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Hedge Funds, Highly Leveraged Investment Strategiesand Financial Markets*

I. Introduction

This note provides general background information on current market prac-tices of hedge funds and other highly leveraged institutions, their creditors andother counterparties and discusses the impact their activities may have on thefunctioning of financial markets. In relation to other sectors of OECD financial mar-kets (banks, pension funds, mutual funds, life insurance companies, etc.), mosthedge funds are small, measured at least in terms of their capital bases. In fact,most are quite small compared with other types of managed funds, includingmutual funds, pension plans, and trust accounts. However, some hedge funds arefairly large and are willing to establish and maintain large positions (often magni-fied via leverage) on one side of a market, and, therefore, can have importanteffects on market dynamics. The central public policy concern follows from theconsideration that some hedge funds, like other highly leveraged financial institu-tions, have the potential to disrupt the functioning of financial markets, raisingissues concerning systemic risk and/or market integrity. The key to the under-standing of the impact of hedge funds on the functioning of financial markets is ananalysis of their trading practices. Many hedge funds attempt to exploit temporaryvaluation differences between similar types of securities. Bond and equity arbi-trage strategies and currency trades may be employed, and these trading strate-gies may or may not involve leveraging and other higher risk investmenttechniques. Still, not all hedge funds engage in all of these activities; those that domight not do so all the time; and other financial institutions (e.g. investment banksand commercial banks) engage in many of the same activities and sometimesemulate hedge fund trading strategies.

* This article has been prepared by Senior Economist Stephen Lumpkin and Head of DivisionHans J. Blommestein, Financial Affairs Division.

Financial Market Trends, No. 73, June 1999

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II. Nature of hedge fund activities: general business practicesand other characteristics

Analysts credit Alfred Winslow Jones with the founding of the first hedge fundin 1949. Jones sought to shield his portfolio’s return from market volatility by bal-ancing his long and short positions through careful selection of a so-called“market-neutral” basket of stocks. The strategy was designed “to generateabove-average returns without taking on more risk than was embedded in the mar-ket, or achieve market returns while actually reducing risk”. Most of the earlyhedge funds were similar vehicles, but today’s hedge funds are a far more eclecticgroup and there is no formal consensus definition of a “hedge fund”. Some partici-pants contend that for a financial entity to be considered a hedge fund it mustengage in one or more of the following activities: invest in multiple asset classes,use leverage, or employ dynamic hedging techniques. A very broad definitionencompasses any pooled investment vehicle that is privately organised (com-monly as limited partnerships or limited liability companies), administered byprofessional investment managers compensated on the basis of performance, andpredominantly targeting wealthy individuals and institutional investors such asinsurance companies and pension funds.1 Others argue for a stricter definition,suggesting that a “true” hedge fund has at least 25 per cent of its portfolio held in ahedged structure at all times. Other definitions exist as well, but none has gaineduniversal appeal and, for want of a common definition, the term has been appliedto many types of entities with widely differing investment operations and strate-gies. Hence, the term “hedge fund” in this note will be used to refer to a broadrange of entities employing a wide variety of investment styles.2

A. Number and size of hedge funds

Owing in part to the lack of a consensus view of what constitutes a hedge fund,coupled with the fact that many hedge funds have adopted a low profile, the exactnumber of hedge funds in existence is not known with certainty. Most estimatesrange upward from around 2 500 or so funds. At the high-end of published figures areestimates by one United States-based hedge fund consulting group, which placedthe number of funds operating worldwide at 5 500 as of mid-year 1998, with justunder $300 billion in assets under management (see Table 1). Most hedge funds aresmall, with less than $100 million in invested capital. A few dozen hedge funds havea capital base larger than $1 billion, with a handful holding capital in the range of$5-12 billion.3 About 3 800 of these funds were reported as being based in theUnited States. However, estimates regarding the number of independent funds inexistence are clouded somewhat by the fact that many of the largest of these fundsestablish parallel operations in offshore locations to accommodate foreign investorswho are precluded from investing in hedge funds in their domestic markets.

Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets

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Within the global hedge fund universe are funds that are active across a widevariety of markets, products and currencies, but there are others that tend to spe-cialise in specific market categories or instruments. As noted in the introduction,any given hedge fund might not engage in all the activities attributed to the hedgefund universe, and other financial institutions also pursue many of the same strat-egies. In fact, in terms of their market activities, most hedge funds are not funda-mentally different from other sophisticated financial institutions, such asinternationally active commercial banks or proprietary trading desks of investmentbanks. There are, however, important differences between hedge funds and otherfinancial institutions, associated mainly with the fact that the latter tend to be reg-ulated while hedge funds are subject to minimal regulatory oversight. Hedgefunds are often resident off-shore for tax and regulatory purposes. Their legal sta-tus and investment mandate place few restrictions on their portfolios and tradingpractices.

This is perhaps most clearly evident in a comparison of hedge funds withother investment vehicles such as mutual funds, which serve a similar function,albeit for a different investor clientele. Take, for example, the case of the UnitedStates, where most hedge funds are based. Generally speaking, hedge funds areunregistered, private investment partnerships/pools bound for the most part onlyby an investment contract investors sign with the sponsors of the fund. Most hedgefunds are structured in such a way as to minimise regulatory and tax impedimentsto their chosen operating strategy.4 Thus, with the exception of antifraud stan-dards, hedge funds in the United States are exempt from direct regulation by theSecurities and Exchange Commission under the federal securities laws.5 Accord-ingly, unlike mutual funds, which are subject to strict regulations concerning theextent to which they may invest in certain types of securities, hedge fund manag-ers face no restrictions on the composition of their portfolios. Indeed, underUnited States federal law, hedge fund sponsors generally are free from any limi-tations on their management of the fund, and are not required to disclose

Table 1. Hedge Funds:Number of Funds and Assets under Management 1988-97

Global Hedge Fund Universe

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Number of Funds 1 373 1 648 1 977 2 373 2 848 3 417 4 100 4 700 5 100 5 500Assets under management ($ billions)

$42 $58 $67 $94 $120 $172 $189 $217 $261 $295

Source: Van Hedge Fund Advisors.


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information about the fund’s holdings and performance, apart from what theyagree to provide to investors.6

Another distinguishing feature of hedge funds is that hedge fund managersfrequently have a stake in the funds they manage. This is again in contrast tomutual funds, where managers hold no stakes in the funds they manage.

