The following article appeared in the winter edition (2008/2009) of AIMA magazine
The After Burn
by City Fund Management Chairman - Christopher Lee
The credit crunch started in mid-year 2007 bringing with it totally dysfunctional markets which have now lasted well over one year. At the time I was planning this article I thought the situation would have stabilised and although I would be writing about a very different market scenario it would be one with clear sign posts and a sense of direction. As it is I am writing this as the tempest rages about us with the future of the whole banking system, both domestic and international, under serious threat. The only certainty is that the market as I have known it for my whole working life of over forty years has gone for the remainder of my lifetime.
There has already been much written about what is happening and what needs to be done to address the situation we find ourselves in with nationalisation of the banking system, a wild speculation just a few weeks ago, now happening. “The Brown Plan” is being applied in various forms across the financial centres of the world.
Whatever happens in the months to come it seems obvious that the whole structure of the markets and how they operate will be changing. Structure and regulation are likely to be the central planks in the new world with excesses being driven out of the system, particularly where excessive leverage and cheap credit are concerned. This will undoubtedly result in dramatically slower growth, an extension of the recession that I already believe we are in, and wholesale changes in working practices.
Many will suffer during this period but I believe there will also be considerable opportunities for those who are nimble and not restricted by the imbalances of the past. Once stability has been re-established I believe governments and regulators will set about re-building the markets in a manner that removes the weaknesses and builds stronger structures for the future. With this in mind I offer some thoughts on how this might evolve.
Firstly, credit risk control has been at the core of the market meltdown and it seems obvious that this will be first on the hit list to ensure lending and associated access to credit are properly controlled. Re-building the capital base of the banking system is central to this but also ensuring that correct application of risk capital is more robustly regulated and managed. This will undoubtedly have an impact on the hedge fund market where gearing through bank borrowing will be severely curtailed. Commission and fee levels which have been sustained through the application of layers of leverage, without which the required high returns would not be possible, will come under downward pressure.
Secondly, it seems likely that commoditisation will continue apace to the extent that exchange traded instruments will flourish where credit risk is primarily centralised through the exchange and clearing house. Now this is really where the rub is. If nationalisation is to have a role why not nationalise the clearing house (currently owned by the clearing banks) and effectively put it alongside the Bank of England in terms of clearing structure? This would put capital into the banks at a stroke on the assumption that a realistic price is arrived at. This would also enable the government review exchange structures so that all parties trading exchange contracts which are capitalised by margin levels in fact have a government settlement risk as the counterparty. This would encourage wider contract development, greater transparency and ultimately more robust regulatory control. In short, a merger of the clearing / exchange mechanism in effect underwritten by government, has many attractions from a counterparty risk perspective also allowing regulators a platform for evaluating risk and, where appropriate, controlling it in a transparent environment.
Much has been made of the damage caused by short selling of equities by hedge funds whereas a significant percentage of the price falls in recent weeks have in fact been the result of funds unwinding long positions leveraged through bank debt. Free markets must be able to function efficiently and this includes the ability to short stocks or contracts. Whether this should be limited in certain markets is open to debate as the foreign exchange markets have been regulated on the short side through the banks for many years in the interest of currency stability. Markets which are unstable and dysfunctional are not in anybodies interest and practitioners should welcome a level playing field whereby structured investment decisions can be made, and transparency is central to this.
There is much work to be done in terms of re-basing some of our existing exchange traded contracts where the underlying price mechanism pretty much broke down. I am think here of LIBOR related contracts in particular (Short Sterling, Euribor, and Eurodollar contracts) where the inter-bank market all but disappeared with the resulting knock effect into products such as interest rate swaps. Any contract is only as good or as deep as the underlying, and we can only hope that the measures taken to restore confidence in the market will have the desired effect.
Thirdly, the one way street bonus system has partly been addressed through a draconian approach via nationalisation of individual financial institutions. In a free market environment the application of regulatory capital is a tool for controlling operational risk which is of course increased by excessive and poorly structured bonus schemes. I believe the regulators can control operational risk through the more robust application of risk capital ratios and thus indirectly control the bonus structures embedded in any institutions operations. Such an approach would surely follow through to the corporate sector as public companies practicing loose remuneration policies would be held to account by both banks and shareholders alike. It is obvious that remuneration packages with no downside, increase risk and should be curtailed. Those who add value should be well and properly rewarded but the “roll the dice” era I suspect has now passed.
