Regulators demand hedge fund look-through transparency

Basel rules on fund investments could mean the end of traditional hedge fund derivatives

On December 13, 2013 the Basel Committee issued its final standards for calculating capital requirements for banks’ investments in pooled funds. The regulators are taking a hard line on fund investments, which will be subject to punitive risk-weights unless banks can demonstrate meaningful look-through transparency into the underlying assets.

The approach outlined in December applies to the banking book. However, the Basel Committee is expected to take a consistent approach to fund positions in the trading book – which doesn’t bode well for banks’ fund-linked trading and derivatives activities.

Previously, the Basel capital rules did not provide a specific framework for calculating capital requirements on fund investments. These exposures were classified as ‘other assets’ and risk-weighted at 100% under Basel II’s standard approach, while banks relying on the advanced approach were able to calculate even lower weightings.

The new rules are far more restrictive. The Basel Committee has outlined a ‘hierarchy of approaches’ that rewards banks for obtaining transparent reporting from funds. The look-through approach (LTA) is the most granular and risk-sensitive method and should result in the lowest possible risk-weights for most fund investments. The LTA essentially treats the funds assets’ as if they were directly held by the bank – allowing for netting of positions when calculating the capital requirements. The catch is that the bank will only be able to rely on the LTA if it can obtain independently verified reports of the fund’s assets on at least a quarterly schedule. That may be feasible with mutual funds and index products – but it could be a problem with hedge funds, which rarely provide that level of transparency to investors.

“There is really no way to calculate the Basel III capital requirements without having access to the full positions, preferably on a daily basis. The summary information that hedge funds provide to investors in their monthly reports isn’t going to be enough,” says Andrew Lapkin, New York-based president of HedgeMark International, a subsidiary of BNY Mellon specialising in structuring and risk monitoring hedge fund investments.

Funds that fail to qualify for the LTA will be subject to the mandate-based approach (MBA), which allows banks to calculate risk-weights based on the fund’s mandate or national regulations governing its investments. The problem here is that banks have to assume the fund is invested to the maximum extent permitted by its mandate – taking into account leverage – in the assets attracting the highest risk-weights. Banks are not likely to receive much relief under the MBA when investing in hedge funds, which tend to have flexible mandates that give the manager freedom to take leveraged positions in a wide range of instruments and markets.

The Basel Committee provided an example where a $20 investment in a simple equity index fund would be risk-weighted at roughly $20 under the LTA. This would increase to more than $40 if the MBA is used to calculate the risk-weights. The difference between the approaches is likely to be even greater in the case of a leveraged hedge fund with an unconstrained mandate.

The MBA is tough on fund investments but it is still preferable to the fall-back approach (FBA), which would apply if the mandate or national regulations don’t provide sufficient clarity to calculate the risk-weights. The FBA imposes a punitive 1,250% risk-weight on these exposures.

The crackdown shouldn’t come as a surprise. The Basel Committee has been concerned with banks’ exposure to hedge funds for some time and published a draft version of the capital standards in July. The final version of the rules closely matches the draft proposals – and the regulators made no concessions with respect to some of the issues raised by the industry in the comment period.

The banking industry isn’t putting up much of a fight either. US banks have been exiting fund holdings regardless, in anticipation of the Volcker rule, which limits private equity and hedge fund investments to no more than 3% of their Tier 1 capital. Given their current capital reserves, Goldman Sachs and Morgan Stanley would have to reduce their hedge fund investments to less than $2 billion, while JP Morgan and Citigroup would be capped at less than $5 billion – a miniscule amount relative to the total assets of these banks.

The big European banks have also slashed hedge fund investments and are not expected to take much of a hit when the new standards take effect at the start of 2017. Daniel Davies, a banking analyst at Exane BNP Paribas, estimates the impact on the capital ratios of some of the largest European banks at “not much more than about 10 basis points”.

Some Asian and European banks still have meaningful principal investments in hedge funds and these firms may have to make changes to the way they manage these positions.

The Basel Committee made it clear the rules are designed to “incentivise due diligence by banks and transparent reporting from the funds in which they invest”. This is easier said than done. Hedge funds are generally reluctant to reveal their positions for fear that people will either trade against them or reverse engineer their most lucrative strategies. But the new rules make it tough for banks to make these investments if they don’t have the position-level transparency necessary to apply the LTA to calculate reasonable risk-weights.

