With its rapid spread in the beginning months of 2020, COVID-19 created havoc for businesses around the world. As major economies went into prolonged lockdowns, which restricted the movement of both goods and people, effects were almost immediately felt in global financial markets as investors pulled out their money from equities and commodities. In such a dire scenario, central banks, including the U.S. Federal Reserve, European Central Bank and Bank of Japan, were prompted to make off-cycle rate cuts and infuse liquidity to the tune of $9 trillion in an attempt to avert another financial meltdown like that of 2008. But even with this aid, major economies entered into a recession in the second quarter of 2020, and it now remains to be seen how the broader economy and consumer sentiment will recover.
In the three years prior to the arrival of COVID, hedge funds were struggling to generate alpha with the rise in passive investing and its impact on profitability. However, the recent volatility in equity, bond and commodity prices compelled hedge fund managers to rejig their strategies and explore new avenues to cut costs. Now with an increased interest in actively managed strategies, hedge funds have been able to counter market volatility by positioning their portfolios to minimize risk while simultaneously capitalizing on temporary dislocations.
COVID-19 has also created significant changes in the way hedge funds manage their operations. As profitability became a challenge, managers sought opportunities to reduce cost and make their processes more efficient by leveraging data, technology and remote working capabilities. With this, a much-needed focus has been on collateral and position optimization like repo transactions where hedge funds will sell an asset (usually a bond) to a counterparty with an agreement to buy the asset at a predefined rate in the future.
In this scenario, counterparties usually give funds a haircut on the value of a bond based on various factors like quality and liquidity. These haircut percentages define the amount a fund can borrow against the asset that they are putting up as collateral and if the haircut is high, it leads to a lower borrow amount or a request for funds to put up more collateral for the same amount.
There is a focus from hedge funds now to optimize these haircut percentages and compare prices provided by multiple brokers in order to obtain the best deal and generate higher returns on their portfolios, which will ultimately attract more investors to their funds and increase overall AUM. Hedge funds around the world are now seeking a system that can help them optimize the rates (haircut) and offer comparable prices across brokers. Here, an opportunity has emerged for technology firms to offer their services across collateral management to help optimize both haircut rates and prices.
Leveraging a new dashboard recently developed in IVP Treasury, funds are enabled to make better decisions with an analysis of these haircut percentages charged by counterparties for the same asset. This analysis will not only help funds get into repo transactions with counterparties that charge the lowest haircuts but it will also help them borrow more with the same amount of collateral.