Hedge funds and prime broker dealers: steps towards a “best practice proposal”.

Abstract

The rapidly growing hedge fund industry has brought substantial benefits to financial markets. At the same time, hedge funds can in some circumstances give rise to a number of potential risks. Not unlike in the period following the Asian crisis and the collapse of Long-Term Capital Management, governments, regulators, and central banks have been called upon to assess whether additional regulatory initiatives are required to mitigate these risks. There are three potential regulatory objectives that can be invoked. They are investor protection, market integrity protection and financial system protection. The link between hedge funds and the stability of the financial system relates to the possibility that large losses in one or several hedge funds get transmitted to one or several large internationally active banks. There are three potential regulatory objectives that can be invoked. They are investor protection, market integrity protection and financial system protection. The link between hedge funds and the stability of the financial system relates to the possibility that large losses in one or several hedge funds get transmitted to one or several large internationally active banks. • Prime broker dealers should ensure that they have a complete risk metric of each of the largest hedge funds they are exposed to. • Prime broker dealers should ensure that they invest sufficient resources in collateral risk management systems to complement their market risk management systems. • Prime broker dealers should permanently monitor variation margins, traditional initial margins and portfolio risk based or VaR-based initial margins. In addition, they should conduct rigorous periodical stress-testing. • On the basis of a wide range of stress test scenarios which are routinely updated, global margin call simulations across all exposures should be conducted between the prime broker dealers and the largest hedge funds on a regular basis. • Prime broker dealers and their most important hedge fund clients should take advantage of benign market conditions to work out clear terms to determine margin call procedures for different simulated scenarios assuming extended adverse market conditions. • The underlying liquidity profi le of hedge funds should be an important element in conducting stress tests and margin call simulations as well as in determining margin call procedures under adverse market conditions.