Are Hedge-Fund UCITS the Cure-All?

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

3. Structuring HF Strategies as UCITS

Structuring and monitoring costs Hedge funds that wish to structure as UCITS will incur one-off costs for re-domiciling offshore funds in Europe of offshore funds and for changes in legal structure or the reorganisation of business models. In addition, they will be subject to ongoing costs for depositary services. Depositary controls are more complex in the case of alternative strategies, yet they may be made mandatory. In addition, there are also more sub-custodianship problems, which, given stricter depositary custodianship liability, mean greater capital requirements at depositaries, and the cost of this capital must be passed through to asset management firms (and to the end-investor). Overall, depositary costs should not be underestimated for hedge- fund UCITS. In some studies, the costs for hedge funds to comply with the European directive are compared with the potential reduction in diversification benefits if hedge funds are no longer accessible to institutional investors (the association of Dutch pension funds stated that 22% of the € 450bn of assets managed by Dutch pension funds are managed by non-UCITS, non-European funds). We find these comparisons misleading, because institutional investors do not need UCITS or even regulated funds to access hedge fund strategies. Alternative means such as performance swaps may be explored. Collateral management Respondents are more likely to disagree with the statement that “collateral management is more demanding than needed” than with any other statement.

It is indeed possible that the current practices of collateral management are not optimal. In addition, the responsibilities for collateral management—and how they are shared by asset management firms and their depositaries—are often unclear. In addition to the Lehman case, in which depositaries regulated in France have been held liable for the restitution of collateral of ARIA funds to a prime broker, depositaries often have valuation responsibilities in derivatives contracts, meaning that they are indirectly liable for possible counterparty risk from inadequate collateral management, since the collateral to be transferred is a direct result of the price movements of the derivatives contract. Total collateralisation may, in theory, be desirable, but because institutions face cash constraints it cannot always be achieved in today’s environment. The norm is to put up liquid assets (cash or collateral), although to keep liquidity available banks often attempt not to apply full collateralisation with their larger counterparties. The more onerous liquidity constraints affecting banks in the wake of the financial crisis (and the realisation that stricter oversight of liquidity risk and perhaps quantitative capital requirements, not stipulated in Basel II, were necessary) will not make anything easier. Here, the degree of collateralisation of derivatives contracts is seen to have a cost, the cost of the funding of the liquidity (the cost of a repo involving a temporary swap of risky assets and cash). Box 7: Towards better management of collateral

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