Surprise answer to regulatory squeeze: use more swaps

Prime brokers are looking to grow, even though a year ago many were downbeat about prospects for the sector. At that time, the industry expected Basel III and particularly the leverage ratio to cause rate hikes for financing that would hurt hedge fund clients badly.

As reported by Risk.net in December, that fear has proved justified for some funds, but not for everyone. Credit strategies have suffered but other funds less so.

Some rate hikes have been as high as 100 basis points, say commentators. Certain funds have been ‘sacked' by their brokers, while new launches are finding it hard to secure financing to begin with. But some have been able to avoid increased costs – among them swap-heavy strategies.

Greater use of swaps is favoured because cash assets take up space on bank balance sheets that derivatives don't. Hedge funds used to think they were paying banks for leverage but that is no longer true, says the head of one prime broker. Instead, funds are paying for balance sheet. Total return swaps or contracts-for-difference are less of a burden under the leverage ratio than holding equities, particularly if the swaps can be internalised.

Elsewhere in the financial markets, a few sophisticated pension funds are also finding reasons to embrace synthetic strategies but for different reasons. Again regulation is partly the cause, but this time in the form of the European Market Infrastructure Regulation (Emir).

Pension funds will have to post cash variation margin on over-the-counter derivatives under the incoming regulation. But they want to avoid holding big cash buffers because doing so drags down their investment yield.

Although using derivatives would seem to contribute to this problem, a counterintuitive approach is to use them more. That way funds are able to hold more cash without giving up yield. So far the approach is limited to a few pension funds. But the idea is talked about more broadly in the sector and by insurers as well.

Basel III and Emir were not conceived to push financial markets firms into heavier use of derivatives. But that seems to be a possible outcome for some.