FRTB threatens popular hedge fund strategies

Brevan exec says market risk capital rules could force buy side out of certain trades

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FRTB could disrupt 'wing' strategies and products

Popular hedge fund strategies such as volatility trading may become unprofitable under the Basel Committee’s incoming market risk capital rules for banks, market participants say.

The Fundamental review of the trading book (FRTB), due to be implemented in 2019, will dramatically increase the amount banks charge for warehousing exotic market risks. Some asset managers are already claiming these costs will discourage the trading of illiquid risks and render certain strategies uneconomic.

“This is huge for us. Most historic regulation has been bank-focused [but FRTB] is really impacting how the whole buy side operates. There is going to be less counterparty differentiation for a start, because everyone is going to start looking at the real ‘wing risks’, and saying, ‘okay, we need to exit those strategies – we don’t want to be trading those products’,” said Jasmine Burgess, head of risk in the US at hedge fund Brevan Howard, speaking on a panel at the FRTB Implementation Summit USA in New York earlier today (May 16).

Burgess earmarked volatility strategies as particularly vulnerable. “If you are charging your trader more for short volatility and we are buying, then we are effectively paying more. It becomes inefficient, and our ability to make money out of that is lower. So we are going to have to try and find new trading strategies that aren’t buying volatility,” she said.

Particular exotic product lines as well as entire strategies would be affected, she said. Burgess gave the example of a hedge fund with an open variance swap position. Hedges to offset the risks of this position would need to be adjusted each day in response to market moves. Under FRTB, banks would be forced to recalculate the capital costs of laying on these new trades daily, likely passing this on to clients.

“That change in your hedge cost is huge. I don’t think FRTB distinguishes between wing strategies and wing products; everything is still very statically measured,” Burgess said.

‘Wing’ strategies and products are exposed to extreme risks at the tail of the distribution.  

FRTB is really impacting how the whole buy side operates

Jasmine Burgess, Brevan Howard

Other panellists agreed the elastic nature of market risk capital allocation under FRTB was a game-changer for the industry.

“It used to be the capital charge was pretty uniform. All this capital becomes a moving target across different desks [under FRTB] and capital allocation becomes a problem. Ultimately the FRTB charge is going to become a very complicated process,” said Gary Lee, chief market risk officer at Pittsburgh-based asset manager PNC.

This complexity will place a premium on banks’ ability to marry front-office oversight of capital allocation by traders with the risk capital calculations made in the back office, others argued.

“Allowing the front office and the traders a view of the impact on FRTB capital at deal inception itself is becoming more and more important. You need a lot more of the risk measures to be embedded in the front-office workflow given capital is becoming more expensive,” said Vinod Bhaskaran, global solution lead for capital markets and risk at software vendor Misys.

Whatever the sensitivity of bank pricing to market risk capital, however, Brevan Howard’s Burgess claimed even an incremental rise in costs would have an outsize impact on buy-side trading.

“If you have a business that is very volume-driven and looks profitable right now, you don’t know what that’s going to look like. That’s a huge business strategy risk for us,” said Burgess.

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