As the latest batch of Asian governments have just demonstrated, hedge funds make convenient scapegoats. Perhaps Malaysia and Indonesia would have been better advised to restrict their reactions to rhetoric. Their attempts to artificially regulate their way out of a crisis did little, other than immeasurably improve the situation from the funds’ perspective.
Since shooting to public prominence at the time of sterling’s ignominious exit from the EU’s exchange rate mechanism in September 1992, hedge funds are now trotted out at least once a year by some government or another as a convenient excuse for their own fiscal shortcomings. However, the publicity misses the point. Hedge funds are here to stay and have become an integral part of the financial markets. Nowhere has that been more the case than in derivatives where there is clear evidence to suggest that they are shaping events – and investment banks.
To service hedge-fund business as a whole, the investment banks offer two distinct types of service: prime brokerage and niche services. Prime brokerage consists of a number of services, ranging from mundane needs such as custody or performance reporting to buying/selling individual instruments, including OTC derivatives. Whatever the type of hedge-fund client, the prime-brokerage providers are typically only the very largest banks, which have sufficient depth of wallet and credit rating.
The niche services give some of the second-tier investment banks an opportunity to play, by offering the funds specific products, such as equity derivatives. In addition, a few large commercial banks that are not in the prime-brokerage business for regulatory or other reasons also provide forex or derivatives.
For the hedge funds, liquidity and leverage are the primary concerns. For some of the larger global macro players, with capital bases running into the multiple billions, liquidity isn’t just a concern – it’s a mantra. As a result, their use of derivatives in some markets will focus primarily on this rather than just on outright leverage. Nevertheless their typical transaction size can be colossal, which has not only made them supremely attractive clients but also extremely demanding ones. Only the very top tier players are likely to be able to offer the major global macro funds the necessary deal size and pricing. This has been reflected in the number of specialist derivative desks dedicated to servicing hedge-fund clients that have appeared at major investment banks.
Peter Vinella, president of consultants PVA International in New York, was the head of fixed-income research at former investment bank Drexel Burnham Lambert, as well as being director of research for one of the firm’s internal hedge funds. “Hedge funds have basically become the big flow mechanisms for investment banks,” he says. “While hedge funds have been around for 20 years or so, they were never as numerous or large as they are now. The investment banks were originally geared toward institutional investors which were the major source of flow. Now that role has been taken on by the hedge funds, primarily because they are in and out of the market on a regular basis. Banks have had to change their methods and operations to accommodate the more eclectic demands of the hedge funds.”
The changes that the banks have had to make to accommodate this reflect the difference in profile between a conventional fund manager and a hedge fund. In particular, the level of leverage typically employed by hedge funds means that effectively they have no credit rating. Since the margin in offering execution services to hedge funds dried up long ago, the banks now have to make their money by selling them credit. As a lot of hedge funds’ strategies are based on cashflow and structuring, they now want credit that is more attuned to those needs, rather than just to borrowing securities.
A typical example is an index swap, where a bank will take the other side of the trade and lay it off in the market. The spread that the bank makes on this is not based on the difference between what it can buy and sell the securities for, but on its credit rating relative to the hedge fund. To provide the leverage those hedge funds are looking for, the banks keep their positions on a margined basis, so a $100 million trade might only require a $10 million cash input (haircut) from the fund. The interest on the $90 million margin difference is where the banks now make their profit.
“A number of banks have seen the hedge-fund writing on the wall and started to realize that they can make better margins by taking on risk rather than trading,” says Vinella. “Their tacit assumption is that there are other traders (namely the hedge funds) who can out-trade them, but who don’t have the balance sheet. They are therefore happy to lend them their own in one form or another and make the margin that way. If you can’t beat Soros – be his partner.”
The concentration of hedge-fund business in the hands of fewer, larger players is a trend that looks likely to increase. In part this is due to the way that hedge funds now prefer to put on their trades – in one hit at one shop. “Funds now tend to leave orders with banks based on spreads,” says Martin Walton, managing director of Gottex Financial Products Limited (London), which markets the hedge funds of Gottex America Limited (Bermuda). “For example, they may make a complete 2, 5, 10 butterfly in a bond or swap good for the day, in order to give the bank time to get the size together. The previous alternative was to split the butterfly between maybe four banks and have four people on line at the same time, each with perhaps two or three further people behind them pricing the trades. This tied up a lot of people and made the market jittery, as four banks would know that a big deal was going through and that they might only get a piece of it. To avoid this sort of confusion many hedge funds now leave spreads with their total size, which means that fewer banks are getting the business.”
