Hedge Funds See Counterparty Risk As Threat To Global Markets

Date: Monday, August 18, 2008
Author: FINalternatives

Hedge fund managers say that counterparty risk in credit-default swaps represents a serious threat to global financial markets and there will be another major financial services firm meltdown as a result of the ongoing crisis.

According to a new study by Greenwich Associates, nearly 60% of the 146 hedge funds, banks and long-only managers surveyed say they expect to see another major financial services firm collapse within the next six months, and another 15% think it will happen in six to 12 months.

“Only 27% of the institutions think there will not be another casualty along the lines of Bear Stearns,” says Greenwich consultant Frank Feenstra. "If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside."

Nearly 80% of the institutions participating in the survey say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. Of the institutions reporting that their banks have imposed stricter requirements, the majority says the change has not had a significant impact on their trading activities. However, more than a quarter of these institutions say the new requirements have caused them to reduce their trading activity.

Concerns about counterparty risk have caused institutions to cut back on their use of CDS. Among fixed-income survey participants that employ CDS, 62% say increased counterparty risk has caused them to limit their use.

Among all institutions participating, the most common method of managing counterparty risk (used by more than 70%) is to trade only with the most financially sound banks and broker dealers. Almost 65% of participants also say they try to limit the concentration of exposure with a single counterparty. About one-third of participants say they make use of cross-collateral arrangements and 5% say they use exchange products for hedging.

Institutions in general support efforts to reduce counterparty risk in the credit default swap market through the establishment of a centralized clearing entity. Three quarters of the institutions say they believe the establishment of such an entity would be effective in mitigating CDS counterparty risk. Hedge funds around the world and institutions of all types in Europe are among the strongest proponents of this plan, with almost 85% of each saying it would help reduce counterparty risk. Almost 60% of these institutions say they would prefer a centralized clearing platform operated by an exchange over one sponsored by banks.

“Seven out of 10 hedge funds say they would rather use a clearing entity operated by an exchange than one operated by the banks,” says Greenwich Associates consultant Tim Sangston.