Hedge funds may be cagey about their investment strategies but their use of credit derivatives is doing the market no end of good. Natasha de Teran explains why a lack of transparency is the least of bankers’ concerns.

When a group of Fitch analysts set out to study the credit derivatives market early last year, the rating agency surveyed and received answers from 181 institutions. The agency had also sought to expand the survey to cover the hedge fund industry, writing to 50 of the world’s largest hedge funds to see if they would provide basic information on their credit derivatives exposures. Unfortunately, none were inclined to do so.

In itself, this is not surprising. Hedge funds are often at the vanguard of new market trends and are notoriously secretive and protective about their investment patterns. Their non-participation was was a setback for attempts to research the fast-growing credit derivative industry.

Ian Linnell, author of the subsequent report and an analyst at Fitch, says the absence of hedge funds in the credit derivatives survey is significant given that they are one of the fastest growing and more influential segments of this market; were this trend of hedge funds using credit derivatives in a non-transparent way to continue, he believes it might heighten concerns related to poor disclosure and counterparty risk.

He says: “While generally not rated, hedge funds are understood to represent one of the fastest growing segments of the credit derivatives market and thus increasingly play an influential role. As a result, Fitch believes issues related to poor disclosure, transparency and counterparty risk could very well be exacerbated by the participation of these non-regulated entities.”

Market impact

For those like Fitch that attempt to analyse the market’s depth, breadth and customs, the secrecy surrounding hedge funds’ use of credit derivatives is undoubtedly a setback. But for the banks and others that serve hedge funds, and enjoy the associated revenues, the funds’ contribution to the market is becoming increasingly important.

According to Olivier Vigneron, a director in the structured credit trading group at Deutsche Bank, hedge funds have become very significant players in the credit derivative market since last September, engaging in a sizeable amount of relative value and leveraged trades.

Nadine Badra, senior credit sales for hedge funds, at BNP Paribas in London, says that almost 75% of the business her team now does with hedge funds is in credit derivatives. She says: “The fall-off in convertible bond issuance has meant that the convertible arbitrage hedge funds have had to look to other areas. It was a natural progression for them to turn to capital structure arbitrage, which almost necessarily involves credit derivatives now.”

At JP Morgan, Ian Slatter, head of UK credit sales, estimates that hedge funds account for around as much as one-quarter of the credit derivative business done by the bank in the UK – and he is almost unequivocal about the benefits of their involvement. He says: “The breadth and depth of hedge funds involvement in the CD market adds liquidity – which is clearly a positive development; increases volatility – which can be seen as a negative or as a positive; provides a new outlet for credit assets; and ultimately allows the credit market to develop and become smarter. In many senses hedge funds are driving our product development.”

Liquidity benefits

Many bankers agree that the biggest benefit of hedge funds’ take-up of credit derivatives has been in the growing liquidity they have bought to the market. Ms Badra says: “To an extent they also impact positively by correcting the market’s inefficiencies and arbitrage opportunities – hedge funds correct the anomalies and bring the market back to fair value. But their biggest impact has been on liquidity.

In addition, and because of the way spreads have behaved lately, there has been increased interest from hedge funds in high yield and cross-over sectors – which have traditionally been illiquid and often not traded at all.

Ms Badra says that hedge funds have looked to this area of the market because their higher funding costs demand higher margin trades. Their interest in these more marginal credits has resulted in more liquidity in a segment that sorely needed it – and direct hedges for what were previously often unhedgeable risks.

But of more importance for banks is the fact that hedge funds have been willing to take on parcels of risk many other classes of investors found unpalatable – correlation risk and equity tranches of collateralised debt obligation (CDO) deals. Finding willing recipients for these risks has enabled banks and other players in the structured credit market to offload unwanted risks and put together new deals.

Taking on risk

Ms Badra says: “Hedge funds have been actively taking on the risks that the banks needed to get rid of – namely the correlation risk. There are not that many sophisticated players in the market – so there is not an infinite number of those that can price or are prepared to take on these risks. In that sense hedge funds have an important role to play by ensuring that banks can relieve themselves of this risk and replenish their stocks for new deals.”

According to Mr Slatter the structured credit markets have historically been somewhat one dimensional – insurance companies were buying risk in leveraged form from banks, which were packaging up risks and selling them on. He says that hedge fund involvement in this part of the market has given it a wider scope, and their growing importance within the market makes it easier for managers to take an active trading approach.

Mr Vigneron estimates that the volume of equity tranches that have been placed with hedge funds in the primary market is well over E1bn. He says: “Hedge funds have, in a sense, completed the market by taking on the equity tranches of synthetic deals. The buyers of the equity pieces of traditional cash-flow CDOs, have shown less appetite for the equity pieces on synthetic deals, but since hedge funds have taken on that role, banks should now be able to price risk of synthetic CDOs more efficiently.”

Similarly now that hedge funds are fluent with these products, Mr Vigneron believes they will also look at other credit derivative and structured credit instruments providing yet more revenue opportunities for banks’ trading and sales desks.

Index activity

Another area in which hedge funds have been among the most active market participants is in the index-based sector of the credit derivative market. Two rival groups of indices based on credit default swaps (CDS) – the most commonly traded instruments in the credit derivatives market – were recently developed by groups of banks. The index families, iBoxx and Trac-x, were developed by competing bank consortia last year.

Bankers say hedge funds were encouraged to step up their involvement in credit derivatives through the indices. Better still – the indices have benefited strongly from the hedge funds active trading interests.

James Parascandola, head of credit derivatives index trading at Barclays Capital in New York, says that a notable amount of customer interest in the iBoxx group of indices has come from hedge funds.

Once the indices gained a following, the rival groups of banks started to market series of tradeable CDO tranches based on their indices. The appeal of the index-based tranched products lies in their transparency and liquidity. Because CDOs are typically private transactions, carried out on a proprietary basis by banks and other CDO managers, there are no liquid markets in them. Although issuers will quote prices to buy back CDO tranches, trading can be expensive for investors as few banks are willing to quote markets in products belonging to others.

In contrast, investors in the index-based products are able to receive live tradeable two-way markets in all the index-based tranches, and trade in and out of them under standardised documents with the banks in the relevant consortium.

Making an entrance

According to traders a large number of hedge funds had not got involved in the synthetic CDO markets previously because of the wide bid-offer spreads and the lack of liquidity. Many of them have since entered the market as they can see that these products satisfy their trading requirements.

Ms Badra says their contribution to liquidity has been especially high on tranched and index products: “Without their flow the banks would not be able to quote 1bp spreads on chunky deal sizes.”

Mr Slatter adds: “They have been one of the main drivers behind the development of a liquid tranched index market. Although I don’t think these products were designed specifically for them, their involvement has been positive for the market’s development.”

Positive view

Against all the positives outlined by the bankers and the heady profits being registered by the ever-growing swathe of hedge funds, Fitch’s observations on transparency seem to pale into insignificance. And in any event the ongoing debate into how these unregulated entities should be treated, may yet force them to answer far more penetrating questions than those that the rating agency is posing.

In the meantime other less established banks wishing to serve them may need to gear up their offering. According to Mr Vigneron banks need to offer transparent pricing and liquidity in the secondary market in order to deal with hedge funds. He adds: “Without that liquidity and without giving some access to the sophisticated models needed to value these instruments, banks cannot serve this sector of the market.”

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