Rehypothecation caps in EU would hurt PBs and hedge funds, warns industry experts
A stringent regulatory cap on rehypothecation would limit prime brokers’ ability to provide financing against illiquid instruments at hedge funds, while it would almost certainly push costs up at managers, a senior executive at Citi Prime Services has warned.
Rehypothecation cap would restrict financing of the more illiquid strategies
This comes following a report published by COOConnect that Patrick Pearson, head of the financial markets infrastructure unit at the European Commission, was reviewing whether or not to impose a cap on rehypothecation. Pearson said any cap, if at all, would be between the 125% cap proposed by Paul Tucker of the Bank of England and 140%, which is currently the level enforced by the SEC, although US regulators are reviewing this limit.
“A cap which is well under 140% at say 125% would have an impact were the collateral at a low investment grade and it would become harder for the prime broker to provide financing to certain strategies. However, were regulators to follow the US line and impose a cap of 140%, I doubt there would be many issues,” said Mark Harrison, European head of prime finance at Citi.
Harrison warned that prime brokers not endowed with generous balance sheets would be the most affected. “It would result in some prime brokers reducing financing to illiquid, high risk asset classes. The likelihood would be that prime brokers with large balance sheets would take on that business,” he added.
This comes at a time when more hedge funds are chasing returns through esoteric strategies. While the majority of managers still run long/short equity portfolios, a growing number are focusing on distressed and credit strategies with MBS even making a comeback in some circles. “We are seeing more hedge funds branch into slightly more complex strategies and some of these managers might be hard-pressed to find a prime broker willing to provide financing were tough caps imposed,” he said.
The rules, if enacted, would ultimately have an impact on prime brokers’ P&L, which is already struggling amid inactivity among their hedge fund clients. “The rule is not terminal but it is hardly helpful,” commented Harrison. Any cap would also ramp up costs at hedge funds and their underlying investors – something Patrick Pearson himself admitted.
David Fletcher, chairman at Odey Asset Management, said regulators would be better placed to monitor the levels of rehypothecation at prime brokers rather than impose a hard and fast cap. He added many hedge funds were already able to negotiate rehypothecation limits at their prime brokers. “Hedge fund investors should understand the risks implied by rehypothecation and this may require managers to negotiate with their prime brokers accordingly,” said Fletcher.
The G20 and Financial Stability Board are delving deeper into how rehypothecation works. Any cap would hit the UK in particular, which currently does not enforce limits on rehypothecation. However, most managers tend to have rehypothecation limits of 140% in place although some will be substantially higher. The latest hedge fund survey by the UK Financial Services Authority (FSA) alarmingly revealed a quarter of managers did not know the precise value of their rehypothecated assets despite prime brokers being legally required to provide daily reporting on such matters.
Pearson said any decision to cap rehypothecation would not be taken lightly and the Commission was carefully reviewing the implications such action would have on liquidity.