June 30, 2014 - Regulation will be the key driver in the next phase of the rapidly evolving hedge fund industry, according to Part II of the Citi (NYSE:C) Investor Services' 5th Annual Industry Evolution survey.
Previous Citi surveys have discussed key drivers of the industry since the global financial crisis, and throughout this period a broad and significant set of global regulations was being formulated. The complexity and scope of the rulemaking has so far had no real impact on the day-to-day operations of hedge funds. But now, with major implementation deadlines from the overhang of Dodd-Frank, Basel III, EMIR and AIFMD finally upon us, these regulatory drivers will now be the predominant force of industry change.
"As the demands of the new regulatory environment emerge, market leaders need to build out new capabilities, platforms and processes to survive and transform their organizations," said Sandy Kaul, Head of Business Advisory Services at Citi. "Understanding how this complex regulatory landscape is changing is a vital first step in that process."
Regulatory Overhang Leads to Financing Overhaul
The exit of proprietary trading from sell-side organizations has allowed key aspects of market-making, inventory management and direct lending to shift from a dealer-dominated activity to one where major hedge funds have a key role in taking on market risk.
Moreover, there is a collateral conundrum in that there are more strategies being executed than ever but less financing available. The pool of collateral that hedge funds control is likely to continue to expand which could lead hedge funds to begin treating collateral as an asset class with which they can supplement their trading book profits.
Optimizing Counterparty Management and Relationships
Hedge funds will need to overcome numerous challenges as the number of collateral pools expand exponentially, further magnified by the introduction of Dodd-Frank and the EMIR OTC derivative rules. To optimize counterparty interactions, new data inputs, analytics and tools will be required to support the effective use of hedge fund collateral assets and efficient deployment of financing positions.
Leading hedge funds are further evolving their scorecards to measure the value of their financing wallet allocation with their key counterparties. Determining the right metrics to track their engagement with the sell side will become a critical component of counterparty management. The cost of financing is also likely to rise as Basel III liquidity coverage ratios negatively impact prime broker balance sheets and force broker-dealers to re-price their offerings. Hedge funds that move from a service-based to a relationship-based model with their counterparties are likely to have better access to financing and realize less extreme price increases.
