It seems to be tempting fate to start considering the financial landscape once the credit crisis is over, but perhaps not – however long it takes u
It seems to be tempting fate to start considering the financial landscape once the credit crisis is over, but perhaps not – however long it takes until the markets start to return to ‘normal’, some things will not return to they way they were before. One is short selling, which has gained a stigma it will take a long time to lose, and which will remain hedged by restrictions, if not outright barriers, for the foreseeable future. The prime brokerage business seems likely to be both smaller and a lot more hard-nosed on the part of both banks and clients. And hedge fund regulation remains the great unknown – has the crisis provided the trigger for a wave of new rules that will damage managers’ ability to do their job?
Does fund regulation matter?
Last week Jersey Finance, the Channel Island’s industry promotional agency, reported that 26 Unregulated Funds had been established in the nearly seven months since the introduction of the new regime, which industry members hope will come to be viewed by hedge fund managers as a European alternative to the extremely lightly regulated funds domiciled in the Cayman Islands.
The launch of Jersey’s unregulated funds, which are either aimed at sophisticated investors or already regulated through listing on a recognised exchange, comes at an interesting time. Much of the reaction to the role, such as it is, of hedge funds in the ongoing market meltdown is that they should be subject to more regulation, not less.
Jersey’s fund industry points out, not unreasonably, that unregulated funds are aimed at institutions and high net worth individuals that know what they are doing, and that anyone investing in something labelled an “unregulated fund” should have at least an inkling that they are not, in fact, subject to regulation. Nor indeed even an audit, unlike Cayman funds, arguably it should be up to investors to decide whether they need the comfort of an audit in order to invest in a fund. In any case, unregulated funds are free to obtain an audit anyway.
But in these turbulent times, will investors feel comfortable about a fund completely free of regulation? Again, lawyers point out that if its manager is based in the UK, as most European hedge fund managers are, they will be themselves subject to regulation from the Financial Services Authority. What more would regulation of the fund offer?
Time will tell. So far, 26 unregulated funds does not settle the argument one way or the other. But there are plenty of interested observers keeping an eye out from across a few miles of sea. When Jersey’s regime was first announced, it was decried for “having won the race to the bottom”, but if unregulated funds strike a chord with European managers and investors, it is whispered that Guernsey may soon seek a similar regime of its own.
Sub-prime brokerage
The tales of woe are growing from the many hedge fund managers that were prime brokerage clients of Lehman Brothers. Estimates of the volume of fund assets frozen in the bankrupt investment bank’s London-based accounts run anywhere from USD40bn to USD70bn – even after Lehman lost as much as half of its prime brokerage assets in the last week of its life. Hedge funds could find themselves waiting weeks to recover their assets from the administrator, PricewaterhouseCoopers – and many will not last that long.
Manager such as Harbinger (which has exposure to Lehman through swap transactions) and GLG, which says its total exposure is around USD95m, less than 1 per cent of its total assets, will be all right. RAB Capital has sued – so far without result – to recover USD50m. Not so smaller firms such as Chicago-based Oak Group, which has USD25m under management, most of it stuck with Lehman, and will close. MKM Longboat Capital Advisors says the issue is a factor in the closure of its USD1.5bn multistrategy fund, which is being wound down, although poor performance also contributed. Others will certainly follow.
Over the past few months hedge fund managers have discovered that prime brokers can pull the rug from under their feet by demanding extra collateral they don’t have or unilaterally withdrawing credit facilities. Now they have found that prime brokers can represent an extreme form of counterparty risk.
But it’s not entirely a one-way street. The haemorrhaging of prime brokerage assets in the final days was one more nail in Lehman’s coffin, and since its collapse it’s been estimated that Morgan Stanley has lost up to one-third of its hedge fund assets as managers feared it might go the same way.
It’s all very well, with the benefit of hindsight, advising hedge funds not to rely on a single prime broker. Even before the crisis, many smaller funds were not in a position to negotiate acceptable relationships with a diversified group of counterparties; in the future, even when lending and leverage are back in fashion, some will struggle to find just one. Hedge funds must look forward to a future in which prime brokers will be rather fewer than a few months ago and their terms, except for a privileged handful of mega-managers, will be a lot tougher.
It ain’t over
Any lingering hopes that the eventual agreement last Friday on the US bailout package would provide a turning point in the market turbulence, finally convincing investors that it was safe to come back into the equity markets and persuading banks to resume lending to each other, were swiftly dashed in a grim day’s trading on the world’s stock markets.
Starting in Asia, continuing across Europe and ending in the US, share prices continued to plummet – 7.87 per cent in the UK, 9.04 per cent in France, 3.58 per cent for the DJIA – amid a stream of lurid headlines about institutions in difficulty or worse: Fortis, Hypo Real Estate, UniCredit, the entire Icelandic banking sector.
Across the world, central banks are ploughing short-term money into the markets and hinting at interest rate cuts, and governments are extending depositor protection promises, but nothing seems able to staunch the bleeding.
Against this backdrop, the Hedge Fund Research index figures for September are as ugly as expected: a 6.9 per cent drop for the HFRX Global Hedge Fund Index, taking its decline for the year to 11.61 per cent, with every sub-strategy losing money. For equity market neutral funds the decline was a bare 0.24 per cent; but pummelled by the short-selling ban, convertible arbitrage plunged 16.55 per cent.
It may seem impertinent to point out that the average hedge fund was down in September, and for the year to date, considerably less that most of the world’s equity markets. Yet despite the handicaps of the shorting restrictions and market conditions that have brought even the most experienced and skilful of managers to their knees, hedge funds are continuing to perform their function of protecting capital in market downturns. Perhaps imperfectly, but less imperfectly than almost anything else.
Back to normal?
Now that the US House of Representatives has passed, with whatever reservations, the Emergency Economic Stabilization Act, the legislation enacting the USD700bn bailout plan devised by Treasury Secretary Hank Paulson, does this mean that the restrictions hastily slapped on short-selling of financial stocks by regulators worldwide will be lifted?
Not so fast. In extending its ban on shorting financials last week, the Securities and Exchange explicitly tied the restrictions to the legislation, saying it was designed to “minimise the possibility of abusive short selling as the Congress works to provide a comprehensive plan to stabilise credit markets and the financial system” and would be extended to allow time for completion of work on the legislation.
Having announced that the ban would lapse at 11:59 p.m. Eastern Time on the third business day after enactment of the legislation, the SEC has now confirmed that it will expire on October 8.
But several of the other measures the US regulator has imposed under emergency rules will live on; it has stated that the rule requiring institutional money managers to disclose short positions (albeit not publicly) will be made permanent, as will new penalties on broker-dealers and their short-seller clients who fail to deliver securities by the settlement date.
It remains to be seen what the environment will be like in practice for short selling in the US after Wednesday. In the meantime restrictions will remain in place in other countries, notably the UK, where they are due to be reviewed only in January. Any changes may not be for the better; British prime minister Gordon Brown has hinted that the ban could remain in place longer and be extended to stocks outside the financial sector.
Of course, it could be that the authorities in the US, UK and elsewhere are taking on board criticism that the short-selling ban has reduced market liquidity, hindered price discovery and hamstrung markets such as convertible bonds, and that they are ready to let short selling in their markets again operate freely. But you’d be ill advised to bet your fund on it.
