Hedge Funds and Swaps:
Why Trading Will Cost You More
By Sherri Venokur, RFG Senior Consultant
February 2012
As the provisions of Title VII of Dodd-Frank go into effect, hedge funds will find that their
activities in the over-the-counter derivatives market are more expensive and, perhaps,
even riskier. This is the result of new demands on their swap dealers imposed by Title
VII, including new clearing, capital, margin, reporting and recordkeeping, and disclosure
requirements, as well as new standards for business conduct, all of which will make it
more expensive for swap dealers to operate. It is likely that swap dealers will pass these
costs along to their clients – to the extent competitively feasible – in the form of
increased fees and pricing. In this environment it will be even more important that hedge
funds carefully select their trading partners and effectively negotiate their trading
agreements.
Costs Associated with Documentation. Title VII presents swap dealers with new
documentation obligations for uncleared trades. Hedge funds will be required to amend
their existing ISDA Master Agreements and Credit Support Annexes so that their swap
dealer counterparties can meet these new requirements. The CFTCʼs proposed rules
require that the partiesʼ trading documentation include “a complete and independently
verifiable methodology for valuing each swap,” allowing each party to value its position
in a “predictable and objective manner,” and expediting the resolution of any potential
valuation disputes. The standard form of ISDA 2002 Master Agreement has an
elaborate provision for determining the value of a portfolio upon its early termination, but
the provision frequently results in disputes.
Title VII-compliant trade valuation provisions may be included in the partiesʼ ISDA
Master Agreement, in a master confirmation for a particular product type, or in an
individual trade confirmation. Whichever the case, hedge funds will want to negotiate
carefully how any non-standard, uncleared trades will be valued, as portfolio value
determines the amount of the fundʼs initial and variation margin requirements. The
International Swaps and Derivatives Association, Inc. (“ISDA”) recently commenced a
Dodd-Frank Compliance Documentation Initiative in order to revise existing ISDA
documentation and to develop new documentation to help the industry comply with the
new regulatory requirements. Whatever standard language and documentation ISDA
publishes, however, will not be able to suit the varied and often conflicting needs of the
different categories of derivatives market participants, including hedge funds.
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Because of the Title VII clearing requirements, hedge funds may find themselves
negotiating clearing agreements for the first time. Hedge funds need to be particularly
careful to ensure that they have sufficient time to move their trades should their clearing
members decide to reduce their exposures or even exit a particular business line.
Costs Associated with Margin. Before Title VII, there was no law or regulation
requiring banks and other financial institutions to collect margin to support their
counterpartiesʼ obligations in OTC derivatives trades. Nonetheless, most swap dealers
have required their hedge fund clients to collateralize their derivatives trading with
margin calculated according to the dealersʼ own risk management standards. The initial
margin amount and the amount of permitted unsecured exposure basically depended
upon the risk tolerance of the swap dealer and the hedge fundʼs
creditworthiness. Before Title VII, swap dealers also insisted upon being able to rehypothecate posted margin and to commingle margin with the dealersʼ own assets. With
few exceptions, this became a market practice.
Title VII requires swap participants to collect margin from their OTC derivatives
counterparties and to segregate it from their own funds. These requirements impose a
significant new cost upon swap dealers, one likely to get passed along to their clients in
the form of increased fees and pricing.
Margin and Segregation. Under Title VII, swap dealers are required to notify their
customers of their right to have their initial margin segregated with an independent
custodian, but it is expected that many, if not most, hedge funds will waive this right.
Yes, having a collateral custodian is less risky, but it creates custodial fees for the swap
dealer that undoubtedly will be passed along to the customer. It is likely that only
exceptionally risk-averse funds, and funds that invest assets owned by special types of
entities, such as pension assets, will choose to deny their swap dealers use of the initial
margin amount in the face of increased fees and pricing.
Interdealer Trades. Swap dealers enter into trades with each other in order to hedge
their customer positions. Before Title VII, these trades did not require initial margin from
either party, and did not require variation margin to be transferred until a high unsecured
threshold amount was met. Under Title VII, all mark-to-market exposure under
interdealer trades must be collateralized – the formerly high unsecured threshold
amount will be reduced to zero. Dealers may be required to post initial margin to each
other and to segregate the margin they receive with a custodian. Because, in this
scenario, the initial margin amount cannot be commingled with the general assets of the
secured party, that swap dealer is effectively denied a revenue source. To the extent
that the initial margin amounts are not netted, interdealer trading will be even more
expensive for both parties. It seems that hedge fund clients of swap dealers will have to
absorb the increased costs to their swap dealers resulting from their new obligation to
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373 Park Avenue South, 6 Floor • New York, NY 10016 • (212) 537-4058 x1 • www.regfg.com
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post collateral on interdealer trades, coupled with their inability to use the collateral they
receive on such trades.
