Changes Driven by Regulation - Article Example

Summary of Changes Driven By Regulation Summary of Changes Driven By Regulation The finance industry has been contemplating the threat of regulatory changes for nearly the entire post- Global Financial Crisis (GFC) period (Citi Investor Services, 2014). Indeed, various stakeholders in the industry like hedge funds, investors, and sell-side participants have been aware of the eminent regulatory changes that would change key programs in the industry (Citi Investor Services, 2014). However, the reality of these changes only became certain and clear recently when the deadlines for implementing the new regulatory rules materialized or approached. The stakeholders are now experiencing the shape of the new regulations and the resultant changes, which are about to influence the strategic imperative driving the strategy of leading hedge fund organizations (Citi Investor Services, 2014). Notably, this marks a shift of the factors driving change in the hedge fund industry. A shift in the investor base had been driving major industry evolution since the GFC until recently. Indeed, the article reckons that the emergence of large institutional investors seeking to allocate capital to hedge fund managers have been driving changes in the industry for the past five years (Citi Investor Services, 2014). These changes adopted diverse strategic imperatives as institutional investors emerged as the industry’s main source of capital (Citi Investor Services, 2014). The investors’ demands changed key structural aspects of the market. Ideally, by financing the industry with huge sums of capital within a concentrated period, institutional investors determined the behaviors of the investment managers and fostered structural changes in the industry (Citi Investor Services, 2014). However, response to regulatory changes is now the main driver of change in the industry where it creates different opportunities and challenges for the hedge fund industry. The survey establishes the reality and eminent approach of major implementation deadlines upon the industry players. The formulation and implementation of a broad and significant set of global regulations is now the dominant force of industry change. These regulations include the Volcker Rule, Dodd-Frank, EMIR, OTC derivative rules, Liikanen Proposal among other rules (Citi Investor Services, 2014). The new regulatory changes are offering new opportunities to hedge funds where they can optimize their business approach. The Volcker Rule and Liikanen Proposal has eliminated the proprietary trading talent from sell side organizations that allowed hedge funds and other buy-side firms to adopt new talent and expand their market-making and trading activities that enhanced competition in the industry (Citi Investor Services, 2014). Volcker Rule and Liikanen Proposal fostered a shift from a dealer-dominated activity to a hedge funds-dominated activity in addressing market risk by allowing hedge funds organizations to adopt key aspects of market-making, inventory management, and direct lending (Citi Investor Services, 2014). Moreover, the Volcker Rule and Liikanen Proposal strengthen the relationship between hedge funds and their prime brokers since there is mutual benefit gained from efficient financing(Citi Investor Services, 2014). On the other hand, the revamped OTC derivative markets arising from the OTC derivative rules enable the hedge funds to help in the effective transformation and provision of high quality liquid assets to support collateralization (Citi Investor Services, 2014). Clearly, the implementation of the new rules have led to significant changes in the banking sector and numerous structural reforms in the securities, financing and OTC derivative markets, which derived increased activity in market-making, collateral management, and financing in the industry (Citi Investor Services, 2014). Indeed, prior to the GFC, many proprietary trading units adopted complex trading techniques and financial advantage. However, the Volcker Rule and reality of the Liikanen proposal have shifted the proprietary trading activities from the bank/non-bank threshold (Citi Investor Services, 2014). The survey establishes that most proprietary trading units have now shifted from dealer organizations to the buy-side. The new regulations have created opportunities for the proprietary trading units to collaborate with existing hedge funds or asset manager organizations (Citi Investor Services, 2014). The proprietary trading units can also initiate their own investment management firms. The dealer organizations experienced the impact of the new regulations since they led to the loss of talent and derived the need to shift the model toward an agency-trading model since the dealer organizations lost the capacity to participate in principal transactions due to the loss of talented and skilled individuals (Citi Investor Services, 2014). In addition, the new regulations influenced market making adversely as the traders remaining in dealer organizations record a reduced risk tolerance (Citi Investor Services, 2014). As such, the new regulations have negative effects on proprietary trading units and positive effects on hedge funds organizations. The implementation of the new rules in the industry have allowed hedge funds organizations to assume some of the roles of proprietary trading