2018 was a year the hedge fund industry would rather forget, with the community recording a loss of 5.7%, according to the Bloomberg Hedge Fund database. This was the industry’s worst performing year since 2011. HSBC’s alternative investment group revealed only 16 hedge funds delivered positive returns before fees last year, from the 450 monitored.
The reasons? Political risk and trade tensions have led to an unpredictable and highly volatile trading environment which, while presenting opportunities to Fixed Income Macro and Relative Value strategies, has hurt all other types of funds in 2018, including CTA/Managed Futures. This poor performance — especially in the latter part of the year — resulted in $15bn leaving the industry in November. This may sound like a drop in the ocean for managers, but the accelerated rate in which investors are pulling funds is something to worry about.
This year managers will still be faced with the same hurdles on top of increasing industry regulation which will result in increased capital — or margin — requirements for the same amount of risk. So, how can managers reduce margin to ensure 2019 is a success?
Get ahead of upcoming regulation
The 2008 financial crisis has resulted in the implementation of an increasing amount of stricter regulation which is only impacting the majority of the industry now. These rules include margin requirements for non-centrally cleared derivatives. While most funds have been clearing derivatives for years and posting collateral on their bilateral transactions, non-cleared regulation is about to take capital requirements to a whole new level. It’s vital to swot up on how this year’s changing will impact your returns.
Mandatory Uncleared Margin rules (UMR) are due to capture over 2,000 buy-side firms by September 2019 and 2020. This regulation has already resulted in the forced deleveraging of derivatives by requiring more margin to be posted on every single trade — tying up essential funds that could be used to generate returns.
So, whereas pre-crisis you could determine what market view you wanted to take and just trade without thinking, today you could very easily need to deploy 50% more capital in the form of margin. The impact on the entire industry is dramatic: the US Treasury has predicted over $2trn additional margin will be posted by 2020.
Peter Rippon, OpenGamma’s CEO, explains: “Making fund managers post more cash sounds great in principle. But in practice, these rules trigger a massive cost for the industry, which ultimately, will be shouldered by the very end investors regulators are trying to protect.”
“Only last week a CEO at one of our top hedge fund clients was stressing how critically important is has become for their returns to use derivatives efficiently.”
Consequently, the upcoming UMR rules will force managers to think about capital allocation. For highly levered strategies, posting margin under UMR means that a recapitalisation of the fund may be required for portfolio managers to continue to trade in the same size. This comes at a time of increased investor scrutiny with unencumbered cash levels being one of the area of focus, so it’s important to get your head round upcoming changes and how to adapt your trading practices sooner rather than later.
Focus on reducing your margin
One of the easiest ways to do this is by reducing the margin you’re paying today for the same amount of risk. However, to do this you need to really understand the ways in which margins are calculated.
For CCPs to cover liquidity and concentration risk, they need to charge additional margin, especially so for large positions. But the margin charged by different CCPs for the same products can vary by surprisingly large amounts, particularly considering they cover the same risks. For instance, margin rates can differ as much as 50%.
“While the clearing landscape is highly sophisticated, it is becoming harder and harder for hedge funds to gain real insight into the drivers of margin beyond what is reported by their brokers,” says Rippon. “At a time when investors are scrutinising every penny, the last thing any fund manager needs is to be restricted by unnecessarily posting more margin than they have to. Some are already finding ways around this issue, which is why we are seeing more firms turn towards in-depth analysis in order to seek out opportunities to reduce margin.”
Identifying the optimal way to express and allocate risk can have a dramatic impact on capital requirements. In the analysis we have undertaken for clients, we have found that moving up to 10 positions between clearing brokers can lead to a 25% reduction in initial margin. This can equate to hundreds of millions of dollars released to scale up positions.
So, 2019 does have the true potential to be a brighter year for hedge funds, but only if managers adapt to the changing regulatory landscape and factor capital into every decision across trading, treasury and operations. This can save managers hundreds of millions of dollars that can be deployed elsewhere to generate returns and improve your fund’s liquidity profile.
Want to know more about reducing your margin today?
You can see how the top buy-side firms use OpenGamma Analytics to save $100m in capital by signing up for a demo at opengamma.com
Founded in 2009, the original OpenGamma business provided open source libraries for derivative analytics. Over the next seven years we built unparalleled expertise in OTC and ETD margin methodologies and been at the cutting edge of market structure changes since.
In 2016 we built an entirely new SaaS business, with the launch of OpenGamma Analytics, which is driving rapid business growth. Our teams in London, New York and Singapore bring together a unique mix of practitioner, quantitative and software engineering expertise.
Today, we are trusted by the largest and most sophisticated global banks, hedge funds, asset managers and pension funds, with thousands of users depending on our analytics every day.