B. Fee structure and investment behaviour

A major difference between hedge funds and mutual funds are the feescharged to investors. In the United States, mutual fund sales charges and otherdistribution fees are subject to regulatory limits under rules promulgated by theNational Association of Securities Dealers and also federal law, which imposes afiduciary duty on a mutual fund’s investment adviser regarding the compensationit receives from the fund. In contrast, there are no legal limits on the fees a hedgefund can charge its investors. Typically, hedge fund managers take a fee of 1 or2 per cent of net assets, plus around 20 per cent of the fund’s annual return. Somehave up-front sales charges as well. Most contracts also include a “lock-up” periodduring which investors cannot withdraw their money. Additional allocations orsales fees also might be charged. Usually a “high-water mark” provision is in placethat denies the manager his incentive fee until any previous losses have beenrecovered.

Both of these distinguishing characteristics have important implications forthe investment behaviour of the management of hedge funds in the form of invest-ment style, return targets and risk profile. Since hedge fund managers get paid onthe basis of the absolute size of realised earnings, they tend to pursue short-terminvestment strategies focused on achieving the highest absolute returns, given theadopted risk profile. In contrast, the money managers of mutual funds and otherinstitutional saving institutions tend to use relative performance measures basedon benchmarks that reflect industry averages.

C. Investment strategies

As noted previously, the managing partner of a hedge fund is given a broadinvestment mandate in order to achieve the fund’s absolute return target. Consis-tent with this objective, hedge fund managers are given the flexibility to chooseamong a variety of asset classes and to employ dynamic trading strategies thatmay involve short sales, leverage, and derivatives.7 Although hedge funds as agroup often use leverage aggressively, analysts familiar with the hedge fund sectorsuggest that most hedge funds use derivatives only for hedging or do not usederivatives at all, and many hedge funds use little or no leverage.


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Table 2. Selected Hedge Fund Styles

Hedge Fund Style

Sub-Category Description

Global International Manager focuses on economic developments in non-U.S. countries, investingin stocks in markets believed to be favourable.

Established Manager focuses on opportunities in established markets such as Europe and Japan.

Emerging Manager invests in less mature financial markets. Because shorting is not permitted in many emerging markets, managers must go to cash or other markets when valuations make being long unattractive. Focus on specific regions.

Global Macro Opportunistic; manager invests wherever he finds value. Use leverageand derivatives to enhance positions, which will have varying time frames ranging from short (under 1 month) to long (more than 12 months).

Event-Driven Investment theme is dominated by events that are seen as special situationsor opportunities to capitalise from price fluctuations.

Distressed Securities

Manager focuses on securities of companies in reorganisation and/or bankruptcy, ranging from senior secured debt (low-risk) to common stock (high risk).

Risk Arbitrage Manager simultaneously buys stock in a company being acquired and sells stock in its acquirers. If the take-over falls through, traders can be left with large losses.

Fund of Funds Capital is allocated among groups of funds.

Diversified Manager allocates capital to a variety of fund types.

Niche Manager allocates capital to a specific type of fund

Market Neutral Manager attempts to lock out or neutralise market risk. In theory, market riskis greatly reduced, but it is difficult to make a profit on a large, diversified portfolio, so stock picking is critical.

Long/Short Net exposure to market risk is believed to be reduced by having equal allocations on the long and short sides of the market.

Arbitrage-Convertible

One of the more conservative styles. Manager takes long position in convertible securities and shorts underlying equities, profiting from mispricingin the relationship between the two.

Opportunistic Arbitrage-Fixed income

Manager buys bonds – often Treasury bonds, but also sovereign and corporate bonds – and shorts other securities that replicate the owned bond; manager aims to profit from mis-pricing of the relationship between the long and short sides.

Sector Manager follows specific economic sectors.

Industry Manager follows specific industry; managers can use a wide rangeof methodologies (e.g. bottom-up, top-down, discretionary, technical)and primary focus (e.g. large-cap, mid-cap, small-cap, micro-cap, value growth, opportunistic).

Short Sellers Manager takes a position that stock prices will fall. A hedge fund borrows stock and sells it, hoping to buy it back at a lower price. Manager shorts only overvalued securities. A hedge for long-only portfolios and those who feel market is approaching a bearish trend.

Long-only Leveraged

Traditional equity fund structured like a hedge fund; i.e. uses leverageand permits manager to collect an incentive fee.

Source: Managed Account Reports, Inc.


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Hedge fund strategies or styles generally tend to be descriptive of the marketor markets in which the manager is active.8 Investment styles vary in terms ofselectivity – the ability to select overvalued (if short) or undervalued securities –and market timing, which refers to the fund manager’s ability to predict markettrends and reversals. The categories listed in Table 2 are generic classificationsand a manager of a given hedge fund might not always conform to any set strategyamong them. Hedge fund managers tend to vary their strategies over time andthus, under certain market conditions, the distinction between, for example,market-neutral hedge funds and investment pools that take leveraged, directionalbets can blur. Furthermore, there are a variety of mixed or hybrid investment strat-egies in use, characterised by a combination of various, specific, pre-determinedstrategies in order to provide a diversified approach. There are also funds offunds, which are akin to portfolios of hedge funds in the sense that funds investedin them can flow into a number of different types of hedge funds. Thus, the list ofhedge fund strategies is representative of the hedge fund universe but is notexhaustive. Moreover individual hedge funds may employ different investmentstrategies.

Hedge funds change investments frequently, so as to benefit from changes inmarket prices and/or to maintain the preferred risk profile. Active trading and theassociated short-term investment horizon are features that hedge funds have incommon with the proprietary trading desks of financial institutions and the trea-suries of large non-financial companies.

