There was an excellent article published on May 7th in Bloomberg Businessweek entitled “Hedge Funds Rush Into Debt Trading With $108B as Banks Trim Risk”, written by Lisa Abramowicz, Miles Weiss, and Christine Harper. We recommend it highly.
The authors primary focus is on how hedge funds have filled the vacuum left by the banks in fixed income trading. The backstory is, by now, familiar: the Volcker Rule (when the rules are finally done) will prohibit prop trading. When combined with higher capital requirements that push banks to limit capital intensive activites, the result is that fixed income trading may not look very attractive as a business. Hedge funds live in a different world; they don’t answer to bank regulators and aren’t held to the same metrics.
A great quote in the article came from Deutsche CFO Stefan Krause,
“There are businesses based on our capital regulation we’ll not be able to do” that “hedge funds will be able to,” and “If I had to bet who is going to benefit the most post-crisis from the asset appreciation you have coming, then certainly hedge funds.”
The article has a lot of interesting detail on how hedge funds have used the opportunity to expand into fixed-income arbitrage, often draining trading talent away from the banks in the process. This is the business of going long and short risk in hope of benefitting on a normalization of the spread. While not necessarily very risky (well, if you don’t count LTCM), these trade balloon balance sheet and, for the banks, can require lots of capital.
The connection to shadow banking should be obvious. Hedge funds, often referred to as “lightly regulated”, aren’t subject to the same regulatory constraints as banks. Hedge funds aren’t SIFIs (at least not yet). They are active in maturity transformation – mismatching funding with the underlying assets.
But remember that hedge funds are typically highly leveraged and get their funding from the bank repo desks and prime brokerages. The risk, less haircut, boomerangs back to the banks. Only now it is more opaque. The regulators have taken note…well, kind of. They have focused primarily on the knock-on effects of funding shocks. We’ve been on a tear this week looking at that topic, first in “Tarullo: short-term funding the next great unsolved challenge” and then in “The NY Fed looks at collateral fire sales and tri-party repo: some good ideas, some well….”
For some related issues, we would point you toward our April 16th post “Who does Shadow Banking when the bank’s can’t” focused on alternatives to repo, securities lending, and securitization. In “The growth of regulatory capital trades and the names of firms taking the other side” on April 11th, we took a look at how banks were offloading regulatory capital.
A link to the Bloomberg Businessweek article is here.
A link to the SFM post “Tarullo: short-term funding the next great unsolved challenge” is here.
A link to the SFM post “The NY Fed looks at collateral fire sales and tri-party repo: some good ideas, some well….” is here.
A link to the SFM post “Who does Shadow Banking when the bank’s can’t” is here.
A link to the SFM post “The growth of regulatory capital trades and the names of firms taking the other side” is here.