurmountable. “I do not believe the collateral shortfall will adversely affect the hedge fund industry. The impact will be felt more strongly in the traditional asset management space. Hedge funds, unlike traditional asset managers, have the ability to strategically deploy their liquid collateral and transform illiquid assets and this should alleviate the challenge,” said Kaul.
The Citi paper advised hedge funds to ensure collateral is managed efficiently. “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 futures commissions merchants (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,” read the Citi paper.
The paper pointed out that many hedge funds still manage their products in silos which split their view of their collateral. The paper recommended firms have a consolidated view of all of their assets within their businesses to streamline the entire process. New data inputs, analytics and tools will also be required to support the effective use of hedge fund collateral assets and efficient deployment of financing positions, it added.
There are even potential opportunities for fund managers whereby they can swap, transform, upgrade or downgrade collateral for swaps counterparts. “As the paper points out, we believe collateral could become its own new asset class and managers will start tracking their profits and losses around collateral, and add that to the returns for investors. In order to achieve this, hedge fund managers will have to understand the nature and value of their assets; look at their collateral pools to understand what is unencumbered and what is encumbered. Managers will have to come to grips with what is usable collateral and provide the cheapest, usable collateral to cover their own positions and take the leftovers in the pool and negotiate with the banks. Hedge funds will have the ability to transform assets into highly eligible collateral. At first, I believe it will only be the biggest managers who are capable of providing these services but in time, it will become commoditised and will be something smaller managers will start offering,” commented Kaul.
The costs of hedge fund financing are also going to rise as Basel III capital requirements take effect, said Citi. A J.P. Morgan white paper in 2014 agreed and highlighted attempts by prime brokers to reduce their dependency on short-term funding, hedge fund and investor restrictions on re-hypothecation of collateral and Basel III capital requirements, were all going to lead to an increase in the cost of financing. There is also a strong possibility regulators in Europe could clamp-down on re-hypothecation whereby they will impose a 140% cap similar to that of the Securities and Exchange Commission (SEC).
“Prime brokers are going to face challenges. However, firms have been digesting the implications of Basel III for around 18 months so people should understand what they need to do. The implications for financing is not that financing will disappear but that it will be higher cost. It is essential hedge funds build up partnerships with the sell side and prime brokers instead of viewing them as simply service providers if they want to ensure financing is delivered in a way that suits them and on equitable terms. Without that deep relationship, it is likely hedge funds will be paying more for their financing,” commented Kaul.
This emphasis on prime brokerage relationships is likely to lead to managers scaling back on their counterparty diversification. “We believe a typical hedge fund running $5 billion will presently have around four or five prime brokerage relationships. With the challenges facing financing, we expect this to fall to around two or three. The challenge for managers is to ensure they get the balance right between counterparty diversification and concentration of financing efficiencies, particularly if they are to keep their clients happy,” said Kaul.
This tightening on financing will disproportionately impact illiquid or highly leveraged strategies. A study in 2013 by Barclays predicted these changes would lead to the average hedge fund’s returns declining by 10 to 20 basis points. Fixed income arbitrage – one of the most leveraged strategies at 13 times Net Asset Value (NAV) – would be hurt the most by the changes with returns falling anywhere between 40 and 80 basis points, said Barclays.
“We are already seeing credit strategies that are highly reliant on leverage being impacted. Alternative sources of financing can be found although it is costly and time-consuming. Other firms are looking at different banks as sources of financing, and these banks might not necessarily be prime brokers,” said Kaul.