D. Performance

The empirical evidence regarding hedge fund performance tends to bemixed, depending on the hedge fund segment. Moreover, performance isaffected by the choice of time period. Data for the United States show that in theperiod 1991-1998, the global macro funds outperformed the S&P500 but theyalso took on greater risks; the market neutral funds and funds of fundsunder-performed the S&P500 but with lower risk levels; the other hedge fundsegments performed poorly relative to the S&P500 and did so with higher volatil-ity. For all hedge fund segments risk was lower than all other benchmarks exceptthe bond benchmark, and returns higher (except for funds of funds) than all theother benchmarks.9

In the period 1994-1997 global funds performed better than the S&P500 albeitwith higher risk levels. In contrast, the market neutral funds and other funds had alower performance relative to the S&P500 but the average volatilities of theseclasses of funds were lower than the S&P500.10


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A few empirical studies have shown that – unlike mutual fund returns, whichhave high and positive correlation with the returns on broad asset classes (consis-tent with a buy-and-hold strategy) – hedge fund returns have low and sometimesnegative correlation with asset class returns, presumably reflecting the use of arbi-trage and hedging strategies.11 There is evidence that the inclusion of hedge fundsin the portfolios of investors increases expected portfolio returns, without anincrease in risk.12 This result can be explained by the low correlations between thereturn on hedge funds and major benchmarks (see Table 3). However, the extentto which hedge funds’ returns are uncorrelated with measures of broad marketperformance varies across funds and over time, depending on the investmentstrategy. Another attractive performance feature is that hedge funds tend to out-perform the market during periods of poor market returns.13

Although a few hedge funds have generated above-average returns for nearlya decade, an investment in the hedge fund sector does not guarantee yieldenhancement, or even success. Indeed, available data indicate that about one infive hedge funds goes bust in its first seven years, which is roughly the same sur-vival rate as for other investment funds.

One development that has some bearing on the ability of hedge fund manag-ers to generate outsized returns is the fact that markets are becoming more effi-cient, owing in some cases to the activities of the funds themselves. In manymarkets, especially the most liquid markets, many pricing anomalies are now rem-edied rather quickly, so arbitrage opportunities are harder to come by. This devel-opment has particular implications for market-neutral funds. Increased marketefficiency suggests that, without leveraging, a true market-neutral manager willearn the riskless rate of return, more or less. In theory, market-neutral funds do not

Table 3. Correlations between Hedge Funds and Major Benchmarks

Averagehedgefund

S&P500Russell

2000MSCIEAFE

MSCI Emerging Markets

Index

LehmanUS Bond

Index

Average Hedge Fund 1.00 0.29 0.13 0.03 –0.08 –0.01S&P500 0.29 1.00 0.24 0.54 0.59 0.06Russell 2000 0.13 0.24 1.00 0.21 0.36 0.21MSCI EAFE 0.03 0.54 0.21 1.00 0.47 0.11MSCI Emerging Markets Index –0.08 0.59 0.36 0.47 1.00 0.09Lehman US Bond Index –0.01 0.06 0.21 0.11 0.09 1.00

Source: Warburg Dillon Read, “The Reality of Hedge Funds”, 30th October, 1998.


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engage in directional trades, but in practice, many do. As markets become moreefficient, market-neutral managers may be forced to make more directional bets inorder to increase their absolute returns.

III. Characteristics of hedge fund investors, investment services and financial instruments

A. Investors

As noted previously, one of the means by which hedge funds avoid regulationas investment companies is by limiting the number and type of investors theyaccept. Generally, the restrictions take the form of minimum net worth require-ments, which satisfy legal limits intended to restrict participation in hedge fundsand other types of unregulated pools to highly sophisticated investors.14 Typically,a minimum net worth of $1 million is required for each individual investor, butsome funds admit investors with lower net worth, provided the investors havetotal investment portfolios above some statutory minimum. In the United States,for example, the National Securities Markets Improvement Act of 1996 enableshedge funds to accept investments from individuals with total investment hold-ings of at least $5 million, regardless of their net worth, although limits still applyregarding the total number of investors permitted.

While hedge funds have historically been targeted to sophisticated individualinvestors (80 per cent of hedge fund assets according to some estimates), in recentyears a variety of institutional investors have begun to invest in these entities. Inthe United States, for instance, institutional investors are said to have accountedfor nearly 30 per cent of new money flowing into hedge funds in the past few years.University foundations and endowments are reported to be among the moreaggressive institutional investors. In 1997, eighty-seven college and universityendowments are reported to have invested in hedge funds, up from seventy-fourin 1996. In addition to endowments, pension funds are also starting to allocatecapital to hedge funds, with both private pension schemes and their public sectorcounterparts getting involved. A few of these institutional investors have pursuedfairly aggressive strategies, but most have opted for a broadly diversified hedgefund portfolio, and have allocated only a small fraction of their total investmentcapital to the hedge fund sector.

Analysts state that conventional institutional investors, such as pension funds,insurance companies, foundations, etc., are accustomed to investments that trackbroad market benchmarks, such as stock or bond indices. Most hedge funds, how-ever, pursue absolute return targets, and thus, tend to eschew benchmarks. Thisfact has not proved to be a major stumbling block as institutional investors appear


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to be increasing their hedge fund investments. Trade reports suggest that institu-tional investors tend to invest with a small number of well-known hedge funds. Forinstance, thirteen of the eighty-seven university endowments that made alloca-tions to hedge funds in 1997 were reported to have invested in Tiger Management;nine others chose Dawson-Sandberg Capital Management. Market-neutral funds,which are considered to be less volatile than the global macro funds and are thusseen as a more conservative way to diversify, have also benefited from the inflowof institutional money.

Given the increasing attractiveness of the hedge fund concept to institutionalinvestors, traditional managers of institutional money have begun to add hedgefunds to their product lines. A growing number of banks and investment banks arenow either running in-house funds or managing funds of funds with linkages tohedge funds. Moreover, a large number of traders and analysts have departedfrom traditional investment houses and asset-management firms to start their ownhedge funds. Some of these fund managers have also developed investmentproducts that are targeted to institutional investors.

Due diligence, transparency and disclosure

Institutional investors have clearly been attracted to the higher returns that afew hedge funds have generated. As the experience of the past year indicates,however, these higher returns do not come completely free of risk, and it is impor-tant for hedge fund investors to take extra steps to reduce the chance that theirinvestment becomes overly exposed to market outcomes. Pension fund trusteesand other fiduciaries are legally required to exercise a certain amount of care inexecuting investments on behalf of their institutional investor clients. Hedge fundsgenerally require more due diligence than most investment funds, and this is par-ticularly true of hedge funds run by managers using dynamic trading strategies.Investors in such funds should make sure they have adequate information to makeprudent decisions on an ongoing basis. This calls for greater efforts in due dili-gence up-front and proper risk monitoring on a case-by-case basis.

Monitoring, in turn, requires transparency and disclosure. The degree of trans-parency and disclosure that institutional investors are accustomed to is perhapsantithetical to the nature of hedge funds, especially those funds that invest inilliquid markets. In reality, hedge funds are subject to less strict disclosurerequirements than many other financial institutions.15 Hedge fund managers with amore conservative investment approach may be more willing to keep investorsapprised of their fund’s performance and risk, but even these managers areunlikely to provide daily reports, and it is unclear how much information value iscontained in less frequent updates, or more generally in balance-sheet reports. As


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noted above, many hedge funds are engaged in active trading practices in whichinvestment positions and related risk profiles are frequently changed. These con-siderations make the transparency and disclosure of hedge fund behaviour anon-trivial policy issue.