International coordination across the markets appears to be taking hold and this can only be positive for the markets of the future. The coming months will be a period of adjustment and re-evaluation when values will be re-assessed with new price levels and correlations emerging. Many of the old rules are being re-written and I suspect the heavy hand of the authorities will stifle certain activities initially and it is as much for this reason that the opportunity for growth will be in exchange traded contracts which will not have the same credit risk issues and will also have optimal transparency. Given that hedge funds will largely have their credit leverage choked off they will have to look for other means of creating the leverage they need if they are to be able to achieve the returns they desire. By definition this suggests that the managed futures arena is ripe for growth which in turn will be good for liquidity.
What does all this mean for the hedge fund arena?
It is clear as referred to earlier, that traditional credit leverage in hedge fund structures is a thing of the past and where it remains it will be significantly reduced and on much harsher terms. It is reasonable to assume the number of funds will reduce in tandem with the reduced returns, partly due to losses incurred and partly because the commission structure will impact negatively on distribution capability.
It will also mean that the secrecy surrounding certain funds will be increasingly difficult to maintain in the face of regulatory demands for transparency. The drive for transparency through more robust regulation will force funds and underlying products increasingly towards exchange traded structures. Risk analysis should become easier or at least more accessible, again part of the transparency equation, with industry standard risk measurements becoming more widely understood by investors. The squeeze on bonus structures will feed through to the hedge fund industry as well not least because the revenue cake will be smaller.
Ultimately I believe this will lead to a better, more fluid market, where risk and return are mentioned in the same breath by investors. Capital losses on investments that were felt to be gold plated will have shaken investors to the core, many of whom will not only have bled profusely but also lost a pound or so of flesh! Our key responsibility in the months to come will be to expound the values of the alternative investment market in terms of providing liquidity, creativity, and increasing transparency. The opportunity is to be proactive and on the offensive rather than reactive and on the defensive. We can lead the way into the new world or be dragged into it against our will. The choice is ours.
The After Burn
by City Fund Management Chairman - Christopher Lee
The credit crunch started in mid-year 2007 bringing with it totally dysfunctional markets which have now lasted well over one year. At the time I was planning this article I thought the situation would have stabilised and although I would be writing about a very different market scenario it would be one with clear sign posts and a sense of direction. As it is I am writing this as the tempest rages about us with the future of the whole banking system, both domestic and international, under serious threat. The only certainty is that the market as I have known it for my whole working life of over forty years has gone for the remainder of my lifetime.
There has already been much written about what is happening and what needs to be done to address the situation we find ourselves in with nationalisation of the banking system, a wild speculation just a few weeks ago, now happening. “The Brown Plan” is being applied in various forms across the financial centres of the world.
Whatever happens in the months to come it seems obvious that the whole structure of the markets and how they operate will be changing. Structure and regulation are likely to be the central planks in the new world with excesses being driven out of the system, particularly where excessive leverage and cheap credit are concerned. This will undoubtedly result in dramatically slower growth, an extension of the recession that I already believe we are in, and wholesale changes in working practices.
Many will suffer during this period but I believe there will also be considerable opportunities for those who are nimble and not restricted by the imbalances of the past. Once stability has been re-established I believe governments and regulators will set about re-building the markets in a manner that removes the weaknesses and builds stronger structures for the future. With this in mind I offer some thoughts on how this might evolve.
Firstly, credit risk control has been at the core of the market meltdown and it seems obvious that this will be first on the hit list to ensure lending and associated access to credit are properly controlled. Re-building the capital base of the banking system is central to this but also ensuring that correct application of risk capital is more robustly regulated and managed. This will undoubtedly have an impact on the hedge fund market where gearing through bank borrowing will be severely curtailed. Commission and fee levels which have been sustained through the application of layers of leverage, without which the required high returns would not be possible, will come under downward pressure.
