Clearers and prime brokers should be careful of new, relatively small hedge funds with an investment charter that grants the manager lots of leeway. With the new portfolio margining rules about to be implemented, some of these funds could get riskier.
That’s what one attorney who represents some small funds says. Randall Steinmeyer, who also sits on the board of directors of the Washington, D.C.-based Hedge Fund Association, has mixed feelings about the new portfolio margining rules, which will reduce funds’ margin requirements and enable them to employ greater leverage.
“When you have more leverage, it increases the chances of people blowing themselves up,” Steinmeyer told Traders Magazine. “For the undisciplined hedge fund, this is like giving the drug addict more access to drugs.”
Greater Leverage
Indeed, some who backed the changes agree that greater leverage could cause problems. “I would imagine that anytime you increase leverage, you have the possibility of failure and accelerate the possibility of failure,” says a hedge fund manager who didn’t want to be identified. However, this manager supported the changes, saying a revelation of failure will tend to come sooner than it would have under the old rules.
Other proponents of new portfolio margining requirements say that without the changes, hedge funds would continue to move offshore. These changes make American markets more competitive, fund managers point out. They will also generate more business for investment banks and prime brokerages, which provide capital for many funds, according to trading officials.
Still, some proponents of the new rules raise the specter of another Long Term Capital Management blowup. LTCM was a $4.7 billion fund that collapsed after several fat years in which it returned 40 percent or more.
LTCM used a strategy that employed significant leverage. “Their use of leverage caused their positions to become so large relative to the rest of the market that it was very difficult for them to unload those positions when faced with losses,” according to “Way of the Turtle,” a new book on trading by Curtis M. Faith, head of research and development for Trading Blox.
Offshore Operations
Nevertheless, while some worry that the new rules could make markets more precarious, advocates argue they are necessary for U.S. markets to stay competitive.
“It is a means of keeping derivatives trades on the shores of the U.S.,” says a prime brokerage official, speaking on background, who is employed at a large investment bank.
He adds that he knows of several hedge funds with offshore operations whose foreign clients fared better than domestic investors with the same strategy, simply because of leverage. “This affects the ability of a fund to perform,” he notes.
“It is essential that regulation of the security futures and equities markets maintain the competitive balance,” Paul Bennett, chief economist and senior vice president of the New York Stock Exchange, told the Senate Banking Committee in 2005 about portfolio margining rules that had been proposed.
Even attorney Steinmeyer tempered his criticism of the new rules, observing that most large hedge funds have tight charters and efficient risk controls. Steinmeyer says newer funds and those trading lightly traded issues in volatile investment categories, such as micro-cap stocks, would be the most likely to run into problems because of greater leverage.
Self-Destruction
One hedge fund manager, a supporter of the new rules, agrees that it will now be easier for a fund to self-destruct. Indeed, more leverage could allow it to happen sooner. He adds that the biggest investment banks as well as small broker-dealers need to be increasingly diligent about risk management and portfolio margining. They must, he said, know their business inside and out.
“You just don’t jump into the lake without knowing the depth of the lake,” he says. Brokerage officials with hedge funds as clients should look for red flags such as style drift and sudden purchases of large volumes of illiquid securities, he adds.
The investment bank official says smaller players should also look at their risk systems and conduct a gap analysis. They must figure out where their risk control systems are not as good as those of the biggest players, and then try to compensate. And they should be proactive, he says.
“Certainly, there’s nothing that stops us from slapping on higher margin requirements,” says the investment banking official. “It behooves everyone, small and large, to know their customers.”
The debate comes on the heels of the Chicago Board Options Exchange and NYSE winning approval from the Securities and Exchange Commission to allow member firms to offer portfolio margining to qualified customers. NASD is waiting for SEC approval for its proposal, which is modeled on the CBOE and NYSE plans.
Under portfolio margining rules, a new risk-based model replaces the strategy-based approach, which required margin based on each individual position. The new rules allow margin to be calculated on the portfolio in its entirety.