The issue of transparency and disclosure has been addressed in some detailby the Basle Committee on Banking Supervision, which looked into the interac-tions between banks and highly leveraged institutions in the aftermath of thewell-publicised, near-collapse of United States-based hedge fund Long Term Cap-ital Management (LTCM). In so doing, the Committee identified a number of weak-nesses in banks’ credit risk management. The Committee’s findings are discussedin detail in a later article in this publication. The main points are: 1) Banksreceived insufficient data from their counterparties, and often based credit deci-sions on qualitative information; 2) the information that was received was notreflective of the entities banks were lending to; and 3) competitive pressuresacted to limit the degree to which banks required more complete disclosure fromtheir hedge fund counterparties. After reviewing the findings of its investigation,the Committee issued a set of “sound practices” for banks to follow in managingtheir risk exposures. These guidelines included: 1) banks should establish clearpolicies and procedures for interactions with hedge funds; 2) banks shoulddevelop more accurate measures of their credit exposures resulting from tradingand derivatives transactions with highly leveraged institutions; such measuresneed to be more forward-looking and not merely reflect current market prices;3) there should be meaningful overall credit limits for highly leveraged institu-tions; 4) banks must develop appropriate credit enhancement tools that are linkedto the specific characteristics of highly leveraged institutions; and 5) credit expo-sures need to be monitored on an ongoing basis, taking into account the tradingactivities, risk concentration, leverage and risk management processes of thecounterparties.

The Basle Committee’s recommendations were intended for use by bankswith respect to hedge fund clients and other highly leveraged counterparties, butthey are applicable to investors and other entities as well. As to the type andquantity of information that is needed by investors/counterparties to reach a com-fort level with hedge funds, it depends on the nature of the funds’ investmentstrategies. For example, information that is historical in nature would not be veryhelpful for understanding what is happening with active traders. It should be notedthat the desire for information by hedge funds’ counterparties and providers ofcredit facilities is balanced against the desire of fund managers to protect tradesecrets and proprietary information. Most fund managers, especially thoseemploying dynamic trading strategies, would presumably be unwilling to discloseactual underlying positions. In practice, the level of information disclosure has


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tended to ebb and flow, depending in part on market sentiment and the relatedbalance-of-power between hedge fund managers on the one hand, and investorsand creditors on the other. During times of heightened market volatility and gen-eral credit restraint, the volume of information provided to creditors and othercounterparties has tended to increase, but the provision of information typicallysubsides as lenders relax and become more flexible.

B. Investment services and financial instruments

Some of the same features of hedge funds that have resulted in attractivereturns for investors – participation in many asset classes, flexibility in use ofleverage and short sales, and use of dynamic trading strategies – have also madehedge funds attractive clients for major banks and investment banks.16 In fact,hedge funds have become an integral component of the new financial landscapeand are considered by most observers to be a permanent feature.

Depending on the investment style, hedge funds can be in and out of themarkets in which they operate on a regular basis and, thus, have become a majorsource of liquidity, surpassing traditional investment funds in their transactionflow.17 The global-macro funds, in particular, tend to trade enormous volumes inorder to maintain returns, and in so doing, are a key source of commission busi-ness for bankers.18 Given their often-innovative trading strategies, hedge funds arealso outlets for complex, structured securities, and are important sources of pricinginformation. When properly positioned, bankers are sometimes, in principle, ableto fully emulate hedge fund trading strategies, but the information gleaned from atrade with a hedge fund is often limited to knowing only the direction (long/short)in which the market is heading.

Two distinct types of service are provided to hedge funds: prime brokerageand niche services. Prime brokerage services include custody, clearance, securitieslending, financing, portfolio accounting, investment banking, trading, etc. Theprime brokerage providers, typically only the very largest investment banks, mayprovide office space and access to technology (telecommunications and comput-ers) as well for their hedge fund customers, especially for start-up funds. Nicheservices include the provision of specific financial products such as equity deriva-tives. These services are usually provided by so-called second-tier firms, whichlack sufficient capital to provide prime brokerage services. In addition to theseproviders, a few commercial banks that are not in the prime brokerage business forregulatory or other reasons provide foreign exchange services, including swapsand other foreign exchange derivatives. In fact, because some hedge funds oftentransact in enormous size, there are specialist derivatives desks dedicated solelyto hedge fund clients.


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Many hedge funds have investment strategies based on highly structuredtrades and a strict timing of cash flows; they require credit that is flexible andattuned to those needs. The result has been the requirement for counterparties toprice and offer increasingly sophisticated and novel derivatives products.19 Creditderivative transactions are unfunded; there is no exchange of principal or of under-lying securities. Unfunded transactions are by definition leveraged, which partlyaccounts for their attractiveness to certain hedge fund buyers.20 Another advan-tage of credit derivatives is that they are often structured with maturities that differfrom those of the underlying asset, which results in synthetic investments that donot exist in the cash market. Finally, credit derivatives enable institutions withhigh borrowing costs to acquire certain assets (e.g. high-quality corporate bondspriced at narrow spreads to LIBOR) they might not normally be able to purchaseoutright in the cash market without incurring negative carry.

As a group, hedge funds are among the bigger buyers of total-return swaps,which are often used to create a long exposure to a specific asset class.21 Hedgefunds are also active users of other credit derivatives, including credit spread con-tracts, credit default swaps, and credit-linked notes.22 By taking on exposures incredit derivatives markets, hedge funds facilitate the hedging activities of othermarket participants, particularly banks and investment banks. Banks, for instance,use default swaps and total-return swaps to lay off selected exposures for capitalconsiderations, using the freed up capital to invest in assets that better meet theinstitutions’ return criteria.23 Investment banks also use derivatives to managetheir portfolios. The willingness of hedge funds to take the other sides of thesetrades provides liquidity to the other market participants. Hedge funds have alsobeen a major source of profits for the core service providers.