Initial Margin Requirements for Hedge Funds. While the amounts of initial margin
required to be posted by hedge funds on all trades are expected to increase once Title
VII becomes effective, hedge funds will be posting even greater amounts to secure
uncleared trades than the amounts they will have to post to the clearinghouse to secure
cleared trades. One piece of evidence for this difference is the models approved by the
CFTC for swap dealers to use in calculating initial margin. According to these models,
initial margin for uncleared trades will need to cover exposure over a ten-day liquidation
horizon, whereas the corresponding period is only one day for a cleared futures
contract. The proposals made by bank regulators and the CFTC set margin
requirements based on the risk profile of the swap entityʼs counterparty, and hedge
funds are likely to be categorized as high-risk financial end-users.
The division between cleared and uncleared trades will result in hedge funds losing
much of the benefit of their portfolio margin arrangements. Under Title VII, initial margin
posted to a swap dealer by a hedge fund to secure its exposure under an uncleared
derivatives trade will be held either by an independent custodian or, if the fund waives
its segregation right, by the swap dealer itself. Margin posted to support cleared OTC
derivatives trades is held by the clearinghouse. Cleared and uncleared trades will be
subject to different margining regimes, thereby creating different buckets of exposure:
derivatives versus cash trades; cleared versus uncleared derivatives.
For this reason, hedge funds that have negotiated portfolio margining arrangements
with their prime brokers in order to reduce the amount of required initial margin likely will
find that these arrangements are not as beneficial as they once were. To the extent that
a fundʼs risk-producing trades are not subject to clearing while its risk-reducing trades
are cleared, the fundʼs initial margin amounts with respect to both its cleared and
uncleared portfolios may not reflect the actual reduced risk of the entire portfolio. An
increase in variation margin may result from the inability to net exposures between
cleared and uncleared trades. Higher margin costs associated with uncleared trades are
anticipated to push hedge funds towards alternative exchange-traded strategies – and
this is exactly what the drafters of Title VII were looking to achieve. Even so, the recent
news that as much as $1.6 billion dollars in customer funds may be missing from MF
Global calls into question the extent to which clearing can reduce counterparty credit
risk in uncleared trades, especially compared to the independent custodian option
introduced by Title VII.
Eligible Collateral. Title VII includes restrictions on the type of collateral swap dealers
can accept from hedge funds as margin. Under the proposed CFTC rules, the only
types of collateral swap entities will be allowed to accept are immediately available cash
and, subject to haircutting, certain U.S. government and agency obligations. Senior debt
obligations of U.S. government-sponsored entities also constitute acceptable collateral,
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but only for initial margin. If a hedge fundʼs swap dealers have accepted other types of
collateral in the past, that fund will now have to acquire collateral that complies with the
new regulations, which could be costly. Even if funds have sufficient cash or other
qualifying assets to meet their new need for cash collateral, they may wish to use their
cash for investment opportunities.
Based on both increases in the amount of collateral required by hedge funds to support
OTC trade exposure, and restrictions on the types of acceptable collateral, it will
become important for hedge funds to manage their collateral in the most effective way
possible. It is anticipated that at least some major banks will be offering collateral
optimization services that will include the transformation of non-cash holdings into
eligible collateral.
Reduction of Close-out Netting Benefits. The “dealer push-out rule” puts restrictions
on what derivatives products may be traded by an insured depositary institution, so a
hedge fund that trade with a U.S. bank may be facing as its counterparty both the bank
itself and a bank affiliate that has been spun off from the bank. Further, for various
reasons, banks may choose to spin off multiple affiliates, each of which will engage in a
different type of transaction, e.g., equity versus commodity swaps. For uncleared trades,
a hedge fund might now have to have a separate portfolio for each such bank
affiliate. Because the set-off of liabilities in a bankruptcy context generally requires
mutuality, a hedge fundʼs exposure to one insolvent bank affiliate probably could not be
set-off against a second bank affiliateʼs exposure to the fund, with the result that the
hedge fund will have an increased exposure to the bank as a whole should it become
insolvent. Depending upon their particular strategies, hedge funds will want to explore
whether non-U.S. swap dealers can give them better pricing and collateral terms.
Costs Associated with Trading with Special Entities. If a hedge fundʼs assets
constitute “plan assets” of an employee benefit plan under Title I of the United States
Employee Retirement Income Security Act of 1974, as amended, the fund will be
classified as a Special Entity, as defined in Title VII. This classification is important,
because Title VII includes detailed rules for swap dealers trading with Special Entities,
and these rules will be costly for the dealer to implement. These costs may influence
some swap dealers to choose not to trade with Special Entities, so it may become
difficult for hedge funds in this category to find suitable trading counterparties.
Hedge funds need to develop an overall response plan to all these changes. They
should start with an understanding of their current usage of swaps and exposures to
swap dealers, and consider several factors including liquidity, credit exposure, and
underlying business needs. To be successful, this kind of plan will require coordination
of the trading, marketing, compliance, operations, technology and legal functions and
the training of personnel in each of these areas.
© 2012 The Regulatory Fundamentals Group LLC
th
373 Park Avenue South, 6 Floor • New York, NY 10016 • (212) 537-4058 x1 • www.regfg.com
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