# There's more than one way to skin a cat

Early on in the hedge fund days, the late 1980s and early 1990s, hedge funds were looking to short instruments, thus creating balance-sheet liabilities. IT systems at the time, however, were unable to handle this, given the long-only nature of most software programmers' investment clients at that time.

Shorting was problematic, requiring "somersaults and workarounds" from an accounting perspective, according to Tony Swei, chief executive of Tradar, a widely used portfolio management system. "The ability to go short on any instrument is a fundamental part of our system," he says, pending a relationship with a bank to trade with (or against).

"You can sell a bond and borrow it," Swei says, although he is unaware of any of his clients actually doing so. "With interest rates being historically low, there has been a lot of speculation about what's going to happen on the credit markets, and a lot of people floating some pretty risky debt," he adds.

Swei notes that credit default swaps (CDS) have become a more popular method of mitigating that risk than shorting the bond directly. "It's essentially an insurance policy and behaves much like a bond, with a coupon rate."

Tradar is only a digital facilitator, of course, and is not a bank. While Swei cannot comment on the trading activities of Tradar's clients, he trained as an economist. "Credit clearly has been over­extended for a long time. We've been awash in liquidity for some time," Swei believes.

"A lot of hedge funds in the US have been taking CDS protection against sub-prime mortgage borrowers, and some of these have paid off rather well. There have been some spectacular bankruptcies in the US recently."

In April Swei said he believed the fallout of the sub-prime sector was "just getting started", given that "only 20%-30% of the adjustable-rate mortgages in the US have reset in the past year. The large portion are still to reset."

backing the backers

Credit default swaps for the financial services sector saw the most active trading in the US, led by SLM Corp, Countrywide Home Loans and CIT Group, according to GFI, an inter-dealer broker for credit derivatives voted best CDS broker in annual surveys since 2000 compiled by Risk, our sister publication. The auto manufacturing and banking sectors were on GFI's list, led by Ford and Washington Mutual respectively.

In Europe, GFI notes that telecoms dominated for the seventh straight month, led by Telecom Italia and KPN. The food retail and wholesale sector remained on the list for the third straight month, led by Sainsbury, with the auto-parts sector completing the list.

In Asia, financial services dominated for the twelfth month in a row, led by ACOM, according to GFI. The banking sector maintained its position on the list, led by Kazakhstani banks Bank TuranAlem and Kazkommertsbank, while the computers sector re-entered the most active category.

Turkey, Brazil and Argentina were among the most active sovereigns, with Ukraine and Russia replacing Philippines and Venezuela in April's top five. "There is a requirement by the market to find new ways to gain exposure to different economic events," Swei says, identifying other derivatives that can be used to achieve the same economic position as a short in the fixed-income space, such as contract for difference and, in particular, interest-rate swaps, whereby a fixed-rate payment is traded for a floating-rate schedule.

"A lot of our credit clients use interest-rate swaps extensively," Swei says.

a full orchestra

However, he doesn't foresee much expansion of the 140 or so instruments that can be processed by Tradar's software.

"You'd be surprised at how little change there is," he says.

"A lot of these instruments have been around a while or are offshoots of other instruments. We add maybe one or two instruments per year, and often they are very obscure - for example, there is an Australian bond that has very eccentric coupon behaviour."

Emerging markets also offer up some unusual products, the idiosyncrasies of which must be accommodated.

"We have a lot of developing economies, where foreign investors are eager to buy up higher-yield debt. That party could go on for a long time."

Of course, as one position is taken, so someone else must take the opposite view. Hedged portfolio stock loan companies like HedgeLender LLC based out of Philadelphia use a variety of hedging techniques to reduce lender exposure, which they pass on in the form of a loan to their clients.

"We occupy an exciting niche that is not yet well developed - that of collateral financial products for consumers that devolve off of the traditional hedge fund and our derivatives techniques used by hedge funds," says Daniel Stafford, HedgeLender's president.

"In our world, rather than the fund being the end in and of itself, the fund acts as the support base for creative financial products.

"In our case, we've chosen to specialise in easily palatable and marketable limited-recourse hedged-portfolio loans against stock for clients with portfolios as small as $10,000 all the way up to institutions with positions up to$200m."

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The week in Risk.net, May 19-25 2017