IV. Leveraging practices by hedge funds and other highly leveragedinstitutions

A. Degree of leverage

Most hedge funds use derivatives as sources of both liquidity and leverage.For the large, global-macro funds, whose sheer size makes liquidity of paramountimportance, their use of derivatives in some markets is focused primarily onliquidity rather than on leverage per se. However, for other hedge fund strategiesuse of leverage is a mainstay, with the degree of leverage a function of the man-ager’s appetite for risk, the riskiness of the bets involved, and the “costs” of lever-aging. LTCM is perhaps a polar case in the sense that it was said to have combineda number of presumably low-risk strategies with enormous amounts of leverage.Few, if any, hedge funds are leveraged to the same extent as LTCM, but many do


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use some degree of leverage. In fact, the degree to which fund managers use lever-age is one of the basic features that distinguish the various hedge fund investmentstrategies.

One hedge fund advisor group estimates that more than half of all fundsworldwide use only moderate amounts of leverage, defined as balance-sheetleverage ratios of less than 2-to-1 on average, and roughly a third use no leverageat all. Around 16 per cent of hedge funds have leverage ratios greater than 2-to-1;of these funds, a very few are leveraged greater than 10-to-1 (see Table 4).

Usually, a hedge fund varies its leverage in accordance with the riskiness ofthe investment. For a given level of risk preference, leverage tends to be higher forrelatively safer investments. Use of leverage by hedge funds also tends to varyaccording to market liquidity. Hedge funds based or operating in the United Statesand Europe tend to make greater use of leverage than most Asian hedge funds,whose leverage ratios are at the low end of the range – between 1-to-1 and 2-to-1.This has been attributed to the greater liquidity in the former markets, which sup-ports higher amounts of leverage and enables funds based in those regions tohedge more effectively.

In the wake of the LTCM rescue, hedge fund proponents were quick to pointout that the hedge fund sector is far less leveraged, on average, than other parts of

Table 4. Global Hedge Funds – Use of Leverage as of December 1997

In per cent

Hedge Fund StyleDon’t UseLeverage

Use Leverage

Low (< 2:1) High (≥ 2:1) Total

Aggressive Growth 35.0 58.4 6.6 65.0Distressed Securities 61.0 35.6 3.4 39.0Emerging Markets 36.1 56.6 7.3 63.9Fund of Funds 21.6 58.4 20.0 78.4Income 35.4 51.2 13.4 64.6Macro 16.9 52.3 30.8 83.1Market Neutral-Arbitrage 18.2 22.7 59.1 81.8Market Neutral-Securities Hedging 31.5 42.5 26.0 68.5Market Timing 32.1 35.8 32.1 67.9Opportunistic 24.4 56.0 19.7 75.6Several Strategies 45.1 52.9 2.0 54.9Short Selling 22.2 75.0 2.8 77.8Special Situations 19.9 73.0 7.1 80.1Value 35.7 61.0 3.3 64.3Total Sample 30.1 54.3 15.6 69.9

Source: Van Hedge Fund Advisors.


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the financial services sector. For example, trading arms of internationally activecommercial banks and proprietary desks of investment banks have netassets-to-equity rat ios around 20-to-1; the gross ratios are far higher(see Table 5). These institutions also tend to make much greater use of deriva-tives to leverage their bets than the typical hedge fund. It should be noted, how-ever, that this particular measure of leverage is not very refined, as it ignores thenature of underlying securities. From a credit risk perspective, there is a big differ-ence, for example, between a leveraged position in United States Treasuries and acomparably leveraged position in emerging market issues. Thus, if one wereconcerned about the riskiness of leveraged positions, one would have to look at amore sophisticated measure of risk than balance-sheet leverage. One alternativeis an estimate of potential gains and losses for a given portfolio, scaled by networth with adjustments for obvious shortcomings in traditional statistical mea-sures (e.g. ratio of adjusted value-at-risk to net worth).

B. Securities lending arrangements

Repurchase agreements and swaps

Financial institutions use a number of techniques to achieve leverage, includ-ing the use of repurchase agreements (repos) and swaps, options, futures andother structured products.24 Of these instruments, repos are perhaps the biggestsource of secured funding, but derivatives contracts are also used extensively toboost leverage.

A standard, fixed-income repo involves the acquisition of immediately avail-able funds through the sale of securities, with a simultaneous commitment torepurchase the same (or equivalent) securities at a certain future date (typically

Table 5. Leverage Ratios for Selected Investment Banks

FirmAssets

(billions)Equity

(billions)

Leverage Ratios

Gross Net1

Merrill Lynch $365.45 $11.47 31.9 18.9Morgan Stanley Dean Witter2 359.58 10.66 33.7 14.8Lehman Brothers 179.07 5.08 35.2 19.8Donaldson, Lufkin & Jenrette 79.56 2.74 29.0 12.3Paine Webber Group 63.97 2.56 25.0 10.0

Note: Leverage ratio calculated at mid-year 1998.6. Excluding “matched-book” financing.7. Excludes credit-services operations.Source: Salomon Smith Barney


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within one year, often the next day or the next month) at an agreed upon rate.25 Areverse repo is the mirror image transaction, involving the acquisition of securitieswith a simultaneous commitment to resell.26 Each party to a repo has the oppositeperspective: a given transaction is a repo when viewed from the perspective of theparty acquiring funds (the supplier of the securities) and a reverse repo whenviewed from the point of view of the supplier of funds (the acquirer of the securi-ties). In most repo agreements, the purchaser of the securities acquires title for theterm of the agreement and thus may sell the securities outright, or may deliverthem to another party to fulfil a delivery commitment on a forward or futures con-tract, a short sale, or a maturing reverse repo. This flexibility enables repos to beused to achieve a variety of investment and financing purposes. For instance,financial institutions use repos and reverse repos to finance the securities held intheir trading and investment accounts, but also use them to establish short posi-tions, implement arbitrage activities, and acquire specific securities for their ownpurposes or to meet specific customer needs.

Valuation of collateral: haircuts/margins

Ideally, the securities used as collateral in repo transactions are valued at cur-rent market price plus any accrued interest calculated to the maturity date of theagreement less a “haircut” or margin for term contracts. That is, the provider ofcash in the agreement usually receives a haircut, in which the mark-to-marketvalue of the securities put up as collateral is above the cash equivalent value ofthe funds provided. In principle, at least, the size of the haircut should be suffi-cient to guard against the potential loss from an adverse price movement duringthe term on the contract. The same is true of initial collateral levels in derivativestransactions, which also are meant to provide a cushion against downturns. In gen-eral, the greater the price variability of the underlying securities, the higher therequired haircut.

In addition to the initial haircuts or margins, the collateral value of the under-lying securities is typically adjusted daily (marked to market) in term agreementsto reflect changes in market prices and to maintain the agreed upon margin level.If the amount of initial margin provided falls below some required maintenancelevel, the borrower in the contract may receive a margin call requesting that addi-tional funds (variation margin) be provided in a very short period of time.

