Hedge fund margining – what are banks offering and what do hedge funds prefer?

London - 13 August 2007

A survey conducted by InteDelta, the risk management consultancy, examines the development of banks’ approaches to margining hedge funds, the challenges banks are facing as they are forced to compete on credit terms, and hedge funds’ preferences for the way in which they are margined.

The dramatic growth in hedge funds has banks competing to build or maintain market share servicing this highly lucrative yet competitive market. Banks face the dilemma of having to compete on credit terms but at the same time ensuring that they have adequate protection against credit losses. This has been a driver for the development of sophisticated portfolio methodologies for the margining of hedge funds. For the most part, hedge funds themselves prefer to be margined on a portfolio basis because these methodologies recognise the real level of risk in their portfolios. Some funds, however, prefer to be margined on a more simplistic and transparent basis.

They key points of the survey are:

• Portfolio margining techniques which mirror banks’ credit exposure (e.g. Value at Risk, “rules based” methodologies and stress testing) are increasingly used to margin hedge funds. However, a significant proportion of transactions continue to be margined on a standalone basis with no allowance for portfolio effects;
• Banks tend to offer a “toolkit” under which different margining methodologies are applied to different products and clients;
• Most banks with hedge fund businesses continue to invest in developing their margining methodologies and expect the proportion of transactions margined on a portfolio basis to increase;
• Many banks are able to margin across products and provide portfolio benefits between offsetting transactions under different legal agreements. Other banks have initiatives working towards this goal, which many hedge funds regard as highly important;
• The expansion of hedge fund volumes, more emphasis on portfolio margining and the incorporation of more sophisticated products is presenting banks with significant challenges in developing their methodologies, processes and infrastructure.

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