The Search for a New Normal in Europe

By Christopher Faille

The European Central Bank’s latest regular financial stability review (click here for the full report and here for an index to its sections) uses the word “normalisation” a lot.  For example, in the Overview it announces that a “normalization of the unsecured interbank market in the euro area has been accompanied by a significant pick-up in debt issuance.”

A little later, and of more interest to alpha-seekers, the ECB cautions readers that there has been a fall in risk aversion since 2009, and that (a symptom of this) hedge fund leverage has increased.  On the one hand, the ECB believes that this lowered risk aversion is worrisome, and should be “monitored,” one the other hand, it re-assures us that such a development can be explained by “a process of normalization in the wake of the financial crisis.”

Normal is good.  Normal is the keystone of the arch of central bankers everywhere.  Of course, alpha is the search for better-than-normal, yet one could argue that the search itself requires some sense of normality among the underlying institutions, and the ECB’s report, issued June 15th,  is a testament to how deeply that normality was shaken by the events of 2007-08.

Lower Redemption Notifications

When the report does discuss the global hedge fund industry specifically, it announces that conditions in that sector have “largely normalized,” in contrast to that sector’s condition as recently as late 2010.  Low nominal interest rates have made alternative attractive investments scarce, which in turn have lessened the redemption risk faced by hedge funds.

Specifically, in mid May 2011, “forward redemption notifications received from investors for administered hedge funds, measured as a percentage of the total capital under management” was quite low, having descended more-or-less steadily through the two and a half years since the worst such numbers.  The percentage of investors who wanted their funds redeemed within one month or less exceeded 18 percent of total capital at the worst of the crisis.  But the peak of that same number in 2010 was a modest-seeming 4 percent, and now sits below that.

In terms of hedge fund performance, though, year to date results in the first four months of 2011 are not as positive as were the results for the same period in 2011.

Short bias funds have been getting clobbered.  Other fund strategies have shown positive, but unimpressive, results.  Distressed securities did respectably well in this period in 2010, but not as well this year.

It is possible that the lessened performance has a quite familiar cause, the crowding of too many funds into too few trades or opportunities.  At the end of April 2011, moving median pair correlations of the returns of hedge funds within investments strategies reached all time highs for several strategies.  This is a good statistical proxy for the crowding effect, the ECB tells us.

Prime Brokers and Central Clearing

The report has important observations, too, about the hedge fund industry’s service providers.  According to market intelligence, the ECB says, “prime broker banks [seem] to be increasingly ready to offer term financing commitments,” lessening the danger of a liquidity crisis for their hedge fund clients.  ECB report indicates this is could imply lower liquidity risk for the hedge fund industry, but there’s a large caveat.  It isn’t sure whether these commitments are generally “cancellable by banks in stressful conditions.”  If they are, then it isn’t clear how significant a development these financing commitments are.  Banks may have re-invented those proverbial airbags that only fail when there’s a crash.

In a section on the euro area banking system, the ECB says – citing the International Capital Markets Association’s “European Repo Market Survey,” that the use of central clearing counterparties (CCPs) for secured lending transactions has increased.  This could prove a very positive development for the lower-tier Eurozone countries, the ones that have been experiencing the greatest stresses in recent years.  Spanish banks have reported a “very positive experience” after they joined an international CCP.  There is a tendency among Portuguese banks toward doing likewise.

Striking Chart on Trigger Breaching

The report returns to the theme of the normalization of the hedge fund world.

One striking chart presents the estimated proportion of hedge funds that are, on a monthly basis (and on a rolling quarterly or a rolling weekly basis) breaching triggers of cumulative total net asset value decline.  Such triggers might allow a counterparty bank to terminate transactions with the breaching hedge fund and seize collateral.  Chart 4.22 shows the rise and fall of the proportion of hedge funds tripping such triggers since January 1994.

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