In practice, the sizes of haircuts in repos and initial collateral levels in deriva-tives contracts vary depending on the term of the contract, the type of securitiesinvolved, the nature of the counterparty, etc., and are sometimes dispensed withaltogether. In Europe, for example, standard practice has been to disregard theuse of haircuts in repo transactions. In contrast, haircuts typically have been


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commonplace in the United States, although the sizes have tended to vary overtime. Prior to LTCM’s implosion, there were no haircuts on US Treasury securities;mortgage-backed securities received haircuts of 3 per cent; high-yield bond dealsgot 7.5 per cent haircuts; dollar-denominated emerging market debt transactionsneeded just 10 per cent, and local currency emerging market debt required only afew percentage points more. Depending on the size of the haircut, traders couldeasily establish a $1 billion position in a given security with only $10 million incapital. All that was required for a trader to leverage up to the desired size wouldbe an initial purchase of the desired security, which was then used as collateralagainst a cash loan in a repo transaction; the cash obtained through the repoagreement would then be used to buy another lot of securities, and so forth.

Repo haircuts in many instances were either low or non-existent. A dealerfinancing a hedge fund client’s position might simply have requested a dailymargining on the fund’s net exposures across all products that required somemargin, rather than apply traditional haircuts.27 Collateral requirements on deriv-atives were sometimes even more relaxed than those on repos. For example,often little or no initial collateral was required on interest rate and total-returnswaps. Further, industry experts suggest that dealers were not only sometimeslax in demanding margin, but also in collecting it.28 According to some reports, afew major dealers and their biggest hedge fund counterparties at times let dayspass before variation margins were settled, leaving one or the other partyexposed to substantial daily settlement risks, depending on the direction ofprice or interest rate movements.

In the initial phase of adjustment after LTCM’s near collapse, many partici-pants tightened their credit standards and haircuts on repos were increased: coun-terparties demanded up to 0.5 per cent on United States Treasuries and federalagency securities, 7 per cent on mortgages, 14 per cent to 15 per cent onhigh-yield bonds, 20 per cent on dollar-denominated emerging market deals, andup to 22 per cent on local currency emerging market debt. In addition, initial col-lateral requirements on swaps rose to the 10 per cent to 15 per cent range. The risein credit pricing induced a considerable degree of de-leveraging on the part ofmany relative value funds and likely contributed to some temporary reduction inmarket liquidity. Subsequently, however, as market conditions stabilised, haircutlevels and initial margin requirements at most service providers began to reverttowards their pre-crisis levels.

Outright securities lending arrangements

In addition to temporary transfers of securities through repo transactions, awide variety of securities are borrowed and lent outright. United States pension


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funds followed by mutual funds and other institutional owners of securities are themain suppliers of securities in these transactions. Most of the demand comes fromhedge funds, which need to borrow securities to implement arbitrage strategiesand to cover short positions. Acting as intermediaries between the two groups arethe so-called lending agents, traditionally the big United States custody banks,but major investment banks and European institutions have begun to establishsecurities lending operations as well.

Lending agreements run the gamut from straightforward overnight transac-tions in government securities to more complex term arrangements involving spe-cific corporate instruments, including (increasingly) equities.29 Securities lendingagreements are a close economic equivalent to standard repos. The difference isfairly subtle: a repo is a sale of securities with a concomitant agreement to repur-chase at a later date, while a lending agreement is a loan of securities with anagreement to reacquire them at a later date.30 The lending institution in a typicalborrowing agreement receives as collateral the cash equivalent value of the securi-ties plus (usually) a haircut. Agents normally indemnify the owners of the securi-ties against default by the borrower, and they require borrowers to post morecollateral, through margin calls, as required to maintain the given margin.

In the past, a securities lender’s profit from a lending arrangement was limitedto the borrowing fee itself. For an institutional investor with a large portfolio, theannual return from lending securities could reach into the millions of dollars. Ofcourse, higher returns are even better. The innovation in the market took the formof active participation in the transactions by the custodian bank or a third-partyagent, which sought to increase the lender’s return (for a slight fee and albeit atsomewhat greater risk) by reinvesting the cash collateral paid by the borrower.31 Avariety of reinvestment strategies are used, including numerous duration or con-vexity trades and credit mismatches, whereby funds are reinvested in slightlylower-rated paper, such as prime commercial paper.32 Often the securities pickedin the credit-mismatch are floating-rate notes.

In an attempt to expand their market share, investment banks have begun tobypass securities lending agents. Instead, the equity finance departments of thedealers are going directly to pension funds and other potential securities lendersto arrange deals. Another tactic institutions have used to capture a larger share ofthe business is to offer rebates in the rates charged to borrowers for the use of thelent securities.33 Bankers are also buying third-party institutions, which has theeffect of placing the dealers in the position of being both lenders and borrowers.By the same token, securities lenders can wind up reacquiring in a repo transac-tion, securities that had been lent to a different counterparty in a previous lendingarrangement. The consolidation of participants on both sides of these transactions


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and the trend towards larger, but fewer, participants poses a challenge for partici-pants’ risk management and concentration analysis.

V. Hedge funds and the functioning of financial markets

A. Liquidity and market efficiency

Financial markets have a range of functions, including: the efficient allocationof capital; the setting of prices, which fully reflect all information about the funda-mental value of a security traded on the market; and the availability of sufficientliquidity, characterised by the ability to accommodate incoming orders in a timelymanner (immediacy) and the ability to satisfy new orders with minimal effect onprices. Taking and transforming risks is another important function of the financialsystem. Repos, swaps and other derivatives support many of these functions byenhancing the ability of financial market participants to handle fluctuations inexchange rates, interest rates and security prices. On balance, most of these activ-ities have clearly been beneficial in increasing the flow of international capital andmaking financial markets more competitive and more efficient.

Hedge funds play a role in this process. They are providers of liquidity andtheir trading activities also promote price efficiency. For example, convergence or“arbitrage” trades eliminate or reduce anomalous variations in the prices ofrelated assets. In doing so, they are providing liquidity to markets and contribut-ing to financial market efficiency.

Hedge funds, with higher performances for risk than some other market partic-ipants, are important participants in the new financial landscape because theycontribute to a more efficient allocation of risk. In particular, their activities are partof the re-allocation of risk from financial intermediaries to investors who are hold-ing a wide range of tradable securities.

