Progress report
An assessment of hedge fund YTD performance in the face of renewed fears for a potential eurozone crash Read More
10/11/2010
Comment: Putri Pascualy
After the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, a number of provisions including the Volcker Rule came into effect. A main tenet of the Volcker Rule is its prohibition on proprietary trading for any banking entity. Recently, UK regulators have announced that they too are considering a ban on proprietary trading for all banks.
In the US where the Volcker Rule rule is already in place, and in the UK, where a similar law may be imposed soon, hedge funds and other institutional investors are carefully watching to see how this change could affect them. Investment banks’ proprietary trading desks have traditionally been important players in the market: on the one hand, they are competitors to hedge funds for investment opportunities and talent. On the other, prop trading desks often serve as reliable sources of liquidity.
In the near team, the reduced presence of prop trading desks may affect liquidity, particularly in less liquid securities. However, the reduced number of players in the space is also a source of opportunity for hedge funds, which have historically operated with lower leverage than prop desks.
The Volcker Rule in the US is intended to mitigate conflicts of interest between investment banks and the clients that they advise. Whether it succeeds will depend largely on how the US Government Accountability Office decides to define “proprietary trading”. The definition is murky with respect to less liquid assets such as deeply distressed corporate bonds, allowing traders of these assets to continue to earn handsome profits for providing liquidity to clients. This has softened the financial impact of the Volcker Rule on some investment banks, but the seemingly more limited compensation upside for traders at banks has still led to the departure of top trading talent from investment banks. Indeed, some banks have simply decided to close their proprietary trading operations.
While the Volcker Rule is an issue, the key driver of talent from investment banks is the banks’ reduction of profitability (and by extension, trader compensation) resulting from the de-leveraging of investment banks’ balance sheets. This was precipitated by the credit crisis (well before the Volcker Rule), and later mandated by Dodd-Frank through stricter capital requirement for banks.
Much of the talent leaving prop desks will endeavor to start their own hedge funds. However, in a post-Madoff world, new hedge fund managers looking to access institutional capital face heightened requirements from investors. In an environment of heightened investor risk aversion, most institutional capital will go to the largest and most well-known hedge funds. Some departing talent may find it easier and more economically attractive (at least in the short term) to join the ranks of more established asset managers.
For investors focused on emerging managers, the post-Volcker Rule environment presents an opportunity to evaluate and possibly invest with top talent at preferred terms. Limited investment capital means that the balance of negotiating power has shifted from manager to investor. The influx of experienced traders setting up new operations has created the opportunity to invest early with seasoned talent. Investors with particular expertise in early stage hedge fund investing are well positioned given the combination of access to a superior pool of investment talents, better governance, control of assets and higher standards of transparency.
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60 seconds with... Kenneth Turchin
CAN YOU DESCRIBE YOUR CURRENT ROLE?
I have worked in public accounting and hedge funds and in the past eight years have been selling middle- and back-office services to the alternate investment industry. My role is to build relationships with clients, teach them about SS&C’s products and services, and ensure seamless transactions every time the firm launches a new fund.
IF YOU WERE DOWN TO YOUR LAST £1,000, HOW WOULD YOU INVEST IT?
I would buy THREE shares in Apple and hope for a repeat 383% return in the next five years.
WHAT WOULD YOU DO IF YOU WERE IN PRESIDENT OBAMA’S SHOES?
That’s one pair of size 12 shoes I do not want to be in!
WHO WOULD PLAY YOU IF THEY MADE A MOVIE ABOUT YOUR FIRM?
Kevin Bacon. He is a versatile actor and the centre of the entertainment universe. I am in sales. Everyone in the industry would be linked to me in six steps or less. My client list would be ridiculous.
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