Secondly, it seems likely that commoditisation will continue apace to the extent that exchange traded instruments will flourish where credit risk is primarily centralised through the exchange and clearing house. Now this is really where the rub is. If nationalisation is to have a role why not nationalise the clearing house (currently owned by the clearing banks) and effectively put it alongside the Bank of England in terms of clearing structure? This would put capital into the banks at a stroke on the assumption that a realistic price is arrived at. This would also enable the government review exchange structures so that all parties trading exchange contracts which are capitalised by margin levels in fact have a government settlement risk as the counterparty. This would encourage wider contract development, greater transparency and ultimately more robust regulatory control. In short, a merger of the clearing / exchange mechanism in effect underwritten by government, has many attractions from a counterparty risk perspective also allowing regulators a platform for evaluating risk and, where appropriate, controlling it in a transparent environment.
Much has been made of the damage caused by short selling of equities by hedge funds whereas a significant percentage of the price falls in recent weeks have in fact been the result of funds unwinding long positions leveraged through bank debt. Free markets must be able to function efficiently and this includes the ability to short stocks or contracts. Whether this should be limited in certain markets is open to debate as the foreign exchange markets have been regulated on the short side through the banks for many years in the interest of currency stability. Markets which are unstable and dysfunctional are not in anybodies interest and practitioners should welcome a level playing field whereby structured investment decisions can be made, and transparency is central to this.
There is much work to be done in terms of re-basing some of our existing exchange traded contracts where the underlying price mechanism pretty much broke down. I am think here of LIBOR related contracts in particular (Short Sterling, Euribor, and Eurodollar contracts) where the inter-bank market all but disappeared with the resulting knock effect into products such as interest rate swaps. Any contract is only as good or as deep as the underlying, and we can only hope that the measures taken to restore confidence in the market will have the desired effect.
Thirdly, the one way street bonus system has partly been addressed through a draconian approach via nationalisation of individual financial institutions. In a free market environment the application of regulatory capital is a tool for controlling operational risk which is of course increased by excessive and poorly structured bonus schemes. I believe the regulators can control operational risk through the more robust application of risk capital ratios and thus indirectly control the bonus structures embedded in any institutions operations. Such an approach would surely follow through to the corporate sector as public companies practicing loose remuneration policies would be held to account by both banks and shareholders alike. It is obvious that remuneration packages with no downside, increase risk and should be curtailed. Those who add value should be well and properly rewarded but the “roll the dice” era I suspect has now passed.
International coordination across the markets appears to be taking hold and this can only be positive for the markets of the future. The coming months will be a period of adjustment and re-evaluation when values will be re-assessed with new price levels and correlations emerging. Many of the old rules are being re-written and I suspect the heavy hand of the authorities will stifle certain activities initially and it is as much for this reason that the opportunity for growth will be in exchange traded contracts which will not have the same credit risk issues and will also have optimal transparency. Given that hedge funds will largely have their credit leverage choked off they will have to look for other means of creating the leverage they need if they are to be able to achieve the returns they desire. By definition this suggests that the managed futures arena is ripe for growth which in turn will be good for liquidity.
What does all this mean for the hedge fund arena?
It is clear as referred to earlier, that traditional credit leverage in hedge fund structures is a thing of the past and where it remains it will be significantly reduced and on much harsher terms. It is reasonable to assume the number of funds will reduce in tandem with the reduced returns, partly due to losses incurred and partly because the commission structure will impact negatively on distribution capability.
It will also mean that the secrecy surrounding certain funds will be increasingly difficult to maintain in the face of regulatory demands for transparency. The drive for transparency through more robust regulation will force funds and underlying products increasingly towards exchange traded structures. Risk analysis should become easier or at least more accessible, again part of the transparency equation, with industry standard risk measurements becoming more widely understood by investors. The squeeze on bonus structures will feed through to the hedge fund industry as well not least because the revenue cake will be smaller.
Ultimately I believe this will lead to a better, more fluid market, where risk and return are mentioned in the same breath by investors. Capital losses on investments that were felt to be gold plated will have shaken investors to the core, many of whom will not only have bled profusely but also lost a pound or so of flesh! Our key responsibility in the months to come will be to expound the values of the alternative investment market in terms of providing liquidity, creativity, and increasing transparency. The opportunity is to be proactive and on the offensive rather than reactive and on the defensive. We can lead the way into the new world or be dragged into it against our will. The choice is ours.