B. Risk management and the stability of the financial system

The role of regulators and supervisors is to protect the integrity of financialmarkets and to ensure that its functions can be executed without endangering thefinancial system as a whole. At the institutional level, market participants have avested interest in self-policing, among other reasons, to avoid a formal regulatorystructure for funding and hedging markets. After the derivatives disaster in 1994,for example, market participants formed the Derivatives Policy Group, which pro-mulgated a set of best practices in March 1995. Included were recommendationsfor reducing credit risk arising from derivatives as well as various other recom-mended procedures regarding documentation, etc. In many respects, periodic


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dislocations in the market are not the result of a lack of self-policing by market par-ticipants. Rather, there tends periodically to be a lack of discipline. The discretionthat participants typically exercise in choosing counterparties during times ofstress often tends to weaken considerably at other times, in particular, when theprospect of short-term profit opportunities arises. One of the more difficultaspects appears to be the need to resist dealing with counterparties whose activ-ity seems excessive in relation to capital. At times, participants seem to be eitherinsensitive, or unaware, of the risks to which they are exposed.

By contrast, in times of general financial stress, senior management of credi-tors and counterparties become alarmed at their exposure to institutions per-ceived to be “vulnerable” to risks of large losses on their positions. This may leadlenders to ask for increased collateral on loans (at a time when the asset value ofthat collateral is falling), or to withdraw credit lines entirely. Furthermore, repo andderivatives counterparties may be reluctant to trade with an institution clearly introuble, even on a fully-collateralised basis. Thus, firms facing funding problemsoften need to resort to sales of assets. However, a firm’s efforts to liquidate assetsduring times of financial crisis add to the downward pressure on securities pricesin the market and on the value of the firm’s remaining holdings. In worst case cir-cumstances, an institution facing a funding problem may be forced into insolvency.Assuming the firm’s creditors and counterparties have taken adequate steps toprotect their interests, it is unlikely that the firm’s failure would trigger otherdefaults, but – depending on the size of the firm’s exposure – the probability is notnecessarily zero. Nonetheless, a more likely scenario to domino defaults is a stam-pede to the exit, as creditors and counterparties attempt to liquidate collateral. Ofcourse, in an existing bear market, if everyone tries to sell at the same time, theprice collapses.

There was some concern that this would happen in some markets althoughthere were severe dislocations associated with the resolution of LTCM’s problems,if LTCM were forced to liquidate its positions. In the final analysis, however, thesystem actually ended up functioning reasonably well: there was no messy bank-ruptcy, collateral eventually moved through the system, losses for most institu-tions were kept to a minimum (or at least masked by profits from other businesssegments) and no public-sector money was involved. Even so, the event high-lighted a few shortcomings of market practices regarding risk management, includ-ing, but not limited to, collateral policies.

The events surrounding the LTCM bailout suggest that the typical counter-party needs to focus first on collateral, secondly on creditworthiness. Collateralhas two aspects: 1) adequate collateral is taken in to cover the exposure; and2) the assets received as collateral can be realised without much sacrifice of value.It is worth noting, however, that if counterparty risk is not properly accounted for,


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even rigorous collateral practices can provide only a false sense of security.Indeed, recent experience has contributed to convincing counterparties that creditrisk is more important than previously assumed.

As the number of counterparties for most institutions has increased and asfinancial transactions themselves have become more complex, the need for moresophisticated risk management techniques has grown as well. On a portfolio-widebasis, risk management has three major aspects: 1) measurement, which entailsdefining the risks; 2) modelling, which involves evaluating/predicting the risks; and3) control, in the sense of managing the risks. The challenge for managers is todesign specialised measures of critical exposures that are: 1) applicable to newcontracts/products; 2) scaleable (can be generalised from individual transactionsto portfolios); 3) fungible across instruments and markets; and 4) flexible (cover avariety of holding periods).

Credit risk can be controlled. To reduce this risk to an acceptable levelcounterparties can restrict their dealings to only reputable, highly rated firmsand properly collateralise their exposures, and investors can simply invest onlyin high quality instruments. Even a portfolio of low-quality bonds can have itscredit risk managed by sufficient diversification across borrowers. Market riskgenerally cannot be reduced in this fashion. Under certain conditions, marketexposures can converge and a portfolio presumed to be diversified can becomeoverly concentrated in a small number of markets. Another important element ofrisk is that, when dealing with highly leveraged counterparties/investment vehi-cles, market risk can quickly evolve into credit risk. This challenges the task ofrisk management.


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Notes

1. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”, report of thePresident’s Working Group on Financial Markets, April 1999.

2. The term “hedge fund” has become a misnomer in the sense that many hedge funds do notemploy the original Jones strategy of hedging through offsetting short and long positions.

3. Some “families” of funds have greater stakes. See “Hedge Funds, Leverage, and the Lessonsof Long-Term Capital Management”, report of the President’s Working Group on FinancialMarkets, April 1999.

4. In the United States, hedge funds are organised in such a way as to avoid regulation asinvestment companies under the Investment Company Act. Mutual funds and other entitieswhich fall under the definition of investment companies must register with the United StatesSecurities and Exchange Commission and are subject to rigorous regulatory oversight.According to the Investment Company Institute, a trade association for mutual funds, virtuallyevery aspect of a mutual fund’s structure and operation is subject to strict regulation underone of the four relevant federal laws: the Securities Act of 1933, the Securities Exchange Actof 1934, the Investment Company Act of 1940, and Investment Advisers Act of 1940. Hedgefunds use a number of measures to avoid regulation, including organisation as limitedpartnerships, limitations on the number and type of investors, and use of private placementofferings. In order to accept United States investors, hedge funds are limited in the numberof investors they may accept. Previously, federal law limited the number to 99 investors, ofwhom at least 65 must be “accredited”, defined as investors having a net worth of at least$1 million. However, funds can admit up to 500 investors, and remain under regulatory limitsgoverning public offerings. Most hedge funds, however, cater only to accredited investors andinstitutions and remain well below this ceiling on the number of investors.

5. Note that applicable laws in many other jurisdictions do not provide for the establishment ofdomestic hedge funds and do not permit foreign hedge funds to operate in the domesticmarket.

6. A notable exception is a requirement for hedge funds engaged in futures trades on organisedexchanges to provide balance sheet reports on large, open positions to the CommodityFutures Trading Commission.

7. Many of the strategies employed by hedge funds are also used by commodity trading advisors,which are registered individuals or trading organisations, authorised to make tradingdecisions on behalf of customers in futures, options, and securities accounts in a variety ofmarkets.


