Hedge funds pose limited systemic risk, according to FSA survey
Hedge funds pose a limited risk to market stability, according to the results of a survey conducted by the UK’s Financial Services Authority (FSA).
Hedge funds not systemically important, says FSA
The FSA highlighted the aggregate footprint of hedge funds was modest in most markets. “There are few asset classes where our sample’s (hedge funds) aggregate footprint was greater than 2% of total market size,” read the paper.
There are, however, exceptions with hedge funds having a sizeable presence in the convertible bond, interest rate derivative and commodity derivative markets. The FSA estimated hedge funds hold approximately 7.3% of the outstanding value of the global convertible bond market and 2.7% of the more systemically important interest rate derivative market.
The FSA said a forced asset sale by hedge funds, brought about by a withdrawal of funding, could be a risk in markets where they have large footprints. “Forced selling could affect market liquidity and efficient pricing if it occurs during periods of heightened market stress or where hedge funds make up a significant proportion of market liquidity,” it read.
“A lot of the markets where hedge funds appear to be more concentrated are liquid. I would be concerned if managers were concentrated in illiquid markets but this does not seem to be the case,” said Phillip Chapple, managing director at KB Associates, a boutique hedge fund consultancy in London.
Hedge fund counterparty risk remains concentrated with just five banks accounting for 65% of aggregate hedge funds’ net credit counterparty exposures. In the FSA’s January 2012 Hedge Fund Survey, these five banks accounted for 60% of net credit counterparty exposures.
“After Bear Stearns and Lehman Brothers, investors wanted hedge funds to use brand name prime brokers which had large balance sheets and were therefore safer. The fact these five banks account for such a chunk of credit counterparty exposure is not a shock but it is indicative that the industry is maturing and becoming more institutional,” said one industry expert who did not want to be named.
The survey acknowledged the size of the banks’ exposures to hedge funds was small relative to bank capital. It said the “average potential exposure of any one bank in this survey to any one hedge fund is less than $50 million.” It also stressed prime brokers had increased their margining and collateral requirements since the crisis reducing their risk exposure to hedge funds.
Interestingly, the survey does not address the risks posed by prime brokers to hedge funds. Several banks with eurozone exposure have looked wobbly of late prompting consternation among managers and investors.
“The FSA are looking at the impact of a hedge fund default on the prime broker but most investors are focused on the risk of a prime broker default on their hedge funds,” commented Chapple.
Hedge fund complacency around rehypothecation of assets continues. Of the 89% of managers which have rehypothecation agreements in place with prime brokers, a quarter told the FSA they did not know the precise value of their rehypothecated assets.
The expert expressed surprise at these findings. “Prime brokers are legally required to give managers daily reports showing the status of the assets and what has been rehypothecated. Either managers are not reviewing this data or the survey does not account for assets which are in custody, which means rehypothecation does not apply,” said the expert.
The data also said hedge funds on average permitted rehypothecation up to 119% of net indebtedness, although the expert queried this again, adding the figure was closer to 140% or even unlimited in some circumstances.
However, hedge funds have sought to reduce their borrowing via repo or short term funding. According to the survey, repo accounts for 47% of hedge funds’ funding, down from 57% in September 2011. More managers are increasingly borrowing via their prime broker or through synthetic borrowing. Unsecured borrowing remains negligible.
Aggregate leverage has remained stable standing at 3.8 times the Net Asset Value (NAV) although fixed income arbitrage strategies reported an increase in leverage from 10 times NAV in March 2011 to 12 times NAV in 2012.
The results are based on the FSA’s Hedge Fund Survey (HFS) conducted in March 2012, and its Hedge Fund as Counterparty Survey (HFACS) conducted in April 2012. The HFS and HFACS surveys will be conducted again in September 2012 and October 2012 respectively.