The link between hedge funds and banks seems obvious, yet if the banks want to make the most of this relationship, they must start offering the kinds of services that the hedge funds are asking for, says Mark Pelham

Logically, FX should sell itself to the hedge fund community, given its depth of liquidity, the unfunded nature of currency investment and the potential for diversification within one asset class – combined with 24-hour accessibility and the arbitrage opportunities that volatile markets provide. However, aside from the occasional notorious exception and the dedicated currency hedge fund sector, FX was not the asset class of choice for most hedge funds. That has now changed, and banks are being forced to react accordingly.

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Cyril Beriot: hedge funds now hiring FX managers “With all the money that has gone into the hedge fund industry in the last couple of years, a lot of funds have grown extensively and are therefore meeting capacity problems in some markets. There are no such problems in the currency market, which is why a lot of hedge funds that were not focused on currencies have started hiring portfolio managers to trade FX,” says Cyril Beriot, head of the institutional sales desk, London, at SG CIB. Tailored service Increased hedge fund activity in the FX space has, in turn, led banks to intensify their efforts to differentiate themselves and attract hedge fund business in an overbroked market. They are attempting to do so by providing additional services beyond execution that the funds want, rather than those that are simply on offer as part of a standardised package. The cornerstone of such services is, of course, prime brokerage – in terms of providing credit extension and meeting funds’ operational, infrastructure and technology requirements, as well as providing risk reporting, measurement and management services. “Prime brokerage is obviously highly important,” says Michael Collins, FX product strategist at Deutsche Bank. “We have spent a lot of money on infrastructure and technology, which has put us in a good position and is obviously something which will continue to be a primary focus in the future.” Utilising prime broking relationships to generate more business seems an ideal solution, especially considering the one-to-one nature of the hedge fund trader-to-bank relationship. It is often the case that an individual trader at a hedge fund will know the salespeople and traders at one particular bank and will deal almost entirely with them; whereas there will be another trader at the same fund, who will know the team at another bank better and deal with that bank instead. “You don’t have as much consistency of bank relationships across a hedge fund as you might do with a real money manager,” says David Poole, principal and chief operating officer at research analysis firm ClientKnowledge. “That is also quite exciting for banks where they perceive that the ability to muscle in and be a part of the client’s wallet is potentially greater with a hedge fund.” That is, however, only a perception in many cases. As Mr Poole says: “Clearly, with start-up hedge funds, the prime broker can apply suitable and appropriate pressure to put business through them, which can be the driving force behind this process. But for the funds that have some sort of record, it can be quite a variety of different banks that they are dealing with. Very sophisticated traders do not always want to talk with a salesperson – the bank can be just an execution point for them.” As a result, banks are having to drill down beyond prime brokerage to provide services that hedge funds really want. At least in part, this means money. Robert Savage, head of FX asset sales at Goldman Sachs in New York, says: “The hedge fund community as a whole continues to expect the sell-side to be very helpful on capital commitment. Although there is not a quid pro quo, there is the expectation that if you do business with a fund, you are supposed to extend as many other services as possible, including capital commitment – which can be through either introduction or actual investment.” Hedge fund investment Deutsche Bank’s capital allocation programme to currency hedge funds, which has been running for just over two years, is perhaps the quintessential investment route. Mr Collins says: “We effectively outsourced a large proportion of proprietary risk. The bulk of the bank capital that used to be involved in proprietary trading was redistributed to people who wanted to be running their own show, which has meant that we have kept good relations with some of the smartest people in the start-ups, as well as the existing big players. This arrangement keeps us hooked into the latest developments on the hedge fund side and changes the nature of the relationships we have with them.” These relationships enable the bank to work very closely with hedge funds. “We are doing a lot of work on restructuring hedge funds to customise them to the needs of their individual clients to include maximum loss provisions underwritten by Deutsche Bank,” says Mr Collins. “We are aiming to expand on this proposition and look at further innovative product solutions.” One area that is not moving forward at any great pace, however, is electronic trading. The plethora of electronic platforms that have been set up both by individual banks and collective bank platforms are now all trying to compete for hedge fund desk real estate. “Most hedge funds trade somewhat electronically, but not on a big scale,” says Mr Savage. “Massive amounts of liquidity are not going to be found on an electronic platform: the trades that they do are usually modest trades. What hedge funds really want from electronic trading is the transparency of price that it can offer.” Conversely, flow data has become more important to hedge funds than it has been in the past. As part of the platform of research being offered, there is a whole range of information that hedge funds expect, including trade ideas and economic research. “Hedge funds like information and they like trading ideas,” says Mr Beriot. “They are usually looking for products and strategies that are highly leveraged, where the up-front cost is not too high. Alternatively, if they need to reduce the cost, a trading strategy must only expose them to a limited downside – and that means using derivatives.” Derivative instruments The use of derivative instruments by hedge funds can be divided into two broad categories, according to Mr Beriot. The larger firms, which may want to put on over E500m in a single trade, can run into liquidity constraints when trading exotic FX options. As a result, he says, those funds tend to only trade vanilla products. “But if you were to propose a good idea with an exotic component, they will trade it – perhaps in smaller amounts, but they will trade it,” he adds. The other, equally important, category is hedge funds that have portfolio managers who do not want to enter into huge one-off bets, either because of their own capacity limits or for strategic reasons. These funds, Mr Beriot says, are keen to use exotic products, as well as take vanilla option positions. There are now many banks that can provide prices across the whole range of currency derivatives so, again, focussing on this aspect of the business is not enough to retain hedge fund clients. “Creativity is something to differentiate yourself with – ensuring you find the right strategy at the right time, will generate a long-term business relationship,” says Mr Beriot. Creativity is one area of the business that banks should want to develop, since hedge funds are experts in the products they trade. “Hedge funds have a good view, are very active and are very flexible, so if you come up with an idea they like, they will be quick to adopt it,” says Mr Beriot. “Usually, the way it works is that we come up with a trading idea in, say, euro-dollar and they might find it interesting but would prefer to do it in sterling-yen, for example. We would then find out why they like that particular pairing, do our homework and come back to them with a strategy. They might like it or they might not, but at least we have developed a dynamic relationship.” Understanding the relationship An important part of the bank-hedge fund relationship dynamic is to recognise that asset classes in the derivatives space are intrinsically linked, according to Mr Collins. “Most hedge funds are not only running currency hedge funds, they are also running macro funds – so they have directional and relative value strategies in all exchange traded contracts: fixed income, commodities and money markets. Although they all benefit from investing in the liquid derivatives space, it is also a basically global-macro market. As a result, we have strong co-ordination between our trading desks, and our sales teams are cross-selling into all those areas. We now see ourselves as a global markets macro shop, which fits well with the hedge fund model.” In the end, however, if FX services are packaged for hedge funds, the essence of the business is straightforward. As Mr Savage says: “Overall, it is not that complicated. We service our clients with quality ideas and try to generate trades that make sense, which make them money and, in reward, generate business for us. The high end of such an FX base is created from using derivative products.”

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