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Hedge fund managers see CDS counterparty risk as growing threat to global markets, says report

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More than 90 per cent of hedge fund managers polled for a new study by Greenwich Associates believe that counterparty risk in credit default swaps represents a serious threat to global fin

More than 90 per cent of hedge fund managers polled for a new study by Greenwich Associates believe that counterparty risk in credit default swaps represents a serious threat to global financial markets.

The study, involving 146 institutions in North America and Europe, was launched by Greenwich Associates following the collapse of Bear Stearns amid widespread speculation about the financial health of other global banks, to investigate how fears of counterparty risk were affecting institutional investment and trading strategies.

Thirty-seven percent of the institutions participating in the study had more than USD50bn in assets under management, and 18 per cent more than USD100bn. The respondents consisted of 32 hedge funds and 114 banks and traditional long-only investors, of which 70 per cent were based in the US and the remainder in Canada and Europe.

Nearly 85 per cent of the US institutions polled see credit default swap counterparty risk as a serious threat to global markets, compare with 55 per cent in Europe. ‘At the other extreme are hedge funds, more than 90 per cent of which see counterparty risk relative to credit default swaps as a significant threat to global markets,’ says Greenwich consultant Jay Bennett.

Most institutions surveyed expect another major financial services firm to fail as a result of the continuing crisis in the financial industry – sooner rather than later. Nearly 60 per cent of respondents predict another major financial services firm will collapse within the next six months, and another 15 per cent within 12 months, although the biggest investors are the least pessimistic.

‘Only 27 per cent of institutions do not think there will be another casualty along the lines of Bear Stearns,’ says consultant Frank Feenstra. ‘If you are looking for a silver lining, most institutions seem to think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside.’

Nearly 80 per cent of the institutions polled say their banks have tightened margin or collateral requirements since the onset of the credit crunch. ‘The results indicate that many of the banks widely viewed as being hit hardest by the credit crisis have been the most aggressive in tightening the margin and collateral requirements imposed on their trading clients, but even banks that have emerged relatively unscathed have tightened terms,’ says Greenwich’s Peter D’Amario.

Among institutions reporting that their banks have imposed stricter requirements, nearly 65 per cent say the change has not had a significant impact on their trading activities. However, more than a quarter say the new requirements have led them to reduce their trading activity.

Concerns about counterparty risk have caused institutions to cut back on their use of credit default swaps. Among survey participants that employ CDS, 62 per cent say increased counterparty risk has caused them to limit their use.

Among all institutions, the most common method of managing counterparty risk – used by more than 70 per cent – is to trade only with the most financially sound banks and broker dealers. Almost 65 per cent of participants also try to limit the concentration of exposure to a single counterparty, one-third make use of cross-collateral arrangements and 5 per cent use exchange products for hedging.

Institutions in general support efforts to reduce counterparty risk in the credit default swap market through the establishment of a centralised clearing entity, with three-quarters of respondents believing that such an entity would be effective in mitigating counterparty risk.

Hedge funds worldwide and institutions of all types in continental Europe are among the strongest supporters of this idea, with almost 85 per cent of each arguing that it would help reduce counterparty risk. Almost 60 per cent of these respondents would prefer a centralised clearing platform operated by an exchange to one sponsored by banks.

‘Seven out of 10 hedge funds would rather use a clearing entity operated by an exchange than one operated by the banks,’ says Greenwich’s Tim Sangston.

Greenwich Associates is an international research-based consulting firm in institutional financial services, specialising in providing benchmark information on best practices and market intelligence on overall trends. Based in Stamford, Connecticut, with offices in London, Toronto, Tokyo and Singapore, the firm offers more than 100 research-based consulting programmes to more than 250 global financial services clients.

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