The UK Independent Banking Commission has issued its final report and made its final recommendations. These recommendations essentially involve an enhanced capital adequacy and loss absorption regime combined with ring fencing between the retail and investment banking businesses.
This made me think about whether there were any implications for operational due diligence teams reviewing hedge funds. The edges between private equity, hedge funds and banks have become increasingly blurred and some of the issues that policy makers are grappling with have an impact on hedge fund risks. These hedge funds which replicate the activities of banks through the credit transactions they enter into, can effectively be shadow banks operating away from the regulatory restrictions imposed on banks taking deposits. They need attention when investors make investment decisions.
The transparency issues around hedge funds potentially operating as shadow banks lead me to think about transparency generally around trading as there is also the issue of how price discovery works on large trades when trading is done through dark pools. These are trading resources that enable trades to be entered into anonymously and have become an increasing feature of trading since 2008. A number of exchanges have dark pools, a number of broker dealers provide them and there are even aggregators of these pools.
Shadow banking and dark pools by their very description are less transparent worlds – and investors do need to understand the implications and risks created by these two quite different areas.
Where a hedge fund is operating as a quasi bank because it is involved in lending, leverage and credit intermediation or other forms of structured credit then the risks are similar to those for banks. These credit strategies create similar issues to those of banks – issues such as loss absorbency and ring fencing to protect different classes of shareholders from cross contamination. Banks are used to applying recovery methods in lending situations and build this into their business models and lending decisions. Hedge funds may not have the same structural support for recovery situations and an operational due diligence review needs to understand the capabilities of the fund to do this. Structural depth to handle this will be critical in reviewing operational risks of a hedge fund that is involved in credit transactions or shadow banking activity. The implications of regulatory arbitrage and regulatory action also need to be considered. These are not risks just borne by an investment manager – investors directly bear these risks through the indemnity the hedge fund gives to its investment manager. That indemnity makes it critical for an investor to understand the potential regulatory risks of the fund’s activities.
Dark pools have an important role to play when a fund does not wish to expose itself to market moves against it because the market is aware of its activities – but this opacity and anonymity creates its own problems for price discovery and transparency. These risks need to be understood. Most of the major broker dealers provide dark pool facilities but there is still much to be understood about them by investors and the risks they present. Just because a fund uses electronic trading platforms does not mean that there will be good price and volume transparency. This has implications for an operational risk review of a fund. The exposure a fund has to information leakage on its activities, price manipulation, the reputation of the provider of the dark pool it uses, any aggregators that may be used and what the risks may be from high frequency and algorithmic traders all need to be considered.
As regulators work to protect structures and create transparency – other structures spring up through regulatory arbitrage or through protective mechanisms where the transparency itself creates risks for the operation of the fund.
Dark Pools and Shadow Banking activity are just two examples of evolving fund activity that create a need to look afresh at the changing operational risks of hedge fund activity.
©Jaitly LLP