Liquidity, Leverage and Those Nimble Hedge Funds

happyannThe Q1 2015 issue of AIMA Journal, the issue that marks that association’s 25th anniversary, includes an intriguing essay about the potential impacts of Basel III liquidity regulations on the dynamics between prime brokers and hedge funds.  I certainly wish AIMA a happy anniversary, but I’m more interested in those dynamics.

The authors of the essay, Edward Grissell and John Duckitt, both of Nomura International, together present the “key themes and topics” of a conference on consequences of Basel that Nomura Prime Finance hosted in January. The specific concerns of that conference included the Basel-spawned Liquidity Coverage Ratio(LCR),  Net Stable Funding Ratio (NSFR), and the Leverage Ratio.

The underlying idea of these three statistics is the same: the Basel Committee on Banking Supervision has decided that banks must maintain a stable funding profile in relation to the composition of their assets and their off-balance sheet activities.

Defining the New Requirements/Ratios

In particular, the LCR is the demand that a bank hold sufficient high-quality liquid assets to handle its total net cash outflows for 30 days under a stress scenario.  As Grissell and Duckitt observe, the phase-in of this rule “has begun as of January 2015 and will be fully implemented by 2019.”

The NSFR is the amount of available stable funding relative to the amount of required stable funding, ASF to RSF, where “available stable funding” is defined as the portion of capital and liabilities that are expected to be reliable over a one-year time horizon.

The leverage ratio, finally, is the capital measure divided by the exposure measure. Tier 1 Capital must remain higher than 3% of the bank’s average total (non-risk-weighted) consolidated assets. That is to say that assets and commitments should not constitute more than 33 times the Tier 1. The assets to be consolidated include: all balance sheet assets; derivative exposures; securities finance transaction exposures; off-balance sheet items. This and the NSFR will come into play in January 2018.

But this is all about boring old banks, you say. What does it have to do with exciting, alpha-seeking hedge funds? This is the point of the Grissell/Duckitt piece.

Overnight? Not so Much

The prime brokers within those boring old banks have already moved away from funding positions overnight, toward the 30 day financing term funding model suggested by the LCR. This entails greater cost for somebody, though as of now “the general consensus [at the January event] was that any increase … had been absorbed by the prime brokers, rather than passed on to clients.”

But that may not remain the case. Hedge fund managers find themselves engaged in conversations concerning “bank hurdle rates of various return metrics,” and those funds that can’t meet certain criteria are asked to leave the affected platforms. So those to whom the Basel mandates apply can and have imposed mandates of their own in turn.  As the date for the implementation of the NSFR nears, this sort of conversation, and ultimatum, will become more frequent.

Further, the NSFR and leverage ratio together “present a high probability that prime brokers will eventually be forced to pass on the additional costs to end clients.”

Five Bits of Wisdom

The authors offer hedge fund managers five pieces of advice:

  1. Consider the benefit you offer as a counterparty. Though recently the trend has been toward increasing the number of one’s counterparties, including one’s prime brokers, the next trend may be toward consolidation. You may be a larger part of the picture for just one prime broker than you can be to any of the multiple PBs you use in that effort to diversify.
  2. Active effort to satisfy PBs in terms of transparency.
  3. Effective management of collateral. Even “at the smallest asset managers, treasury functions will have to become much more sophisticated.”
  4. Look for opportunities.  Shadow banking could move in perform functions that banks are abandoning because of Basel and other elements in the new regulatory mix. It “remains to be seen exactly what form” the new relationship between traditional banks and their shadows will take, established credit hedge funds in particular are natural candidates for picking up some of the slack.
  5. Be nimble! A hedge fund might have to evaluate its own strategy, how that strategy uses or contributes to the bank’s balance sheet, and how that might create vulnerability. It isn’t yet obvious which strategies are most vulnerable, though, given “the sheer number of interplaying parts.”



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