If “AIFMD Depositary Liability” is prefixed with the word “Strict”, it must also be suffixed with the qualifier “for assets which are held in custody”. This umbrella could cover collateral that is potentially re-usable, but not assets that are actually being re-hypothecated – since title has by then been transferred. This potential re-use of collateral must be pre-agreed and disclosed to investors, according to articles 14, 15 and 109 of the directive. So AIFMD Depositary Liability does not remove the need for investors to get comfortable with counterparties, including depositaries, prime brokers and sub-custodians. Consequently, some investors are stipulating particular depositaries as a condition of investment, according to a panel at The ALFI European Alternative Investment Funds conference, held in Luxembourg in November. Meanwhile AIMA, whose new CEO Jack Inglis we interview on our website, has recently updated its Guide for Selecting a Prime Broker.
In some quarters there is speculation that one or more of political duress, reputational risk, negotiation, or litigation, could at some stage force depositaries to compensate investors for any losses arising from any re-used collateral (within pre-agreed limits). This seems improbable in light of the fees depositaries charge – typically single-digit basis points, whereas the cost of credit default swaps (CDS) that some hedge funds do selectively purchase on counterparties is many multiples higher. If depositaries could accommodate this risk at far lower cost than CDS sellers, they would surely go out and sweep up the CDS market. Yet we hear CDS is one of many credit markets where various regulations are reducing dealer inventory and liquidity in general, so some banks have even ceased making markets in CDS.
Of course, there are plenty of hedge funds that have no prime broker counterparty exposure. Hedge funds that are not using balance sheet leverage, or borrowing securities for the purposes of shorting, may not need a prime broker. Some hedge funds, particularly smaller ones, use exchange traded funds (ETFs) or options to obtain leveraged or short exposures, and some employ neither leverage nor shorts.
The value of shorting is questioned by some investors after an extended bull market – but 2014 underscores the benefits of an unconstrained mandate that can go long and short across all asset classes. Emerging market currency indices have made decade lows and the oil price has fallen as fast as in 2008; Russian equities have crashed while mainland China’s bounced 60% from the lows; Venezuela’s sovereign yields are above 20% while Germany’s are now negative near-term. So far it has been macro funds, managed futures and CTAs that have made most hay out of these violent divergences, but soon other strategies could be feasting on juicier merger arbitrage spreads, fatter credit spreads – and a greater supply of distressed debt.