The following white paper was written by Hazeltree
The outbreak of COVID-19 continues to impact the investment management
ecosystem. Hedge fund managers are endeavoring to stay well ahead of potential demands on their treasury operations with sudden shifts in trading patterns, likely increased redemptions, and a re-doubling of efforts to protect assets and ensure liquidity. Managers continue to broadly deleverage and build-up cash positions on a scale that has not been seen since 2008. Therefore, mechanisms to manage daily liquidity are being put to their highest use.
Are we living through another 2008 crisis? Is it a deeper crisis? How long will it last? Are you betting that the safeguards put in place to protect against global systemic financial risk will hold through the COVID-19 crisis? Can today’s challenges trigger a credit
event at one of your counterparties? Are the major counterparties well enough capitalized to support their businesses across the range of potential COVID-19 economic ramifications? These, and many more, are questions that hedge fund managers are facing
every day while focusing on cash and liquidity to support their trading activity, and concentrating on exposure to, and the relative health of, counterparties.
Deleveraging / Liquidity Buffers
Based on a measurement of equity long/short managers across the Hazeltree client community since the beginning of February 2020, we have seen a clear trend toward de-leveraging from over 230% to under 200% in early March 2020. Similarly, we have seen managers increasing their cash positions along the same timeline.
Monitoring and Managing Liquidity
As cash amounts continue to build and liquidity buffers grow, managers should be prepared with efficient processes to easily and quickly invest into safe harbor vehicles such as treasuries, and treasury/government backed money market funds. Indeed, due to the high utility of money market funds generally, US funds recently grew to $3.7 T, the highest since 2008.
“Money market funds provide a haven for cash investors looking for incremental yield in a near-zero rate environment,” says Jonathan Spirgel, Managing Director and Global Head of Liquidity Solutions at BNY Mellon. As a result, he says, “we have seen cash sweep balances into our LiquidityDirect platform grow substantially since the beginning of March.”
To minimize counterparty risk/exposure, managers should consider custodial and direct sweeps into money market funds (as compared to concentrating liquid assets via auto-sweeps). Additionally, managers should ensure that they have the technology to support straight-through processing and monitor their cash/liquidity on a continual basis with the flexibility to sweep and redeem to/from money market funds.
In addition to the impact to overall portfolio performance and a potential decrease in the
value of portfolio holdings, managers should expect a significant increase in margin calls from their prime brokers and OTC counterparties. Over the months of February and March 2020, Hazeltree has seen an increase of more than 20% over historic average margin calls across our clients trading collateralized derivatives. Additionally, the recent market turmoil arising from COVID-19 may result in an increase in withdrawal/redemption requests for upcoming liquidity cycles. Hedge fund managers should stand ready to institute the full suite of tools available, both from an operational perspective and as allowed under their fund offering documents.
In the event that mechanisms such as gates, side pockets, in-kind distributions and suspensions may be invoked to help manage investor requests as well as address sudden illiquid investments, managers should maintain and enhance the technical tools to ensure that the increased volume of cash movements are controlled and automated in order to comply with procedural, timing and approval parameters.
Counterparty Health Check Up
As the COVID-19 outbreak disrupts day-to-day operations across markets, hedge fund managers may want to increase their monitoring of critical service providers such as brokers, banks, OTC counterparties and custodians. It is imperative to ensure that
these service providers have business continuity plans in place that will enable them to remain functioning with minimal disruption and, also, to understand any potential stress impacts on the counterparties themselves.
Not only the general credit worthiness, but the dynamics of stock price, CDS spreads, credit ratings and other factors are important to weigh and monitor as market volatility remains at elevated levels.
As was the case during the crisis of 2008, CDS spreads, in particular, and the relative spreads between specific counterparties, are being watched very carefully.
In addition to overall counterparty health, it is critical to have the ability to monitor net exposure, as frequently as possible, to trading and financing counterparties. Importantly, all asset types and sub-entity counterparty levels should be included to ensure all
dimensions of exposure are considered.
As answers begin to emerge about the relative depth, severity and length of this disruption, most managers will, having experienced an entirely different kind of economic crunch, likely focus on many of the same liquidity, funding and counterparty management
concerns as in the last crisis. The importance of transparency and controls, and the role of treasurers and risk officers in actively managing these processes, cannot be overstated.