April 9, 2012 5:50 pm

Hedge funds keep a lid on leverage

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Since 2010s adoption of the so-called Volcker rule, Wall Street’s banks have moved fast to drop some of the most prominent vestiges of their past success: their proprietary trading operations.

Banks once dominated bond and equity markets thanks to the operations of such desks – which acted, to all intents and purposes, like internal hedge funds, speculating with a bank’s own capital – but now their presence is barely felt.

The exit began with Goldman Sachs, which starting in 2010 saw the departures of its three main prop traders and their teams: Pierre-Henri Flamand in Europe left to set up a hedge fund, Edoma Capital; Morgan Sze in Asia departed to establish his hedge fund, Azentus Capital; and Bob Howard in the US left to set up a hedge fund for private equity house KKR.

It was a pattern repeated by peers. Deutsche Bank, Morgan Stanley, Barclays and most recently JPMorgan have all lost top risk takers to the hedge fund industry in the past 18 months.

It should come as little surprise then that many observers ask whether the transfer of manpower has been met with a transfer of risk.

For most hedge fund managers, the answer is easy.

“Hedge funds are presently leveraged one to three times; if they’re mad, five times; if they’re insane, 10 times,” Michael Hintze, the chief executive of the $9bn London-based hedge fund CQS, told the Financial Times in 2010. “But 15 or 20 times was normal for bank prop desks,” he said.

Mr Hintze’s point has been borne out by the statistics.

According to the UK’s Financial Services Authority, which in February published its annual survey of the global hedge fund industry, the average hedge fund currently uses leverage of about 2.5 times its capital – as it has done for the past three years.

Indeed, unlike prop desks, most hedge funds have to grapple with all too finite liquidity and financing – issues no manager has been able to ignore since 2008.

And while assets for the hedge fund industry have grown since 2009, and are now somewhere near their 2007 peak of $2tn, the industry’s influence in the market is still much smaller than is imagined.

The banks themselves, as regulators know, are still the regulators of hedge fund risk-taking: it is their prime brokerage operations and repo desks that specifically calibrate the amount of risk on the table. Hedge funds are exposed to less than 1 per cent of listed equities, according to the FSA.

Even in more niche markets, such as convertible bonds, the figure is not overwhelming: hedge funds account for 7 per cent.

The number has fallen over the past three years as banks’ appetite to lend to funds for such strategies has dimmed.

“Gone are the days of free balance sheet,” says Nick Roe, global head of prime finance at Citigroup.

Banking rules, as regulators well know, are not just for banks.

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