While the Volcker rule hasn’t taken effect because regulators are still working out details, some banks have already closed proprietary trading desks. Hedge funds, because they aren’t subject to the rule or to capital requirements, can take on the risk, increasing potential returns.
The move of fixed-income trading strategies to hedge funds could pose a risk to the financial system, according to Fed Governor Daniel K. Tarullo. He warned in a May 3 speech that regulators haven’t adequately addressed the dependence of some banks and other financial companies on short-term, borrowed money that can dry up quickly in a crisis, which contributed to the 2008 collapses of Bear Stearns Cos. and Lehman Brothers. Cracking down on such market funding only at banks could push those businesses elsewhere, he said.
“The regulatory change should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund,” Tarullo said.
‘Regulatory Pressure’
Pine River’s $3.9 billion Fixed Income Fund posted a 35 percent return last year, the most among 15 hedge funds focused on debt-arbitrage strategies, according to HSBC Holdings Plc data. Millennium Partners has returned 3.41 percent this year through April 18, HSBC data show. BlueCrest’s $1.6 billion Multi-Strategy Credit fund gained 4.7 percent this year through April 30, a person familiar with the returns said.
The Solus Recovery Fund, which has investments in claims from the Lehman Brothers and MF Global Holdings Ltd. bankruptcies, returned 17.8 percent in the 13 months ended March 29, according to an investor letter obtained by Bloomberg News.
“As a general matter, any time you have a big financial crisis like Long-Term Capital in 1998 or the recession of 2008, fixed-income arbitrage usually gets hurt during the crisis and has very good returns afterwards,” said Anne Casscells, chief investment officer of Aetos Capital’s absolute-return strategies. “What is different between now and 1998, is that now the banks are under regulatory pressure not to return to proprietary trading or even positioning.”
Long-Term Capital
Long-Term Capital Management, one of the world’s biggest hedge funds at the time, lost more than $4 billion, mostly as a result of a highly leveraged fixed-income arbitrage strategy, after a debt default by Russia. It required a bailout by banks overseen by the Fed.
Profitability at the biggest banks has declined as regulators globally sought to fortify the financial system after the mortgage-debt crisis resulted in $2 trillion of writedowns and credit losses after June 2007. The average return on equity at Wall Street firms fell to a range of 10 percent to 13 percent in 2012, from 15 percent to 20 percent before 2008, according to a Boston Consulting Group study released April 30.