Are Hedge-Fund UCITS the Cure-All?

Are Hedge-Fund UCITS the Cure-All? — March 2010

3. Structuring HF Strategies as UCITS

Figure 27b: Views of quantitative restrictions (AIFs)

Limitation of borrowings to 10% involves the use of less appropriate synthetic or derivative instruments The limitation of counterparty risk to 5%, 10% for a credit institution is not a good as more sophisticated risk-management Compulsory diversification means many hedge fund strategies will be unable to comply with UCITS regulation or will be heavily distorted Collateral management is more demanding than needed

8.3%

57.3%

28.1%

6.3%

9.4%

42.7%

40.6%

7.3%

8.8%

49%

40.6%

6.3%

20.8%

41.7%

22.9%

14.6%

0

20

40

60

80

100

Not at all Somewhat

Very much so I don't know

By the same token, 80% of respondents are worried that restrictions on eligible assets will make it harder for them to set up profitable strategies; 85% of respondents from AIFs and 95% of respondents from offshore share this view (graphs not shown). In general, the views of the financial community are that UCITS restrictions may lead to changes in hedge fund strategies. These constraints, apart from distorting strategies, may involve costs: costs for derivatives, for instance, or for structuring and monitoring. Costs of the use of derivatives As UCITS will take short positions through derivatives (rather than by borrowing), the cost of shorting should increase. Whereas alternative funds face the cost of borrowing securities, UCITS will buy a product whose cost involves a margin on top of the cost of borrowing securities faced by the broker. In addition to the normal cost of using derivatives, the more hedge funds structured as UCITS there are, the more expensive shorting may become. Currently, borrowing securities is easy because hedge

funds, unlike UCITS, allow prime brokers to reuse securities as part of their collateral arrangements. The fewer funds structured in non-UCITS form, the fewer sources of securities as collateral with prime brokers. The use of derivatives will dry up the market for lodging securities as collateral with prime brokers and there will be fewer securities available to borrow or lend, thereby increasing costs. 14 The cost of borrowing securities may rise more for some securities. Current re-hypothecation agreements usually specify a maximum amount of securities held at the prime broker that can be reused (usually 120% of the amount of loans made by the prime broker to the fund), but not which security may be reused, so the prime broker is free to pick any security held by the fund to lend it to another firm at any point in time. But without this freedom to re-use any security, individual investment funds fund will need to choose the security they will lend, and certain securities may become scarcer on the securities lending market (for instance, those that may have to be sold in the short term in volatile periods). Scarcer securities will naturally become expensive to short, and in a way much more visible than in current arrangements.

14 - It is, however, difficult to estimate the impact of such an eventual crowding of hedge fund strategies into the UCITS form. A rule of thumb would require knowing the proportion of securities lent by prime brokers that are actually being reused (vs. the proportion that are being borrowed on securities lending platforms).

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An EDHEC Risk Institute Publication