Faltering flows

Hedge funds face soaring margin requirements following the global credit crunch. But with optimism about financial markets growing, those prime brokers that have kept a lid on margin demands may ultimately benefit. By William Rhode

A Singapore-based start-up hedge fund interested in pursuing a long/short equity strategy focusing on South Korea and Taiwan recently asked a major US prime broker what kind of margining requirements he could expect. Given market conditions, he was prepared for an unpleasant response. Ever since the global credit crunch took hold in August, banks have tightened their credit controls and reduced exposures to hedge funds.

And Asian hedge funds have posted a negative return of 5.6% in the year to April - the worst first four months in at least eight years, according to data from Singapore-based data provider Eurekahedge. This compares with a 1% decline for global funds. The combination of poor performance and liquidity concerns has led some Asian prime brokerage arms to increase margining requirements substantially, sometimes by as much as double.

Still, the start-up hedge fund manager didn't think things would be so bad. He wasn't looking to leverage much, he had a strong investment background and the stocks he was interested in were not toxic. He was thinking the prime broker might ask for a 20% - or at worst 30% - initial margin requirement (the amount required to be collateralised for him to open a position).

However, the bank would not even allow him to buy securities through it - the reason it gave the amazed fund manager? "Too risky." Clearly, the bank now profiles risk differently since tightening credit controls.

And this has been the story for many hedge funds in Asia, which have been forced to cut positions and deleverage, due to tighter credit controls. The trend has become so extreme, it is actually preventing hedge funds - especially those that seek out more risky exotic investments and arbitrage opportunities - from being able to operate at all say some parties.

"I was really shocked when I was told by the bank that they weren't even interested in taking my business," says the hedge fund manager. "I mean, a long/short strategy in South Korea and Taiwan stocks is fairly plain-vanilla by comparison to a lot of other hedge fund investment strategies. But they simply did not want the business. Not at any margin. It seemed as if they had totally lost the ability to price and understand risk."

Changing models

An equity-focused hedge fund manager based in Hong Kong says: "A lot of the worst-case scenarios for prime broker risk models have changed since the credit crisis. So margining requirements have doubled in a lot of instances and, for exotic stuff involving over-the-counter (OTC) derivatives, the show has come to a complete stop."

There has been a lot of deleveraging that has been hurting both sides, he says, adding: "We've seen a 75% drop in the volume of business this year."

A Singapore-based hedge fund manager says one major US prime broker stopped making prices completely on all OTC derivatives for three days in the first quarter. "That liquidity constraint completely freaked the market out," he says. "There was a dramatic widening of spreads in the OTC market that spread the fear. After that experience, many hedge funds have become as risk-averse as the prime brokers. They just want to get back to cash and stay there until things have settled down. It is leading to a massive slowdown in business."

Javed Rahman, Hong Kong-based chief executive of Skye Fund Services, which offers middle- and back-office solutions to hedge funds, says he has not seen a significant slowdown in hedge fund activity. "But leverage is definitely becoming more difficult and a lot of new start-up funds are having to delay their launch because of the situation," Rahman adds.

The Hong Kong-based hedge fund manager says the prime brokerage arms at Citi and Merrill Lynch have been among the most aggressive in terms of cutting their exposures to hedge fund activity. A spokesperson at Citi declined to comment, but a spokesman at Merrill Lynch had more to say. "Tighter global credit controls have not impacted our PB (prime broker) business in Asia at all," he tells Asia Risk. "In fact, we have not even raised financing costs for hedge fund clients in Asia."

While some prime brokers appear to be reducing their exposures to hedge funds and cutting back on prime broking activities, other firms are seeing the situation as a good opportunity to increase market share. Among the most aggressive are UBS and Deutsche Bank, say market participants. Lehman Brothers, which has had a long prime broker presence in Asia, is maintaining its market share with strong support for the market, say hedge fund managers. And in response to assertions that it is cutting back, Merrill Lynch on the contrary says it is expanding in the area.

"We are expanding PB in Asia," says the bank spokesman. "We are net positive in headcount today versus the end of 2007, we are net positive in client assets today versus the end of 2007 (not including market movements), and we are net positive in number or PB clients today versus the end of 2007."

