Counterparty risk now much more critical for hedge funds, says report

Date: Wednesday, January 7, 2009
Author: Hedgeweek.com

Managing counterparty risk is a much more critical component of a hedge fund's overall business operations today than it has been in previous years, according to a white paper published by Pershing, a subsidiary of Bank of New York Mellon Corporation, and Aite Group.

The study, entitled Risk and Reward: Hedge Funds Changing Views on Counterparty Relationships, focuses on the heightened importance of effectively managing counterparty risk and the integral role it plays in partnering with a prime broker. 

It also highlights best practices that have been implemented by other hedge funds to help address and mitigate counterparty risk. 

The study found that counterparty risk monitoring has become a significant part of overall business operations. One of the major drivers for heightened attention to managing counterparty risk are hedge funds' concerns about the negative impact it could ultimately have on their firms' operations should one of their key counterparties default on their obligations.

More than 50 per cent of respondents reported monitoring counterparty risk on a daily basis and nearly 85 per cent consider it an extremely important or very important business issue. A further 96 per cent of respondents also cited managing counterparty risk as the number one factor in selecting their prime broker relationships. 

Concerns about managing counterparty risk two years ago were not a primary issue for most hedge funds, as 26 per cent of the respondents considered counterparty risk important and 22 per cent viewed it as moderately important.

The report says effectively monitoring counterparty risk will continue to be a critical component of a hedge fund's business operations. The development of a standardized, well-documented approach to analyzing counterparty risk remains one of the top priorities for the hedge fund community. 

Best practices for proactively managing counterparty risk include: leveraging innovative services from prime brokers, such as a tri-party account approach; conducting consistent internal portfolio and risk assessments; formalizing business processes by outsourcing and installing in-house technology solutions such as portfolio management systems; and implementing third-party independent valuation technology solutions and service providers supplemented with in-house valuation tools.

The study found there is no silver bullet for hedge funds when attempting to actively monitor the balance sheets of important counterparties despite the growing concerns over counterparty risk management. 

Most hedge funds currently go through manual-intensive processes to keep track of counterparty relationships.

The report says the reality is that despite the industry's lack of a comprehensive technology platform to fully automate counterparty risk management, hedge funds continue to expand their presence globally and invest in more complex instruments.

'Reliable counterparty relationships will become even more critical, and continual innovation in terms of technology and services from leading service providers will be key to mitigating the hedge fund industry's exposure to counterparty risk,' it states.

Craig Messinger, managing director of Pershing Prime Services (photo), says: "Managing counterparty relationships is one of the most important business and operational issues facing hedge funds and the broader industry today. In order to help ensure continued growth and success, hedge funds of all sizes must continue to invest in and implement the proper internal controls and systematic processes to effectively monitor, manage and mitigate counterparty risk."

Sang Lee, managing partner at Aite Group, adds: "The current credit crisis has elevated the importance of counterparty risk management in the eyes of many hedge fund managers.  Creating a more systematic approach to counterparty risk management will go a long way in restoring market confidence and helping the hedge fund industry recapture its profitability."