Risks and return of banking activities related to hedge funds

J P. Mustiers and A. Dubois

Financial Stability Review, 2007, issue 10, 85-94

Abstract: There are approximately 10,000 hedge funds worldwide, managing assets of over USD 1.5 trillion. Investment banking activities are more and more intertwined with hedge funds, as hedge funds obtain financing from banks through prime brokerage and are clients or counterparties of banks for all sorts of products. The development of hedge funds has therefore created many opportunities for investment banks. Bank benefit from hedge funds activities directly to the extent that hedge funds are their clients. All capital market activities benefit from it, from brokerage and research to derivatives. Prime brokerage has become a growing source of income. Banks have a very important business of providing derivatives and products, from vanilla products to more complex, customized and exotic products. Hedge funds are also possible underlyings for derivatives. Many banks, including Société Générale, have developed a business of writing options on hedge funds as well as providing leverage to funds of funds. Investment banks are not only making profits by transacting with hedge funds. They also benefi t indirectly through more trading: on certain specifi c specialized market, like structured complex derivatives, there would be no market at all without the availability of hedge funds that are willing to take the risks. Together, as two intertwined partners, hedge funds and investment banks have extended the reach and effi ciency of capital markets. The benefi ts that this system brings to the economy as a whole is widely recognized. Not only do hedge funds provide important benefi ts for the economy in general but their risks are manageable. The risks for investors are overplayed. Whatever the risk measure, hedge funds are clearly less risky than equities. As regards operational risks, the market itself is able to generate protection solutions. Academic research has shown that operational risks can be dealt in the most extensive way by using managed account platforms, such as the Lyxor platform. The risks for banks are under control and the move toward “risk-based margining” has improved very much their risk management. Banks in general invest a lot of resources in monitoring hedge funds qualitatively through due-diligences. They also put different types of limits in order to cover different aspects of risks: nominal limits, stress test limits, limits on delta, limits on vega, expected tail loss limits. Moreover, they regulate their capital requirements using not only Value at Risk, the usual tool used by banks to allocate capital to market risks, but also stress tests losses based on the worst possible scenarios. These very sophisticated models are quite convincing. There is no reason to believe that they will not work in practice under stress conditions. There are also general consideration about a systemic risk that would be something else than banking risks, but it has no real argument to back it up. Hedge funds are fi rst of all the result of a signifi cant improvement of asset management techniques. These improvements are here to stay, whatever the regulatory environment will become, since these techniques will be more and more part of the mainstream asset management world. Hedge funds are more and more institutionalized. They will eventually merge with “classical” asset management, while some forms of compromises between hedge funds and classical asset management, such as absolute return funds or 130-30 funds, are becoming more common. Hedge funds are just a nice new development of capital markets that, like all past capital market developments, will be irreversible and will contribute to a more effi cient fi nancial system.

Date: 2007
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