Hedge funds step into the shadows; Financial investors replacing banks in $5tn repo markets

Last updated: October 3, 2013 5:59 pm

Hedge funds step into the shadows

By Tracy Alloway and Arash Massoudi in New York

Some of the world’s best-known hedge funds have stepped into the shoes of Wall Street banks and expanded into the $5tn “repo” market, where financial companies lend out their assets in exchange for short-term loans. The rise of non-bank players in the repo market has come as new rules make the decades-old business less attractive for banks. It marks an evolution of financial markets since the 2008 global financial crisis, which has seen the withdrawal of banks from certain markets and activities where they were once the main actors.Hedge funds including Och-Ziff and Moore Capital have begun beefing up their repo business, according to people familiar with the matter.

At the same time, broker-dealer Pierpont Securities has teamed with a California-based start-up to build a platform that directly matches borrowers with lenders in the vast repo market.

The shadow banking system, which encompasses less-regulated financial companies such as hedge funds and asset managers, has grown in size since the crisis, as banks shrink their balance sheets under more regulatory scrutiny.

“If past is prologue, when banks step away from a fundamentally attractive business, non-bank institutions will step in,” said Steven Abrahams, a strategist at Deutsche Bank. Mr Abrahams said he expected big money managers and new capital markets vehicles to also fill some of the gap left by retreating banks.

The repo market is a vital source of credit to the overall financial system, though it has also come under scrutiny for playing a big role in the recent financial crisis.

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Banks have traditionally used the market to pawn their assets in exchange for short-term loans, but they also act as intermediaries that arrange repo deals between other entities.

It is this “match book” repo business that some banks say they may be forced to shrink because of new “leverage ratio” rules that would require them to hold more capital against all of their assets on their balance sheets. That could wipe out the thin strip of profits banks currently eke out from the business, bankers say.

One hedge fund manager said that providing repo financing was “part and parcel of [a trend of] increasing participation of the buyside in traditional sell-side spaces”. Another person added that lending out assets or extending credit may be a way for funds to generate profits at a time when interest rates are still at historic lows.

Still, others expressed doubt that hedge funds would find repo financing a profitable venture. Banks have traditionally offered repo services as an add-on to other businesses that generate more fees. Hedge funds also tend to have a higher cost of funding than banks, which may make it difficult for them to compete.

Och-Ziff, Moore Capital and Pierpont declined to comment.

Some repo experts also pushed back on the notion that having less-regulated entities in the repo space would make the financial system riskier. They argue that having a variety of repo providers could help distribute risk away from banks, while electronic platforms could make it easier for regulators to keep track of the murky market.

“The concern regulators typically have is about more activity being pushed into the shadows,” said Seth Kammerman, who used to work on the secured financing desk atGoldman Sachs and is now setting up an electronic platform that will also directly match repo borrowers with repo lenders.

“A platform like this can provide them [the regulators] complete transparency on funding and collateral flows.”

Pierpont, which is headed by former JPMorgan Chase banker Mark Werner, is working with GLMX, also headed by a former JPMorgan banker, for its platform.