Credit Limits and Hedge Funds Author: Financial-edu.com
Hedge funds contribute unique risks to the global financial system. On one hand, due to their active trading nature, hedge funds generate substantial liquidity which increases the ability of market participants to trade efficiently. However, due to their nature as private pools of capital and their use of higher than average leverage, hedge funds can pose substantial counterparty risk. Thus, the issue of credit limits for hedge funds becomes very important, both for fund managers, and for counterparty banks and brokers.
Most major prime brokers utilize a counterparty credit risk management system to control their exposures to individual hedge funds and hedge fund groups / investment managers. The main issue with such systems from a sell-side standpoint is the inability to capture a hedge fund's complete exposure profile. Most hedge funds have multiple prime brokerage arrangements, which would theoretically allow for duplication of the same or similar directional positions with multiple brokers, each lacking complete visibility to the others' exposure, and therefore the total risk profile of the hedge fund. This situation is exacerbated from the broker's standpoint by the lack of reporting requirements (regulatory or otherwise) imposed on hedge funds.
While this may appear to be an opportunity for an aggressive fund manager, there are natural limitations to the possibility of over-leveraging through multiple prime brokers.
First, hedge funds grow assets by maximizing their portfolio return-risk profile and branding value of their franchise to potential investors. The larger a fund gets, the higher up the food chain the fund must swim, and the higher the standards for risk-adjusted performance. A fund that over-leverages by taking too much directional risk exposure across multiple prime brokers will suffer badly when the market turns against its strategy, and investors are liable to pull money out or not invest at all.
Second, credit risk is typically calculated on a net basis by the prime broker across all positions with a particular hedge fund client. If it is assumed that all prime brokers manage their risk in this way, the net risk exposure as a percentage of portfolio value should be roughly the same for every prime broker. Furthermore, due to natural differences in each prime broker's product focus, and the timing and size of trades, no position is likely to be the same across a hedge fund's prime brokers. Hence, there is likely to be a natural diversification of risk across prime brokers which reduces catastrophic risk of ruin.
In recent years (and especially with the most recent ABS and MBS default crisis), prime brokers have made substantial strides to reduce their counterparty risk with hedge funds. The counterparty credit risk management system is enhanced by means of margin and collateral posting based on recent market volatility. As market volatility increases, the hedge fund is required to post more maintenance (variance) collateral for existing positions and more initial collateral for new positions. This has the natural effect of de-leveraging the hedge fund when market volatility increases. Naturally, this does not eliminate exposure to sudden large unforeseeable market events or sudden jumps in volatility combined with dramatically reduced liquidity (jump risk). However, prime brokers are naturally more inclined to issue margin calls, requesting cash or marketable securities, or simply liquidation of positions to reduce notional exposure.
Credit limits and collateral management are tied together using Value-at-Risk (VaR), stress testing, internal credit ratings, due diligence, and ongoing monitoring of concentration exposure of hedge funds by their prime brokers. These methodologies are designed to highlight potential unforeseeable market risks by simulating low probability, but high impact adverse events. Typically credit limits are set by selecting "tail risk" of 95-99% as shown in Monte Carlo simulations, both within a single hedge fund portfolio, and across a fund manager's various funds. This maximum exposure taken by the broker is further reduced by any known external exposures which are uncovered during due diligence and past relationship issues with a particular fund. Marketable collateral (either cash or marketable liquid securities or both) is then required to be posted by the hedge fund to cover this calculated maximum exposure.
Liquidity and complexity of various structured instruments are a significant issue for prime brokers when calculating hedge fund credit limits. How can a dealer calculate limits if a fund's positions are highly unique and illiquid, typically where the hedge fund makes its greatest potential returns? Forcing a hedge fund to unwind such complex positions can actually drive down the value of the instruments themselves, increasing the event risk. To some extent, this is a major vulnerability of hedge funds, as they are dependent upon the prime broker's willingness to allow the fund to hold risky positions through market turmoil. As we have recently seen in the MBS and ABS markets, many hedge funds trading asset-backed leveraged instruments have been forced out of business by their brokers, who have taken the client's positions as its own, and later sold them at a profit when liquidity improved. On a much grander scaale, this is exactly what occurred to Bear Stearns, one of the largest global prime brokers, when the Street failed to support the firm through recent market turmoil and JPMorgan made a timely purchase of the firm. The sword cuts both ways in times of market stress.
Hedge funds themselves may occasionally incur counterparty credit risk if one of their prime brokers gets into trouble. The most recent and glaring example is the failure of Bear Stearns, once one of the largest global prime brokers. In an odd twist of fate, the venerable firm's exposure to the mortgage-backed market sparked a crisis of confidence in the ability of the firm to operate as a broker dealer. In the aftermath, JPMorgan bought Bear Stearns and the counterparty deals had to be sorted out. In some cases hedge fund clients found themselves counterparty to another bank (or even another hedge fund) who now owns the opposite side of its positions.
Further research and guidance on hedge fund credit limits can be found at the following sources:
Counterparty Risk Management Policy Group II (2005) www.crmpolicygroup.org
EDHEC Risk and Asset Management Research Centre www.edhec-risk.com
Federal Reserve Bank of New York www.newyorkfed.org
U.S. Department of the Treasury Office of Financial Market Policy http://www.treas.gov/offices/domestic-finance/financial-markets/fin-market-policy/
Financial Stability Forum (2000, 2007) www.fsforum.org
Financial Services Authority (2005) www.fsa.gov.uk