units and bear more risks from the dealers. This has increased the competitive advantage for the hedge funds and diversified the relationship with their investors as they started to interact in a new platform. The survey notes, “Hedge funds are likely to develop new roles with these competitors and leverage an increasingly interoperable collateral landscape to swap, transform and either upgrade or downgrade collateral to help meet demand from their counterparts or the clients they introduce as agents” (Citi Investor Services, 2014). The new capacity achieved by the hedge funds will motivate the traditional asset managers and private equity firms seeking to expand their production, which is a great opportunity. The new regulations may expand the pool of collateral that hedge funds control with the increased the demand for high quality liquid assets (HQLA). The expansion of the collateral pool will allow hedge funds to start treating collateral as an asset class that can supplement their trading book profits by effective use and pricing of their collateral pool (Citi Investor Services, 2014) thus leading to changes in pricing, profits, and valuation of assets. The new changes in collateral and asset treatment will increase the costs of financing since the Basel III liquidity coverage ratios and net stable funding ratios will adversely affect prime broker balance sheets and coerce broker-dealers to adjust the prices of their offerings (Citi Investor Services, 2014). On the other hand, in implementing the new rules, leading firms will; focus on enhancing financing efficiency with their top prime brokers, which will consequently allow hedge funds to access financing and attain less extreme price increases in an efficient manner (Citi Investor Services, 2014). Indeed, by enhancing the prime broker’s funding and coverage needs, the customers in the industry will enjoy huge returns on assets and reduce balance sheet utilization. Most assuredly, by allowing proprietary trading units to collaborate with existing hedge funds or asset manager organizations or initiate their own investment management firms, the implementation of the new regulations will increase the pool of institutions in the industry. The multiple firms existing in the industry have created a “convergence” zone that allows them to manage their own securities positions which acts as a counterparty for hedge funds (Citi Investor Services, 2014). However, to enjoy the benefits derived by the new regulations, hedge funds will need to overcome numerous challenges. The new rules will expose hedge funds to more fragment and difficult collateral management environment that will force them to upgrade their capabilities (Citi Investor Services, 2014). As such, the hedge funds will have to outsource or deploy efficient platforms in the market to compete with the market leaders that will be seeking to establish new capabilities, platforms, and processes to transform their organizations (Citi Investor Services, 2014). The hedge funds will have to consider the number of pools of collateral since the new regulations forced hedge funds to manage multiple interactions between their prime brokers, swap dealers and these new counterparts (Citi Investor Services, 2014). This daunting task is prone to misrepresentation and inaccurate conclusions. Moreover, the new regulations will increase the number of counterparties and collateral pools that hedge funds will have to manage. As such, this leads to the challenge of having the capacity to measure the benefits and relationship value offered by specific counterparty to their service providers due to the scarcity of the resources available for such ventures. Hedge funds and other leading firms will have to focus on choosing which counterparties are more effective. Making this decision is challenging yet very important because it can define the competitive advantage and effectiveness of the organization in the industry. Additionally, hedge funds must rethink about their use of financial advantage and determine the trade-off between rising costs and likely returns with an aim of achieving competitive advantage and maximizing profits (Citi Investor Services, 2014). The hedge funds face the challenge of determining the right metrics to track and shape their engagement with the sell side in counterparty management. This decision will help the hedge funds to identify and manifest the financing efficiencies and benefits they offer to their set of prime brokers and their increased value as a counterpart (Citi Investor Services, 2014). To enjoy the benefits of implementing the new rules, we will need new data inputs, analytics, and tools to ascertain the effective use of hedge fund collateral assets and efficient deployment of financing positions. Hedge funds will equally face the challenge of mimicking margin calculations of relevant counterparties, ladder their collateral for delivery, and perform different types of trade analysis to support the ability of the firm to step into certain market-making opportunities and accurately price collateral transformation, upgrade, and downgrade trade margins (Citi Investor Services, 2014). Reference Citi Investor Services. (2014). Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization. Retrieved from: http://www.citibank.com/icg/global_markets/prime_finance/docs/citi_2014_spring_survey_part_2.pdf Read More