Counterparty Risk a Growing Concern for Hedge Funds
January 7, 2009
Managing counterparty risk has become a much more critical component of hedge funds’ business operations than it was two years ago, according to a white paper from Pershing and Aite Group.
The study, issued Jan. 5, says hedge funds are increasingly worried about the potential impact of a key counterparty defaulting on its obligations. Such a default, notes the paper, can lead to reputational damage and disrupted operations, both of which can cripple a firm. Ninety-six percent of the 23 global funds surveyed by research firm Aite over the summer cited counterparty risk management as the number-one factor in selecting prime brokers. Eighty-five percent identified it as an important business issue, versus 26 percent in 2006.
“In order to help ensure continued growth and success, hedge funds of all sizes must continue to invest in and implement the proper internal controls and systematic processes to effectively monitor, manage and mitigate counterparty risk,” said Craig Messinger, managing director of Pershing Prime Services, a unit created last year by Bank of New York Mellon Corp.’s clearing subsidiary.
Sang Lee, managing partner at Boston-based Aite Group, noted in a statement that “the current credit crisis has elevated the importance of counterparty risk management in the eyes of many hedge fund managers.” Of the respondents, 50 percent said they monitor counterparty risk on a daily basis.
In an interview, Lee added that over the past 12 to 18 months, “the concept of risk management of counterparty risk has grown enormously,” as has the practice of maintaining relationships with multiple prime brokers in the wake of Lehman Brothers’ bankruptcy and the collapse of Bear Stearns. “There was the overall perception that [hedge funds] could be leveraged forever, as redemptions increased--the market seemed fundamentally changed,” said Lee. “A lot of it is perception. In financial services, perception is incredibly important.”
Despite the growing risk concerns, the study notes that there is no silver bullet to help hedge funds actively monitor the balance sheets of important counterparties. Most funds still use largely manual processes to keep track of such relationships. The paper recommends a set of best practices, including implementing third-party valuation technology; formalizing business processes by outsourcing and installing in-house solutions such as portfolio management systems; leveraging innovative services from prime brokers; and conducting consistent internal portfolio and risk assessments.
Nonetheless, Lee said he would be surprised if some type of hedge fund regulation is not forthcoming. The worst is not over for the hedge fund industry, he said, predicting that assets under management will fall by a total of 20 percent to 50 percent as a result of the financial crisis. “It is hard to pinpoint the exact amount, but assets under management and total number of funds will be down. There will be certain counterparties that are not that stable, and they will not get the business. The market has to earn back the trust of investors. It will be very tough.”
