NY Fed Study Says Counterparty Risk Management Still Best Defense to Hedge Fund Risk

However imperfect it may be, counterparty credit risk management is still the best way to limit the potential for hedge funds to generate systemic disruptions, according to a study by the Federal Reserve Bank of New York. The study’s conclusion dovetails with the fact that financial regulators in the United States and abroad have for many years been guided by the principle that counterparty credit risk management, not hedge fund regulation, is the optimal way to control hedge fund leverage and limit systemic vulnerabilities. This position was recently reaffirmed by the President’s Working Group on Financial Markets.

Largely unregulated hedge funds, which interact with banks and securities firms via such channels as prime brokerage relationships, complicate risk management through their unrestricted trading strategies, liberal use of leverage, opacity, and convex compensation structure. An important part of these relationships is the extension of credit to the hedge fund, exposing the financial institution to counterparty credit risk. But the study points to developments such as enhanced risk management techniques by counterparties, improved supervision, more effective disclosure, and more efficient hedging and risk distribution techniques.

As a result, traditional counterparty risk management remains the first line of defense between unregulated hedge funds and regulated financial institutions. An integral part of this risk management is margining and collateral practices, which are designed to reduce counterparty credit risk in leveraged trading by providing a buffer against increased exposure to the dealer providing the financing or derivatives contract.

But to be sure, the study concedes that the unique nature of hedge funds may generate market failures that make counterparty credit risk for exposures to the funds intrinsically more difficult to manage, both for regulated institutions and for policymakers concerned with systemic risk. In addition, there is concern over factors causing a breakdown of effective counterparty risk management.

For example, the apparent profits to be earned in this business may create competitive pressures that weaken credit risk mitigation practices. Both Fed Chair Bernanke and the Financial Stability Forum have noted how competition for new hedge fund business may be eroding counterparty risk management through lower than appropriate fees and spreads, or inadequate risk controls, such as lower initial margin levels or exposure limits.

Another concern is that the opacity of the hedge fund counterparty makes it harder for outsiders who are less informed of the fund’s risk profile to determine the appropriate counterparty risk ratings that drive credit terms.

A recent concern is that, while hedge funds have typically been viewed as liquidity providers, they have been moving increasingly into less liquid markets, with structured credit and distressed debt at the top of the list. In the presence of leverage, the combination of relatively illiquid assets and short-term financing exposes the
hedge fund to possibly significant liquidity risk.