| Passport Capital portfolio manager Timothy Garry |
Here’s a scary Wall Street movie scenario: A scandal hits an industry sector that has been a darling among equity traders — think tainted cold remedies or cars that spontaneously combust. Hundreds of traders decide they’d better unload all of their stocks in the industry — only to find that hardly anyone is willing to buy their shares. As the clock is ticking toward the end of the trading day, Brad Bounty, head of a $10 billion hedge fund, played by Matt Damon, sees a great opportunity to buy shares for pennies. “Hmm . . . tell me why we should do this,” he grills a senior analyst on his staff. By then the stocks have dropped to what looks like rock bottom, but Bounty would have to spend nearly $1 billion to buy to stop the fall. It’s way more exposure than he can take with his investors’ money. A lot of traders slink home, finished.
This is a hypothetical situation that is somewhat more likely in even a minor crisis, according to some risk analysts, now that U.S. banks have had to do away with their proprietary trading desks.
The potential for a big run on liquidity is something that keeps Timothy Garry up at night. “The market-making and risk-taking function of the sell side has been severely reduced,” says Garry, a portfolio manager as well as the chairman of the risk committee at $4 billion Passport Capital in San Francisco.“The risk has been transferred to the buy side.”
Prop desks traded on the banks’ own accounts, something the Volcker Rule of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits for the most part. Now the European Union is considering a proposal that would ban prop trading within the EU’s top 30 or so banks that have global assets of more than €30 billion ($41 billion) or are deemed “globally systemic” in the sense that their failure might trigger a financial crisis. In the past, prop desks could stop a crash from happening because they served as buyers of last resort when there was a massive sell-off — although in a big enough sell-off they too can lose money, as they did in the global market crash of 2008. One of the assumptions in the markets has been that other entities will step in as the buyers that stop the fall — and large hedge funds could be a natural substitute. Already, there are plenty of former prop desk traders running their own hedge funds. But there may be limits to how well hedge funds can perform this role.
Garry is skeptical about the ability of hedge funds to take on the role of liquidity provider. The prop desks on the sell side — ie., the banks — served a different role than the hedge funds and other asset managers that make up the buy side.
For one thing, hedge funds don’t hold permanent capital the way bank prop desks did. “As we saw in 2008, usually when markets decline sharply, managers and investors are looking to deleverage instead of adding to exposure despite prices being cheaper,” says Garry. For another, market dislocations happen quickly, and hedge fund managers aren’t always prepared to act without due diligence. That is also the case with endowments, pension funds and sovereign wealth funds, which in theory might have enough capital to buy falling assets but are seldom willing to make fast decisions.
“A buyer of last resort needs to be someone who is actively getting paid to provide liquidity when there is a seller — not someone who is on the sidelines waiting for opportunities,” says Garry.
Another shortcoming, according to Garry, is that hedge funds add exposure and risk in times of low volatility and take the risk off when correlations and volatility rise. It is possible to take on risk when markets fall; Passport does it, albeit judiciously. If fund managers were to stop a fall, Garry says, they’d want to buy at the rock-bottom prices. “They’d want a very clear indication that they’ve seen the worst,” he says. “It will have to get pretty ugly before they step up.”
Robert Macrae, a founder and managing director of $900 million Arcus Investment in London, also believes there is a potential risk of a liquidity crisis without a buyer of last resort. Macrae’s firm specializes in long-short Japanese equity, so in 16 years of running the strategy he has developed a keen awareness of how a financial crisis can play out.
But from Macrae’s perspective of the climate in Europe, he is not especially worried about the EU doing away with the biggest prop desks. He believes it is possible for hedge funds to become buyers in a liquidity crisis, provided they can deploy sufficient amounts of capital — a question that no one can answer until a crisis happens. “Of course,” Macrae quips, “that means we need more hedge funds.”
What he thinks is going to be problematic is a tendency in Europe, especially in France and Germany, to believe that all financial market participants should be subject to the same regulations and risk management as banks. Right now if some asset becomes unattractive to banks holding it, it will fall in price until it becomes cheap enough for hedge funds and other equity-funded investors to step in and take advantage of the buying opportunity. “But what happens to the price of the asset if everyone is subject to rules that force them to value assets in the same way as banks?” says Macrae. “The price will drop further because these return-oriented buyers will not emerge.”
In short, a more homogenous system is likely to be more volatile. “There will be sharper falls than you’d have with a substantial nonbanking sector in the markets,” says Macrae.
None of this is to say that a liquidity crisis is imminent. Macrae says that since the markets are still recovering from the last financial crisis, traders are not so optimistic — at least not yet — as to assume that liquidity will always be there.
As Garry sees it, hedge fund managers should keep a stash of liquid holdings so that in the event of a crisis they won’t be blindsided. “Hedge your tail with put options that could be helpful if you sell them in a flash crash or other big downturn,” he says. “And consider cash an asset.”
