Regulation boomerang?

These are tough times for the financial industry. Basel III and Dodd Frank regulations are causing investors and financiers to stumble into a modern-day “Alice in Wonderland” type of continuous rabbit hole with nightmarish bureaucracy at the end rather than easy trading and lending.

This tunnel is not only winding and tortuous, but seems to lack clear direction. The complexities of these regulations are only confounded by talk of potential changes to the Dodd Frank regulations by President Donald Trump's advisers.

This financial regulation became the rallying cry after the Great Recession of 2008, spurring Dodd Frank legislation in the U.S. and the Basel I, II and III regulations covering the banking and investing business over much of the world. Basel III requires governance over regulatory capital where banks are required to meet certain solvency requirements, while assets and liabilities management (ALM) requires banks to ensure there is sufficient liquidity and quality funding sources available.

Hedge funds are seeking stability and prime brokerage providers following restrictions placed on traditional bank partners

Although the intent of the regulations is to make the financial landscape safer for all parties, there are unexpected and painful side effects. The consequences have sent hedge fund managers down unfamiliar paths, searching for stable and adequate financing and have forced prime brokers to fund investments with lower risk. Banks are also dealing with the costs of building more infrastructure in technology, compliance and legal areas.

"Basel III has had a dramatic impact on major regulated markets," said Artie DiRocco, managing director, head of Equity GSF Americas at ING. The relationship between hedge funds and other asset managers and prime brokers and banks is one area that has been fraught with anxiety, he explained.  Hedge funds constantly seek financing from not only prime brokers and banks, but are searching for alternative sources. Banks and prime brokers are now being cautious in their lending decisions due to Basel III regulations.

The liquidity coverage ratio (LCR) is the element that is aggravating this relationship. The LCR requires that banks calculate how liquid they are during a 30-day period in order to be able to deal with external and internal stress. Banks and prime brokers would need a 60% cover in case there is a catastrophic market fall. That has to be of high quality liquidity - cash or U.S. government securities. The cover will eventually rise to 100 percent. "This has led to banks hoarding good assets," said Mayra Rodriguez Valladares, managing principal of MRV Associates, LLC, a financial consulting and training organization.

According to DiRocco, hedge funds will have to look at their investment strategies closely and have more liquid portfolios. "It adds to the risk for the whole system," he said. "There is a kind of domino effect that is taking effect and in the next three years we will continue down this road."

A bank or prime broker can thrive, however, if it has big retail deposits and can figure out how to fund investments cheaply, giving advantages to big banks and contradicting the idea to give smaller banks "a more level playing field," said DiRocco. "Small banks are being forced out because they can't afford the infrastructure and the big banks just keep getting bigger."

Banks and prime brokers have to make choices on clients because there are minimum hurdle rates that have to be met. After years of prime brokers chasing hedge funds to loan them money, the hedge funds now have to do the chasing, dramatically driving up costs, explained Mr DiRocco. "It used to be that hedge funds got committed term loans and didn't pay for them. They relied on cheap stable funding,” said Artie DiRocco. “They now have to include a cost they haven't had to before, causing them to look at their books and what they are trading in."

Some hedge fund and asset managers searching for new tools have turned to synthetic prime brokers instead of physical prime brokers. Diversity is one of the key advantages to using synthetic prime brokers, said DiRocco. Before 2008, hedge funds had never thought of using synthetic product but now the investor is forcing them to diversify. The biggest advantage to synthetic prime brokerage is that it is a quick, safe way to diversify credit and a fast way to access new markets.

The future of ING’s synthetic prime brokerage will be in customized multi-asset strategy programs, so asset managers can add any type position and not just what you hold in a single swap. "When we hit that, there will be no difference between synthetic brokerage and physical prime brokerage," said DiRocco.

Both hedge funds and banks will benefit. It will be an advantage to hedge funds because of the ease of use and the fact that swaps are heavily regulated. Thus, the risk from the counterparty will be less. Banks will benefit because synthetic is far less expensive to run.

Synthetic prime brokerage will continue to increase as a percentage of the overall prime brokerage market, said DiRocco. "A lot of banks are looking at offering synthetics alongside their physical prime brokerage and they will slowly transition people into synthetic."

The popularity of synthetics stems from their lower cost infrastructure, which is critical to eclipsing hurdle rates. Investors use hurdle rates to calculate whether an investment is profitable, depending on finance costs and other factors. Higher infrastructure costs pressure hedge fund managers because they increase capital spending to banks and to the funds. That raises lending fees and makes it more difficult to exceed a hurdle rate.

And although banks may not be happy they were forced to pour so much money into a financial compliance program that may be rescinded, it is too early to ascertain what the Trump Administration will do. "It's not so easy to eliminate Dodd Frank," said Mayra Valladares. Some tentative Republican proposals such as last summer's Financial Choice Act wouldn't necessarily be lighter than Basel III.

Valladares emphasized that under the Financial Choice Act proposals, a bank with a leverage ratio of 10% would be able to avoid some of the more stringent requirements of Dodd Frank. She said the Basel III recommendation for leverage ratio is 3% in the U.S., 5% at the bank holding level and 6% at the bank entity point. There may even be light at the end of the tunnel. "Banks might find a new love for Basel III," said Ms Valladares, emphasizing that the Republican proposal may be have financial benefits. "If a bank is better capitalized, it is good for the economy."