Hedge funds are increasingly approaching private equity firms to trade complex “deal-contingent” currency derivatives directly, threatening to sideline investment banks that have long dominated this niche market, according to a report by IFR.

These derivatives hedge FX risks on cross-border M&A deals but only activate if the deal closes, making them tricky and risky for banks to manage.

Traditionally, banks such as Bank of America, Barclays, BNP Paribas, Deutsche Bank, and Morgan Stanley offered these hedges to clients but have recently offloaded risk to hedge funds like Citadel, Millennium, Jane Street, and DE Shaw. While some banks welcome hedge funds for improving liquidity and pricing, the prospect of funds bypassing banks and pitching directly to private equity raises concerns.

Industry insiders caution private equity firms may be wary of the counterparty risk and operational complexity of dealing with hedge funds directly, given the crucial timing and scale of payments involved in M&A transactions. Hedge funds, meanwhile, face regulatory and operational hurdles that make direct deals challenging.

The move spotlights the evolving dynamic as hedge funds expand into traditionally bank-dominated markets amid ongoing pressure on banks’ capital and risk limits. While proponents highlight improved risk distribution and pricing, critics warn of conflicts of interest and sensitive information leaks.

Some private equity sponsors are actively insisting that banks keep hedge funds out of their deal-contingent transactions to protect their objectives, illustrating the delicate balance between innovation and risk in this complex space.