Federal Reserve Credit Officer Survey Identifies Trends in Prime Broker Credit Terms, Hedge Fund Leverage and Counterparty Risk

One of the fundamental premises of the Dodd-Frank Act is that leverage in the financial system – if inadequately monitored, insufficiently understood and too voluminous – can create systemic risk.  Accordingly, many of the provisions in the Dodd-Frank Act are intended to reduce leverage or increase monitoring of leverage.  In the same vein, regulators have been collecting information about leverage via interaction with market participants.  In the U.K., for example, the FSA conducts a periodic study of potential systemic risk engendered by hedge funds.  See “U.K.’s FSA Issues Latest Biannual Report Assessing Possible Sources of Systemic Risk from Hedge Funds,” Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  In the U.S., since 2010, the Federal Reserve has been conducting a quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms.  The survey generally asks dealers about the availability and terms of credit, securities financing and over-the counter (OTC) derivatives markets.  On March 29, 2012, the Federal Reserve published the results of its most recent survey (Survey).  The Survey polled the senior credit officers of the twenty largest dealers in dollar-denominated securities financing and the most active intermediaries in OTC derivatives markets.  The purposes of the Survey were to: (1) obtain a consolidated perspective on changes in the management of credit risk between December 2011 and February 2012; and (2) identify trends in financing terms between dealers (including prime brokers and other counterparties with whom hedge fund managers effect trades) and their customers (including hedge funds).  This article summarizes the Survey’s findings with respect to trends in: credit terms offered by dealer-respondents, including prime brokers; demands by hedge funds for better credit terms from prime brokers; overall use of leverage by hedge funds; credit terms with respect to OTC derivatives; and demand for and credit terms relating to securities financing.

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