Finadium has released a new research report, “Hedge Funds on Leverage, Repo and Prime Custody: A Finadium Survey.” The report aims to identify how hedge funds are evolving in their thinking about leverage and how they will use prime broker balance sheets going forward.
Whether due to rising capital costs or the shift in derivatives trading to centrally cleared platforms, regulation is going to change the way prime brokers and hedge funds do business. This is now apparent in how hedge funds think about leverage, how they strategize about using bank balance sheets and what they expect from their prime brokers in the coming years.
The new survey by Finadium looks at the opinions of hedge funds on leverage, equity financing, repo and OTC derivatives. Each section of the report provides collective and anecdotal evidence on the current thinking and projected future actions of hedge fund managers. The report puts an emphasis on the speed of transitions to exchange-based products for leverage, how far hedge funds have gone towards maximizing their self-financing opportunities, and how hedge funds view the health of prime brokers going forward.
We also heard from hedge funds on their attitudes towards prime custody as a prime brokerage alternative and other areas of future competition for prime brokers. While an apples-to-apples cost comparison for these services remains elusive, funds recognize the areas where prime custody adds value. They also note where convergence of prime brokerage and prime custody makes sense and where they would prefer to see services remain separate.
Hedge funds drive financial market activity through their financing and trading activities. For all clients, equity trading revenues at the top investment banks is estimated at US$40 billion annually. Of this, prime brokerage is estimated to account for 30%, according to Coalition data. Hedge fund trading volumes may be recorded in this figure or may appear separately under equity, options or futures trading. At the very least, hedge fund activity is thought to account for at least US$12 billion annually in equity-related revenues. A decision by a large group of hedge funds to reduce leverage or to seek alternative financing in leveraged products would impact liquidity in equities, options, futures and bilateral transactions.
In fixed income, hedge funds are thought to account for 25% of market volume, according to Greenwich Associates. Already, increased costs of capital for repo transactions have widened the spread for agency transactions from 26 bps on one month paper to 34 bps on six month paper as of late last year, according to Finadium research. Further increased costs in credit or repo financing would affect not only hedge funds themselves but also their investors and the broader markets. The ramifications extend to costs borne by governments to finance their own debt. In other words, more hedge fund trading creates tighter spreads and more liquid markets. Conversely, higher costs can damage corporate government financing abilities.
Given the outsized importance that hedge funds have in financial markets relative to their assets under management, changes in hedge fund leverage and investment strategies will impact broad swaths of financial market activity. The results of our new survey suggest strategic directions for hedge funds, prime brokers, their service providers and other participants in securities financing and asset servicing markets.
More details on the report and the Table of Contents can be found at the Finadium website.