Hedge funds under pressure to manage collateral risk

Hedge funds and other asset managers are expected to boost demand for collateral management services due to imminent regulation that will raise capital reserve requirements against counterparty credit risk, according to Citi.

“With Basel III being implemented in 2013, banks are putting a lot of pressure on counterparties. The main ones are hedge funds, but asset managers and insurance companies are also under pressure to implement collateralised relationships," says Sam Ahmed, Citi's head of collateral management sales for Asia-Pacific.

New requirements under Basel III will tighten counterparty risk for collateral holders. One major area of impact will be in instances when prime brokerages lend money to hedge funds in return for collateral assets, such as over-the-counter (OTC) derivatives. Prime brokers will need to keep greater capital reserves against the collateral and, in return, require independent valuation and management of the assets from the underlying owner – in this case, hedge funds.

“We see tremendous demand over the next 12 to 15 months” for collateral management, says Ahmed, who joined Citi this month as the bank expands its regional collateral services division.

Ahmed joined from Merrill Lynch in Singapore where he managed regional collateral management and derivatives client services teams for the private banking division. He reports to Pierre Mengal, regional head of collateral services for Citi, based in Singapore.

His appointment follows the launch in May of Citi’s OpenCollateral platform in Asia, which manages OTC derivatives, ETFs and repo products on behalf of institutions. “We’ve so far mandated six clients and there’s been tremendous interest in Singapore, Hong Kong and elsewhere in the region,” says Ahmed.

The existing clients are mostly asset managers and insurance companies, says Mengal, who expects the range to broaden to include sovereign institutions, local and regional banks, and smaller broker-dealers. He notes that OTC derivatives and repo products are the most common products being managed on the platform, although the product mix is expected to diversify along with the client base.

Collateral tends to vary among different client segments, notes Ahmed. Asset managers and insurers have credit default swaps, foreign exchange forwards or interest rate swaps while broker-dealers often have “exotic” OTC derivatives.

Other banks that offer collateral management include JPMorgan, BNY Mellon and Merrill Lynch, which are also leading global custodians. Mengal believes Citi has an edge in Asia, where it offers direct custody services.

“As a collateral agent and a local custodian, if you combine those two services for your clients, it means you are in full control of your collateral," says Mengal. “You don’t have another intermediary bank in the chain.”