One of the major attractions of derivatives for hedge funds is the ability to put on complex multi-legged trades in a single OTC trade. A popular trade recently among US hedge funds has been to buy mortgages, enter interest swaps (paying the fixed) and buy payer’s swaptions to lock in the mortgage spread on the assumption that they are hedging the pre-payment risk. Their ideal is to do that in a phone call and at the same time pick up attractive rates on the necessary credit facilities. The effect of this has been to force banks to bring together previously disparate parts of their business in order to provide a suitable pre-packaged product. “There’s no question that the barriers between, for example, repo, bond and FX desks are disappearing rapidly due to hedge fund requirements,” says Walton. “Having said that, any bank that tries to charge the full bid-offer on each component from those individual departments is going to lose the business. In fact a lot of generic products are trading very much at mid market.”
Another factor that has made hedge funds the clients of choice for investment banks has been the nature, rather than just the size, of the flow that they generate. “Banks need to diversify their revenue stream away from traditional markets,” says Patrick Moriarty, president of Evaluation Associates Capital Markets in Connecticut, which manages $800 million in a fund of funds hedge fund. “Hedge funds are the ideal catalyst for helping them to do that, particularly the market neutral, event-driven or global macro players. Their trades will typically have little correlation with more conventional managers who are focused on a long-biased directional market.”
While hedge funds are by nature innovative beasts (after all, they have traditionally creamed off the best of the trading talent among the proprietary traders and asset managers at investment banks), they are increasingly becoming victims of their own success. As their burgeoning size makes manoeuvring in the markets more difficult, they are being compelled to increase their level of innovation in order to maintain returns. This situation has been further exacerbated by investors putting increasing pressure on hedge funds to account for how closely they are following their stated strategy. Funds have not therefore just had to innovate to increase returns, but have had to do so within more strictly enforced boundaries.
The result of this has been the requirement for investment banks to be able to price and offer increasingly sophisticated and novel derivative products. It’s no longer so much a case of someone at the bank dreaming up a product and then trying to sell it to the hedge fund, more a case of the hedge fund saying: “We want this, combined with this and this – can you do it?” A case in point was the appearance in around 1993 of the double-barrier one-touch binary option (which pays a fixed amount if the price stays in range, or nothing if it breaks the range). A particular need among hedge funds at the time was an instrument that would allow them to go short of volatility in an efficient manner and had a binary pay-off. Using a double barrier straddle was possible, but it hadn’t been an ideal solution, because it didn’t have a binary payoff and threatened unlimited downside losses. The double-barrier one-touch binary allowed a hedge fund, which expected flat volatility, with the price staying in a trading range, to make a clean one-off bet. A fixed premium was paid by the hedge fund, and the investment bank made a fixed pay-out if the security stayed “in range”. If either barrier was hit, the option ceased to exist.
Hedge funds hunting for what they are probably best known for – maximum leverage – have also driven the creation of the contingent premium option. The fund pays no premium up front, but a number of premium trigger levels are set (below the market for a call, above for a put). If the market trades to the first of these trigger levels, a premium becomes due. If it then trades to the next trigger level, another premium becomes payable – and so on. If however the market moves immediately in the direction anticipated by the fund, and continues to do so, no premium is paid at all – thus providing potentially infinite leverage.
However, the hedge-fund-inspired product that probably aroused the greatest interest recently was the put option that Credit Suisse Financial Products agreed to write this summer – on a hedge fund client’s own performance. CSFP pays out on the option if the fund’s performance falls below a specified level. Logistically the transaction should prove something of a headache, as CSFP will have to actively monitor all the hedge fund’s transactions and open positions in order effectively to manage the risk. (This would be far simpler to do were the client a conventional fund manager.) Even though it is guaranteed access to some proprietary information in order to help it hedge the deal, the downside for CSFP is still considerable. So considerable in fact, that its internal risk committee is reported to have banned any further such transactions when it heard of the trade.
Though not everyone agrees, there are those who see hedge funds as one of the primary driving forces in the creation of new derivative products. “Wall Street is a service industry, so if there’s a client in sufficient size looking for something specific, someone will sell it to them,” says Marc Landeau, chief executive of Olympia Capital Management in Paris. “That is driving the development of derivatives.” However, the global macro funds that have become household names are not necessarily the ones that are doing the driving. “Probably the most sophisticated are the mortgage-backed arbitrage relative value players,” says Landeau. “The mortgage-backed market is a huge industry, intimately familiar to the professionals who devise and use complex derivative structures to determine precisely their desired exposure.”
Tom Schneeweis, finance professor at the University of Massachusetts, agrees with this view. “I don’t think that the global macro hedge funds are necessarily the ones putting on the most innovative trades, as they have to trade enormous size in huge markets,” he says. “Their focus tends to be on trend-following, information impact and liquidity issues. The market arbitrage neutral funds do the most interesting things in terms of innovation in financial modelling, because they have to come up with a relative value on primarily OTC instruments.”