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8. However, the hedge fund sector has not established a consensus regarding style classificationsand definitions, which tend to change over time.

9. The data cover the period from January 1991 through August 1998. The benchmarks usedare the S&P500, the Russell 2000, MSCI EAFE, the MSCI Emerging Markets Index, and the USBond Index. See Warburg Dillon Read, “The Reality of Hedge Funds”, 30th October 1998.

10. See “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”, report ofthe President’s Working Group on Financial Markets, April 1999, which is reprinted in thefollowing chapter of this publication.

11. See, for example, William Fung and David A. Hsieh “Empirical Characteristics of DynamicTrading Strategies”, The Review of Financial Studies (Summer 1997), Vol. 10, No. 2,pp. 275-302. Recent studies by hedge fund analysts in the United States have shown thathedge funds over the past five years have generated higher returns on average than standardequity and bond indices and mutual funds.

12. See Warburg Dillon Read, “The Reality of Hedge Funds”, 30th October 1998.

13. For example, hedge funds outperformed the S&P500 in all quarters in the period Q4 1987-Q31998, except Q4 1994. See Warburg Dillon Read, “The Reality of Hedge Funds”,30th October 1998.

14. Of course, United States-based hedge funds can also accept other types of investors if theyrely on other exemptions under the Investment Company Act or if they operate outside thedomestic market.

15. See “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”, report ofthe President’s Working Group on Financial Markets, April 1999.

16. Both commercial banks and investment banks need a means of diversifying their revenuestreams from traditional markets, and global-macro, market-neutral arbitrage, and otherhedge fund styles are less correlated with the market than conventional long-biaseddirectional asset managers.

17. On a leveraged basis, the positions of large, global macro hedge funds can exceed those oflarge mutual funds, and are typically turned over much more often.

18. Size makes manœuvring in the market difficult and many funds have been forced to increasetheir level of innovation in order to generate adequate returns.

19. The degree of leverage employed by some hedge funds would prevent them from obtainingcredit on favourable terms in the cash market, and many do most of their financing in theover-the-counter market. For the banks and investment banks, the provision of credit andderivatives provides better margins than straight transactions services, and many have begunto do a considerable volume of business with their hedge fund clients.

20. To provide the leverage the hedge fund is after, banks and investment banks keep theirpositions on a margined basis, such that a $100 million trade might only require a $10 millioninitial cash input from the borrower. The interest on the $90 million margin difference is whatgenerates the profit on the trade for the lender.

21. Total return swaps are agreements in which the coupon and any capital appreciation on aninstrument such as a bond are exchanged for a LIBOR-linked payment plus any depreciation


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in the capital value of the underlying asset. Typically there is no exchange of principal andownership and funding of the underlying instrument is unchanged by the contract.

22. Credit spread contracts are option contracts that grant the right to buy/sell an underlyingcredit-sensitive asset at a pre-determined price for a pre-determined period of time. Theyare the oldest credit derivatives. In a credit default swap, a lender with an exposure to aparticular borrower transfers the risk of that borrower defaulting to a third party. If theborrower defaults, the hedger delivers a pre-specified reference asset (typically a bond issuedby the borrower, but may also be a loan, swap or trade receivable) to the swap counterpartyat par. If the borrower does not default, the hedger pays the swap counterparty a spreadbased on the LIBOR spread received by an investor buying the same underlying obligation inthe cash market or the asset-swap market. A credit-linked note is a default swap embeddedin a bond. The buyer of the bond assumes the default risk of the specific borrowers, whichenables the seller to originate new business.

23. A typical example is an index swap, in which a bank takes the other side of the trade and laysit off on the market. The spread the bank earns on the trade is largely a function of its creditrating relative to that of its hedge fund customer.

24. From an economic perspective, repos and swaps are very similar. The primary differencebetween them lies in the treatment of the underlying asset. With repos there is an initial andfinal exchange of the underlying securities, while with swaps, floating-rate and fixed-ratepayments are exchanged on some underlying principal (“notional amount”); the underlyingsecurities usually are not exchanged.

25. Repo transactions have many characteristics of secured lending arrangements in which theunderlying securities serve as the collateral.

26. Repos and reverse repo agreements need not be arranged with the same term to maturity.For example, if interest rates are expected to rise during the term of the agreement, a dealercould arrange a repo with a longer term to maturity than an associated reverse, in order to“lock-in” favourable borrowing rates. In a declining rate environment, a longer-term reverserepo could be profitably financed through a number of shorter-term repos arranged atsuccessively lower rates. Reverse repos are sometimes arranged so that the purchaser of thesecurities holds the securities until they mature, thereby eliminating the seller’s repurchasecommitment altogether.

27. An argument in favour of the relaxation of standards is that new technologies and nettingacross products eliminates the need for traditional haircuts in repo transactions. Opponentscontend that the practice is indicative of a deterioration in risk management.

28. In some cases the counterparties had collected variation margin, which basically marked theposition to market. However, variation margin is not forward looking and thus does notprovide protection against future dislocations.

29. In the United States, SEC regulations set a limit of 50 per cent on the amount which may beborrowed to purchase stocks; this is termed margin. Repos, however, with various haircuts,or initial collateral levels can be leveraged considerably more. Thus, these agreements havebecome attractive alternatives for hedge funds and proprietary trading desks of investmentbanks, which borrow stocks to implement a variety of strategies. Many of these strategieswere first implemented in Europe, where the agreements initially gained wide acceptance, but


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United States institutions are becoming more active participants in their domestic markets aswell. For example, event-risk funds may wish to establish a position in the stock of the targetfirm or acquirer in a merger or acquisition. Equities are also borrowed to implement taxarbitrage schemes.

30. Under United States bankruptcy laws, in the event of the borrower’s bankruptcy, thedifference between consummated sales and contracts to repurchase versus collateralisedloans is an important consideration, affecting the legal ability of the party holding collateralto liquidate them in the event of the counterparty’s insolvency.

31. Some participants have been allocating the reinvestment portion of the transaction tothird-party asset managers.

32. A simple variant involves using cash generated from lending long-term securities to invest inshorter-duration securities. Equity repos also become a credit trade when the collateral isreinvested in a subsequent repo secured by securities with a lower credit rating than thesecurities originally lent.

33. Of course, in order to offset the higher rebate, the lending agent generally must invest at leastsome portion of the cash in riskier assets to generate a sufficiently high return.

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