Managed accounts
One option for banks is to convert hedge fund investments to managed accounts. Earlier this year, an Asian bank transferred a portion of its hedge fund portfolio to the managed account platform (MAP) operated by Man Group’s FRM division in order to obtain the transparency necessary to apply the LTA to calculate Basel III risk-weights, according to Steve McGoohan, the firm’s London-based head of managed accounts. FRM is providing the bank with details of the underlying positions of all the managers it invests in on a quarterly basis, subject to a non-disclosure agreement (NDA). McGoohan says the funds were comfortable with providing this information to the bank in this instance – even though this raw data is generally not made available to investors. “It’s quarterly reporting with a lag and it’s being provided for regulatory reasons subject to an NDA, so the managers were comfortable with it. It is possible to get this transparency from hedge funds if you approach it the right way,” says McGoohan.

The question now is whether regulators will take a similar approach to calculating risk-weights for fund exposures in the trading book. The Basel Committee says it is “mindful of the need to avoid a disparate treatment between the banking book and trading book and will ensure, as part of its fundamental review of the trading book, that a consistent approach is applied”.

Some banks have questioned whether this makes sense. “Fund activities in the trading book are typically managed on a net delta basis with most trades being executed to facilitate client access. This contrasts to a long banking book or investment strategy. Additionally the volume and turnover of funds held in the trading book could impose severe due diligence and operational requirements on firms if an approach designed for the banking book is directly read across,” says Peter Estlin, the acting chief financial officer of Barclays, in a comment letter filed with the Basel Committee in September 2013 in response to the draft proposals.

If the Basel Committee takes a consistent approach to fund exposures in the trading book, it could spell the end for hedge fund-linked derivatives desks, which cater to investors that want to transform the risk or regulatory profile of hedge fund investments. Hedge fund derivatives desks write call options, principal-protected notes and constant proportion portfolio insurance products linked to hedge funds and funds of funds – and hedge these products by dynamically buying and selling shares in the underlying funds.

“When you’re talking about a 1,250% risk-weighting, that pretty much kills the traditional hedge fund derivatives business,” says an executive in the fund-linked products group at a bank in London.

While banks have scaled down their hedge fund derivatives activities in recent years, some are still active in this business. Deutsche Bank sold around $2.5 billion of hedge fund derivatives in 2013 of which around two-thirds were linked to strategies on its MAP. A handful of other European banks are said to be active in this business, albeit to a lesser extent than in the past.

The LTA effectively treats a fund-linked derivatives desk as a trading desk in the underlying assets held by the funds themselves. This approach, while elegant in principle, would be complex and resource-intensive in practice, especially with respect to hedge funds. Even if dealers could secure reliable and timely reporting on a hedge fund’s positions, accounting for the counterparty credit risks associated with a fund’s derivatives and securities financing transactions and the leverage embedded in these positions would still be a challenge.

The easiest solution is to use managed accounts for fund-linked derivatives. Firms such as Deutsche Bank and Societe Generale have been running in-house MAPs to support their hedge fund-linked derivatives activities for some time. Other dealers use third-party MAPs operated by the likes of FRM to obtain look-through visibility into hedge funds.

FRM recently completed a deal with a bank to provide daily liquidity on a diversified portfolio of managed accounts to an end-client via a derivatives wrapper. “The bank was comfortable providing the wrapper because we were giving them the necessary transparency to manage their risks,” says McGoohan.

Lyxor also works with a number of banks to provide structured products and derivatives on funds on its platform. “The way we address capital requirements and transparency issues is by providing fairly detailed reports on risk exposures on a weekly basis. So far that has been sufficient but we could provide position-level transparency on a weekly or daily basis if necessary with the managers’ blessing and even calculate the capital requirements on behalf of clients,” says Paris-based Nathanael Benzaken, deputy head of the alternative investment business at Lyxor, a subsidiary of Societe Generale.

The Basel rules permit banks to rely on third-party calculations to determine the risk-weights for fund investments if they do not have access to the information necessary to perform the calculations themselves. However, the risk-weights in this case will be 20% higher than if the calculations were done in-house by the bank. The industry had argued that third parties, such as custodians and MAPs, that have direct access to fund positions are in the best position to perform these calculations – and a penalty should not apply. The regulators relaxed their original stance – that risk-weights calculated by third parties should be ‘one notch higher’ – but refused to provide equivalent treatment for external calculations.

That potentially throws a spanner in the works for firms such as FRM and Lyxor that planned to provide regulatory capital calculation services to banks and European insurers, the latter being subject to very similar requirements under Solvency II rules. European authorities have been following the Basel Committee’s lead in crafting prudential regulations for European insurers – the tough stance taken by banking regulators could herald a strict implementation of Solvency II’s capital requirements.

The ongoing viability of the hedge fund-linked derivatives business will become clearer once the Basel Committee completes its fundamental review of exposures in the trading book in early 2014 and issues its final recommendations for calculating bank capital requirements, although it should be noted that this may be subject to delay.