In the process of doing this, the hedge funds also keep the banks on their toes by arbitraging between their OTC derivative quotes. The variety of methods used by banks for pricing more complex derivative structures means that these opportunities are not uncommon. “I wouldn’t say that it was an everyday event,” says Philip Moffitt, executive vice-president at Tokai Asia (the in-house hedge fund of Tokai Bank) in Hong Kong. “But our specialist relative-value traders do spot these quotes when they get out of line and trade them. The situation doesn’t usually arise in the straight volatility quote on an option – it’s more typically in the implied volatility in a structured product. You’ll have two quotes for a cap or floor structure, barrier or knock-out and the implicit volatility quote will be quite different. Then it’s a question of whether you can transact the component parts cheaply enough, or offset the two deals cheaply enough, to arbitrage the volatility.”
Apart from pushing the creation of new derivative products, hedge funds have also performed a key liquidity role in some existing OTC markets. Credit derivatives are one group of products where this has been particularly crucial in helping the market to develop. As hedge funds are one of the few investor groups typically using credit derivatives to take on additional credit exposure in this market, they are facilitating the hedging activities of others, such as commercial banks. Apart from the ubiquitous global macro hedge funds, many of the sub-species of fixed-income hedge funds have also been active in this market. That’s hardly surprising as the market has a number of characteristics that makes it a natural fit for a variety of different types of hedge-fund managers.
“When credit-derivative professionals refer to the advantages of credit derivatives for those who lack the infrastructure to buy and handle loans, hedge funds spring to mind as the likely candidates,” says Randy Kaufman, managing director of global derivatives at BankBoston. “They’re increasingly using credit derivatives to access new asset classes and are one of the biggest users of total-rate-of-return swaps. They also like the unfunded nature of such instruments as credit-default swaps and typically use them to gain access to (rather than lay off) exposure, which gives them a key role as counterparty to more conventional investors looking to hedge positions.
“They have a preference for names that they already know and often use credit derivatives on a specific name to enhance the total yield of a bond that they already own issued by that name. Hedge funds have also been heavy users of total-return swaps as a means of accessing high-yield or emerging-market bond indices. Their activity in derivatives on corporate credits has been marked by a penchant for rated US corporates in basket deals as opposed to individually.”
Hedge funds have also been adding liquidity in the mortgage-backed market. “Over the last 18 months hedge funds have been getting involved in callable mortgage deals,” says Charles Schoenig, senior vice-president at CDC Investments in New York. “They’ve been taking the calls on both the pass-throughs and the tranches created from them. On the back of the seemingly endless compression in credit spreads, hedge funds (both global macro and the more specialized fixed-income mortgage-backed funds) have also been taking an interest in the newer bonds created from the lower-grade mortgage credits.”
They don’t buy just anything
Desirable clients though hedge funds may be, they certainly don’t fall into the category of impulse shoppers when it comes to derivative products. “The assumption that investment banks devising the latest complex structured product will find a ready market for it among hedge funds is wide of the mark,” says Sohail Jaffer, chairman of the Alternative Investment Management Association, an international trade association with offices in London and Paris that includes a number of hedge funds among its membership.
“While they will certainly be part of the enlightened user base likely to receive an approach, hedge-fund managers are above all mindful of liquidity,” Jaffer adds. “I think one needs to consider what drives hedge-fund managers, namely the development (and maintenance) of as good a track record as possible. If they are in for the long haul, any dips below the loss norms indicated in their offering material are going to hurt when raising money. The bulk of their earnings come from performance fees, so it is not in their interest to go out on a loose limb and trade exotics for the hell of it. Why run the risks of getting locked into an illiquid position that will entail a major performance hit to exit? An example of this has been the lukewarm response that catastrophe bonds [products that securitize the reinsurance risk relating to natural catastrophes, such as earthquakes] have had among hedge funds. Though several investment banks have worked hard to promote them, and even though the products have a lack of correlation with bond and equity market downturns that should be attractive to hedge funds, activity has been muted.”
However, hedge funds’ scepticism makes them valuable as a litmus test for new derivative (and other) products. With higher management fees than conventional managers, they also have more cash and more inclination to spend on information technology. Consequently they have the firepower to analyze the most complex products. “If we have a really off-the-wall idea that is particularly computationally intensive, which we want to bounce off someone, we’ll show it to a particular hedge-fund client of ours,” says the head of hedge-fund derivative sales at a major investment bank. “Let’s face it, they’ve got a Cray supercomputer – we haven’t.”
