Two solutions to the Hot Cash / operational deposits problem (Premium Content)

The problem of prime brokers and custodians holding hedge fund cash and other operational deposits is becoming acute. We are now seeing two sets of solutions emerge to solve this problem; there will be more for certain.

Hot cash is the result of rules in the Liquidity Coverage Ratio that require banks to hold extra reserves of high quality liquid assets (HQLA) to cover cash outflows over a 30-day period under stressed conditions. According to the Basel Committee on Banking Supervision publication “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools,” all funds that are deposited for operational requirements qualify for a relatively painless 25% run-off factor, but hedge funds and other funds have a 100% run-off factor for cash because those funds are considered unstable.

The Basel Committee also prohibits netting from cash held by prime brokers:

“Customer cash balances arising from the provision of prime brokerage services… should not be netted against other customer exposures included in this standard. These offsetting balances held in segregated accounts are treated as inflows… and should be excluded from the stock of HQLA.”

This is a sharp stick for prime brokers and their clients. Custodian banks are also feeling the bite and they hold even more cash. The obvious solution is simply to get this cash invested somewhere off balance sheet.

Bloomberg now reports that UBS is selling their hedge fund clients short-term structured notes in exchange for cash. According to the article, “UBS Diverts $5 Billion of Asia Deposits to Curb Basel III Costs“:

“The world’s largest manager of millionaires’ money has helped some clients such as hedge funds move their cash into assets held in structures including special purpose vehicles, according to Alessandro Caironi, head of capital market and banking product sales for Asia Pacific at the Swiss bank’s wealth management arm. In return, clients receive securities such as short-term structured notes.”

“Clients investing cash in these alternative products done via SPVs get a higher coupon than they normally would,” Hong Kong-based Caironi said. “UBS benefits from being able to keep the accounts of these deposit holders, for relationship purposes and potential transactions in future.” Citi has also been selling a “collateralized fund solution” to Asian clients.

No wait, its not repo, its a special purpose vehicle. We’ll have to put a bookmark here and come back later – that could be innocuous or a big can of worms.

Another solution we are hearing is giving the money to third party asset managers. This is also tricky – how safe are these managers and what do they do with the cash? While this solution appears to be viable for some holders of operational deposits, large banks and prime brokers may reject the notion as too far outside of their and their clients’ preferences. There is also a big question of what happens if lots of hedge fund cash goes into the short-term markets then gets pulled out quickly for buying opportunities. There does seem to be a cottage industry here in Hot Cash management, but it is uncertain how much it can grow without becoming its own source of systemic risk.