By Citi Investor Services
This article gives the key findings from Part 2 of “The 2014 Citi Investor Services 5th Annual Industry Evolution Report”.
The factors driving change in the hedge fund industry are shifting. For the five years since the Global Financial Crisis, major industry evolution occurred primarily in response to a shift in the investor base.
Part I of this year’s survey explored the circumstances that caused institutional investors to emerge as the industry’s main source of capital and how demands from this audience changed key structural aspects of the market. In turn, these structural changes allowed for expanded understanding of hedge fund strategies, the broader placement and use of hedge fund managers in the core of institutional portfolios, and the emergence of a multi-tiered industry structure in which different profile hedge funds face off to unique investor audiences. The continuation of these trends is likely to help drive the amount of assets being managed by hedge fund firms from $2.9 trillion in 2013, of which $305 billion is in liquid alternatives, to $5.9 trillion in 2018, of which $977 billion will be in liquid alternatives.
Throughout this period of change, a broad and significant set of global regulations was being formulated. The complexity and scope of the rule-making has allowed these programs to hang over the market for the past several years without significantly impacting much of the day-to-day hedge fund activity. Yet, with major implementation deadlines upon us or looming, these regulatory drivers are now becoming the predominant force of industry change.
Some of the changes wrought by the emerging regulations are providing hedge funds new opportunities, each of which involves them optimizing their business approach.
- The exit of proprietary trading talent from sellside organizations resulting from the Volcker Rule and Liikanen Proposal has allowed key aspects of market-making, inventory management and direct lending to shift from a dealer-dominated activity to one where major hedge funds have a key role in taking on market risk. In many instances, hedge funds have leveraged their institutional relationships to be co-investors or even direct investors in these deals—shifting the dynamics of the marketplace and blurring the lines between investor and investment manager.
- The pool of collateral that hedge funds control is likely to continue to expand at a time when demand for high quality liquid assets (HQLA) hits all-time record highs. This could position hedge funds to begin treating collateral as an asset class with which they can supplement their trading book profits by effective use and pricing of their collateral pool. The strategies likely to attract the bulk of assets in the coming five years lie in a convergence zone where not only hedge funds, but traditional asset managers and private equity firms are looking to build new products. Hedge funds are likely to develop new roles with these competitors and leverage an increasingly interoperable collateral landscape to swap, transform and either upgrade or downgrade collateral to help meet demand from their counterparts or the clients they introduce as agents.
- The costs of financing are likely to rise as Basel III liquidity coverage ratios and net stable funding ratios negatively impact prime broker balance sheets and force broker-dealers to re-price their offerings. Hedge funds that move from a service-based to a relationship-based model with their counterparts are likely to have better access to financing and realize less extreme price increases. Leading firms are likely to concentrate their efforts to achieve financing efficiency with their top prime brokers as a tool in their relationship arsenal. Such efficiency will focus on the placement of debits and shorts. If done with an eye toward the prime broker’s funding and coverage needs, this will decrease the clients’ balance sheet utilization and increase their return on assets.
Achieving these optimization opportunities will not be easy, however. There are a number of challenges that hedge funds will need to overcome.
- The number of pools of collateral that hedge funds must now consider in administering their daily operations is expanding exponentially. A desire to protect cash assets in the wake of the Lehman Brothers bankruptcy already created a major challenge for the industry as new third-party custodial accounts were introduced into the equation and hedge funds were forced to step in to manage many of the interactions between their prime brokers, swap dealers and these new counterparts.
- These challenges are being multiplied several fold by the introduction of Dodd-Frank and EMIR OTC derivative rules. Now 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 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.
- Most hedge funds still manage their products in silos that split their view of their collateral. Securities lending teams will manage the cash and HQLA assets that result from financing activities and look for opportunities to better leverage the firm’s fully paid-for assets. OTC and listed derivative operational teams manage margin and collateral with FCMs, swap dealers and custodians. Treasury teams oversee the organization’s passive FX risk and operational currency, and HQLA reserves. Market leaders are bringing these different parts of their organization together to create liquidity management utilities that have a consolidated view of all the firm’s assets. Some are even allowing these units to leverage the collateral pool to generate a P&L for the firm.
- Increasingly, leading hedge funds are looking to create scorecards to measure the value of their wallet and engagement with their key counterparties. These scorecards are becoming important relationship management tools. Determining the right metrics to track and method of using these outputs to shape their engagement with the sell side will become a critical component of counterparty management. This will be especially important for hedge funds to capture and demonstrate the financing efficiencies and benefits they provide their set of prime brokers, and how they have increased their value as a counterpart.
- New data inputs, analytics and tools will be required to support the effective use of hedge fund collateral assets and efficient deployment of financing positions. Hedge funds will need to extract the terms of their key prime brokerage, clearing, ISDA and other documentation. They will need to be able to mimic margin calculations across their set of counterparties and model the impact of individual trades on their portfolio and on their collateral needs. They will have to be able to ladder their collateral for delivery and perform “what if” and other types of trade analysis to support the ability of the firm to step into certain market-making opportunities and accurately price collateral transformation, upgrade and downgrade trade margins.
As the demands of the new regulatory environment emerge, market leaders are going to be looking to build out new capabilities, platforms and processes to transform their organizations. Smaller firms are going to need to reassess their set of service providers to identify those organizations able to help them navigate in the new environment through outsourced offerings or new tool-sets. Understanding how the landscape is changing is a first step to that process.
The whole report (60 pages) can be downloaded from the Citi website:
http://www.citibank.com/icg/global_markets/prime_finance/docs/citi_2014_spring_survey_part_2.pdf