He says not one person from prime broking in Asia was let go as part of the 4,000 global layoffs announced by Merrill Lynch chief executive John Thain at the first quarter earnings. "Asia is the growth engine of this industry going forward," the spokesman says. "Why would we or anyone else withdraw from PB in Asia when you could do so in more mature markets if you really wanted to. The pie in Asia is getting bigger; you can grow without having to take market share from other PBs."

Yet there have been a couple of significant staff departures from Merrill Lynch. In April, it lost capital introductions veteran Yvonne Wong, who plans to go into service provision in Hong Kong in August. Martin Visairas succeeds Wong on an interim basis, while the securities dealer considers a permanent replacement. And Merrill Lynch's former head of Pacific Rim equity financing and sales, Harvey Twomey, left Merrill Lynch in February to join Deutsche Bank in Hong Kong as Asia-Pacific head of global prime finance sales, working in partnership with Ryan Bacher, the German bank's regional head of global prime finance.

As for Deutsche Bank's service provision, Bacher says: "Our clients don't face margin rate changes because of intra-day volatility. The haircuts embedded in our proprietary system are predefined and have not changed as a result of recent market volatility.

The key for any hedge fund seeking to rein in its margining requirements, says Bacher, is portfolio diversification and liquidity management. "If we see a concentration of risk we will penalise the client," he adds. "We are very prudent on asset quality. We do look closely at illiquid instruments, such as credit products and distressed-debt situations. While we are still open to take on this business, closer analysis is required before we extend leverage on these assets."

Others make similar points. The best way for hedge funds to manage margins is to choose a prime broker that can margin a portfolio across markets and asset classes to gain a maximum benefit from diversification and risk offset, says Tim Wannenmacher, Asia-Pacific head of capital markets prime services at Lehman Brothers in Hong Kong. "We use a scenario-based margining system that is responsive to a range of market conditions such as volatility," he says. "While we aim to provide consistency in our approach to margining requirements, if there is a significant increase in volatility, then margins may go up. But we do provide caps for our clients, so they can have the assurance that while margins may change, they will never breach a certain level yet they will fully benefit in a favourable environment." He did not provide detail on those levels.

"In general, the more diversified the portfolio, the more attractive this approach is," says Wannenmacher. "If a client has exposure in concentrated or illiquid assets, for example, an individual margin rate may be more suitable."

And investor appetite may reinforce this trend. Kurt Baker, Asia-Pacific head of prime brokerage at Morgan Stanley in Hong Kong reportedly told a conference in Shanghai on May 22 that instead of the country-focused funds that were in fashion last year, investors are now showing greater interest in funds investing in the broader Asia region. But Japan-focused funds are a notable exception to this trend. Hedge funds that employ multiple investment strategies are also in greater demand this year. So are so-called event-driven funds that seek to profit from companies undergoing significant corporate events, such as mergers and acquisitions, bankruptcies and reorganisations.

Furthermore, Wannenmacher believes the deleveraging by hedge funds in Asia is largely a result of their own prudent risk management controls and not necessarily due to prime brokers increasing margins. "There are more prudent risk controls happening on both sides of the fence," he says. "And that is a healthy response to the market conditions. We always partner up with our clients on risk, allowing them full access to our model, fully disclosing how the model works and allowing them to test the model with their own numbers."

Lehman Brothers says it does not take margin figures from a black box and hand them over to clients. "As far as we're concerned, understanding risk is a problem for both sides, so we want to manage it together instead of separately," Wannenmacher says.

Making adjustments

Still, some banks that had previously pursued prime brokerage business in Asia have had to adjust their margining requirements dramatically, says David Gray, Hong Kong-based head of prime brokerage for Asia-Pacific at UBS. "It's possible that they miscalculated their margining formulas by failing to factor-in the volatility levels that were needed to set the margins accurately," he says.

Gray says UBS has not made any mistakes in this area. "As a result, we haven't had to increase our margins," he adds. "We've received a lot of business this year from clients who were unhappy with the margin changes imposed on them by other firms."

Morgan Stanley's Baker said at the conference that Asian hedge funds have reduced their cash holdings since March, indicating more optimism about financial markets. Baker said total investment by hedge funds in Asia using Morgan Stanley as a prime broker, including securities they are holding plus borrowed stocks they have sold in anticipation of their prices going down, has risen by 10 percentage points from the trough in late March.

Now could be the time for those firms that are managing to keep a lid on their margins to expand prime broker services in Asia.