Few doubt that the global credit crisis, which has led to mind-boggling write-downs by almost every major investment bank, has forever altered the capital markets. With the economic fallout stretching into its second year, the meltdown in collateralized debt obligations (CDOs) tied to pools of subprime mortgages and other toxic debt continues to make life difficult for asset managers and hedge funds. So how is the buy side adapting in order to survive in the markets' new world order?
As the credit crunch spread, traditional asset managers and hedge funds that trade fixed-income securities saw liquidity from the battered bulge-bracket firms dry up. To avoid collapses of their own, many buy-side firms have reexamined their fixed-income strategies and operating models. They have moved into different sectors and asset classes, tapped electronic bond trading systems, and revamped their mark-to-market models to reflect changed market conditions. They've even begun training the new generation of traders on the desk to deal with a crisis the likes of which they never encountered before.
"The credit crisis has impacted the market as a whole," comments Basil Williams, CEO of New York-based Concordia Advisors, an alternative asset manager that runs a core global multistrategy hedge fund with $2 billion in assets invested in six strategies spanning global equity and bond markets, distressed debt, and credit default swaps. "The impact can be felt in a number of areas," including fund performance, investor expectations and relations, internal strategies and procedures, and how a fund interacts with prime brokers, Williams notes.
Credit Crisis Raises Counterparty Risk
In addition to a lack of liquidity in fixed-income products, for the past year or so traditional asset managers and hedge funds have been wrestling with fears of counterparty risk. Events such as the near collapse of Bear Stearns have raised fears on institutional trading desks that a trading partner could go out of business, causing asset managers and hedge funds to scrutinize their exposure to bulge-bracket firms, something that was previously unthinkable.
"The increase in counterparty risk has been so significant," explains Jonathan Kleisner, managing director, investment strategies, at REX Capital Partners, a commodity hedge fund group in New York. "A year ago you never looked at the balance sheet of your clearinghouse." REX Capital's models conduct arbitrage, index replication and volatility strategies against a futures contract based on a basket of 17 commodities traded on the IntercontinentalExchange, according to Kleisner, who says counterparty risk has become one of the top questions asked by potential investors.
Noting that some of the bulge-bracket brokers have lost as much as 50 percent of their share value, Kleisner adds that he spends a higher percentage of his time evaluating the balance sheets of clearinghouses. He cites financial concerns at Lehman Brothers, FC Stone and even Merrill Lynch, in particular, as major concerns.
When a hedge fund opens a segregated account at a clearinghouse, however, its assets technically shouldn't rub up against the liabilities of the clearinghouse, Kleisner continues. But if there were a problem with the clearinghouse's solvency, the hedge fund could have trouble accessing its segregated accounts, he points out.
"The buy side has definitely looked to strengthen counterparty credit risk," says Paul Middleton, a VP at consulting firm Sapient who specializes in derivatives in the firm's trading and risk management practice. "No counterparty is infallible, particularly with the household names that have been affected."
"We will continue to trade with counterparties that we think are long-term viable," adds the director of fixed-income trading at a large asset management firm who requested anonymity. Noting that the firm has pared down the number of counterparties with which it deals, he explains that the firm has taken a hard look at capital adequacy in cases where it has extended settlement — such as with credit default swaps, financing trades or mortgage positions — as well as any trade that involves an irregular settlement.
For example, while Treasury bonds settle in T+1 and many other instruments settle in T+3, the standard for mortgage pass-through securities is 20 days or more, which places them in a higher-risk category. Credit default swaps, which can take as long as 10 or 15 years to settle, involve even more counterparty risk.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio