CHARLES UNIVERSITY IN PRAGUE

Transcription

1 CHARLES UNIVERSITY IN PRAGUE FACULTY OF SOCIAL SCIENCES Institute of Economic Studies Marcel Hrošovský Risk assessment of major shadow banking entities Bachelor thesis Prague 2017

2 Author: Marcel Hrošovský Supervisor: prof. Ing. Oldřich Dědek CSc. Academic Year: 2016/2017

3 Bibliographic note HROŠOVSKÝ, M Risk assessment of major shadow banking entities.? p. Bachelor thesis. Charles University in Prague, Faculty of Social Sciences, Institut of Economic Studies. Supervisor: prof. Ing. Oldřich Dědek CSc.

4 Abstract Shadow banking is a part of the financial system, that operates similarly to the banking system, however, is typically less regulated. As a result of incorrect risk assessment and insufficient regulation, shadow banking played a significant part in the recent global financial crisis of My thesis consists of two major sections, in the first section I describe the shadow banking system, I assess its positive and negative features, and I describe the methods for mapping the shadow banking entities. In the second section, I conduct a risk assessment of major shadow banking entities. Based on the evidence I conclude, that even investments that appear risk free under standard market conditions are exposed to incorrect risk assessment, especially when investing into assets with complicated structure, furthermore, in time of systemic contagion, even healthy companies are exposed to runs and lack of credit available on the market to help fund their operations. Keywords Shadow banking, risk, assessment, crisis, regulation Range of thesis: Characters

5 Abstrakt Tieňové bankovníctvo je súčasť finančného system, ktorej činnosť sa podobá činnosti bankovému system, avšak typicky podlieha menej prísnej regulácií. V dôsledku neadekvátneho odhadu rizikovosti a nedostatočnej regulácií, zohralo tieňové bankovníctvo významnú rolu počas nedávnej globálnej finančnej krízy z roku Moja práca sa skladá z dvoch hlavných častí, v prvej časti popisujem systém tieňového bankovníctva, hodnotím jeho pozitívne a negatívne vlastnosti a popisujem metódy mapovania subjektov spadajúcich do systému tieňového bankovníctva. V druhej časti posudzujem rizikovosť jednotlivých kľúčových subjektov tieňového bankovníctva. Na základe dostupných dôkazov vyvodzujem, že aj investície, ktoré sa za štandardných trhových podmienok javia ako bezrizikové sú vystavené nesprávnemu odhadu rizika, predovšetkým v prípade investície do aktív s komplikovanou štruktúrou. Ďalej vyvodzujem, že čase systémového zlyhania trhu sú aj zdravé spoločnosti vystavené masovému výberu podielov a vkladov a nedostatku finančných zdrojov na trhu, potrebných k financovaniu svojej prevádzky. Kľúčové slová Tieňové bankovníctvo, risk, posudok, kríza, regulácia

6 Declaration of Authorship 1. The author hereby declares that he compiled this thesis independently, using only the listed resources and literature. 2. The author hereby declares that all the sources and literature used have been properly cited. 3. The author hereby declares that the thesis has not been used to obtain a different or the same degree. Prague Signature

7 Acknowledgments I would like to express my deep gratitude to my supervisor prof. Ing. Oldřich Dědek CSc. for his guidance and usefull comments. I would also like to thank my parents for their never ending support.

8 In my thesis I intend to cover several problems connected to shadow banking. First I will introduce several definitions of shadow banking (as there are currently more and consensus has not been reached so far) and reason which one is the most fitting for the purpose of regulation. In the second stage I will describe the difference between features that are positive (those that actually bring some efficiency to the financial markets) and negative (harmful features that pose threat to systemic stability). During the final stage I will introduce the major shadow banking entities, and conduct their risk assement. I will end my thesis with general conclusion on the conducted risk assessment and its implication for regulation. Institute of Economic Studies Bachelor thesis propsal Main sources: GRILLET-AUBERT, Laurent, et al. Assessing shadow banking non-bank financial intermediation in Europe. ESRB Report, 2016, 10. ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, 1. SCHWARCZ, Steven L. Regulating Shadow Banking: Inaugural Address for the Inaugural Symposium of the Review of Banking and Financial Law, Shadow Banking Symposium. Journal of Review of Banking and Financial Law, 2012, 31. GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings papers on economic activity, 2010, :

9 1 Content INTRODUCTION LITERATURE REVIEW, METHODS AND HYPOTHESES Literature review Hypotheses and methods DEFINITIONS OF SHADOW BANKING POSITIVE AND NEGATIVE FEATURES OF SHADOW BANKING Positive Features Disintermediation Decentralization Negative features Regulatory arbitrage Systemic risk to financial system Maturity transformation Liquidity transformation Credit risk transfer Interconnectedness SHADOW BANKING MAPPING SHADOW BANKING ACTIVITIES Difference between off-balance-sheet financing and on-balance-sheet financing Securitization Introduction Special purpose vehicle Securitisation summary Repo operations Introduction Use of repos Current repo regulation Risks Derivatives Introduction Options Futures Swaps Forward contracts Risks FUNDS Introduction Open-end, close-end and exchange traded funds Money Market Mutual Funds Introduction Popularity Breaking the buck Risks Hedge funds Introduction Leverage Operations Risks Bond funds Introduction... 40

10 Risks Equity funds Introduction Risks: FINANCIAL CORPORATIONS ENGAGED IN LENDING CONCLUSION BIBLIOGRAPHY... 47

11 3 Introduction After the Great Depression of 1929 the United States created a bank regulatory system that resulted in over seven decades liberated of large scale financial panics, which is significantly the longest such period since the foundation of the United States. This sound period ended in year However, now the epicentre of the crisis was not as much the traditional banking system but rather the new shadow banks, that operate similarly as traditional banks, though under very few regulations. Because of the large magnitude and harmful potential, it is imperative that we look at shadow banking from a complex perspective. Whether we look at the issue from the perspective of an investor or from the perspective of the regulator, we must get to understand, what is it, why does it even exist, how it influences the market, which parts are desirable and which are not and properly assess the potential risk accompanying different parts of this system. The purpose of my thesis is to introduce the reader to the topic of shadow banking, to provide an overview of the term and the major shadow banking entities and research their exposure to a variety of risks they are facing. My thesis will consist of two major parts. In the first part, I will provide several definitions of shadow banking and discuss the origin of the term. I will continue by assessing positive and negative features of shadow banking and introduce methods for mapping the shadow banking entities. In the second part of I intend to focus on specific shadow banking institutions and activities, provide an explanation of how they operate and examine their exposure to specific threats. In some cases, I will also examine entities that do not necessarily belong to the shadow banking realm but are widely utilised by some of the major shadow banking institutions. At the end, I will provide a conclusion about my findings.

12 4 1. Literature review, methods and hypotheses 1.1 Literature review This section is a short summary of an important literature concerning shadow banking functioning and risk assesment. Without unified definition and proper reporting requirements, economists, investors and regulators still lack proper data to conduct a proper analysis of the overall sector. Mapping of shadow banking is thusan important task, that is currently conducted by two major bodies, the European Systemic Risk Board and Financial Stabilty Board. Based on their findings, the ESRB publishes annual report about monitoring shadow banking, 1 this report provides an overview of development of shadow banking in the EU, it points out issues that have potential to create a systemic risk such as leverage, interconnectedness of banking and shadow banking sector, maturity and liquidity transformation. The monitor is supported by accompanying occasional paper bz Grillet-Aubert, 2 that provides more in depht analysis of the same topics. Similar analysis is conducted by FSB, it monitors the shadow banking activity, however, unlike the analysis of ESRB, the FSB works with data available worldwide, and not just the EU. In the global shadow banking monitor, FSB provides overview of mapping methodology, interconnectedness of entities and cross-jurisdiction analysis. 3 After the crisis, FED Economist Pozsar 4 created an overview of the shadow banking system, explained the functionality of the shadow banking entities and analysed interconnectedness by creating maps showing flow of funding. Rise of shadow banking was a reaction to rising regulations and other legal requirements. Risk assessment and regulation are strongly interconnected topics, without proper regulation and supervision, shadow banking has an increased potential to 1 ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, 1. 2 GRILLET-AUBERT, Laurent, et al. Assessing shadow banking non-bank financial intermediation in Europe. ESRB Report, 2016, FSB, Financial Stability Board. Global Shadow Banking Monitoring Report Technical Report,May, POZSAR, Zoltan, et al. Shadow banking

13 5 trigger the systemic risk. Gorton and Metrick 5 adressed this problem and proposed principles to regulate shadow banking, mainly by creating strict guidelines on collateral and government-guaranteed insurance for various shadow banking entities. Schwarcz 6 believes, that regulation could indirectly reduce fragmentation, interconnectedness and opacity, however, by limiting the factors that give rise to shadow banking. He thus proposes to erase the regulatory arbitrage, however, while Gorton and Metrick propose to strenghten the shadow banking regulation to reduce the systemic risk, Schwarcz believes that deregulation of banking system instead is also a feasible method. Similarly to Schwarz, Adrian and Ashraft 7 focus on erasing the regulatory arbitrage by proposing enhanced capital and liquidity requirements for shadow banks, however, they do not discuss the possibility of deregulation of banks. With increasing banking regulation, the incentive for rise of shadow banking is strenghten and thus there is a need for transparent, credible and robust credit and liquidity to prevent the risks associated with maturity transformation. FSB analysis 8 provides an assement of risk exposure of shadow banking entities and suggests an accurate policy framework, which includes creation of appropriate capital requirements, restrictions on scale and scope of business, liquidity buffers, requirements on elligible collateral and other. 1.2 Hypotheses and methods In my thesis I will provide an overview of the shadow banking system, discuss positive and negative features and assess the risk exposure of the main shadow banking entities. After finishing my research, I will confirm or reject the following hypotheses: 1) Entities, that appear risk free under standard market conditions, are also exposed to risk during time of systemic stress. 2) Use of synthetic leverage increases risk exposure. 3) Lack of regulation of shadow banking is source of potential systemic risk 5 GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, : SCHWARCZ, Steven L. Regulating Shadow Banking: Inaugural Address for the Inaugural Symposium of the Review of Banking and Financial Law, Shadow Banking Symposium. Journal of Review of Banking and Financial Law, 2012, ADRIAN, Tobias; ASHCRAFT, Adam B. Shadow banking regulation. Annu. Rev. Financ. Econ., 2012, 4.1: FSB, Financial Stability Board. Strengthening Oversight and Regulation of Shadow Banking Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August, 2013

14 6 My work will be theoretical, to achieve my target, I will analyse available sources concerning shadow banking risk assessment and regulation, furthermore, I will describe the concerned major entities and enhance these descriptions by providing explanatory diagrams.

15 7 2. Definitions of shadow banking To be able to not only discuss but to be able to recommend a remedy for the problem, first we must know the subject of our discussion. As of this moment, there is no unified definition of shadow banking and therefore I will begin by introducing some of the currently used definitions. Economist Paul McCulley, commonly known as the originator of the term shadow banking, used it to refer to the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures. This characterization approximately describes the system of structured finance. This system develops and further utilises these types of conduits, vehicles and structures which could be jointly titled special purpose entities or SPEs. 9 Another definition comes from Federal Reserve Bank of New York economists (Pozsar, Adrian, Ashcraft and Boesky): Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. 10 This includes numerous entities, examples are asset-backed commercial paper (ABCP) conduits, consumer finance companies, securities lenders, structured investment vehicles, credit hedge funds, money market mutual funds (MMMF`s) and government sponsored enterprises. By this definition, special purpose entities are already included in the asset-backed commercial paper. Economist Steven L. Schwarcz in his Inaugural Address for the Inaugural Symposium of the Review of Banking & Financial Law raised two valid questions: Should shadow banking refer to the provision by shadow banks of any financial products and services, or only to the provision by shadow banks of products and services ordinarily provided by traditional banks? The second question: Should shadow banking, or, at least, the concept of a shadow-banking network, be limited to the provision of financial products and services by shadow banks, or should it also embrace the mediums used by shadow banks to provide those products and services? MCCULLEY, Paul. Teton Reflections. PIMCO Global Central Bank focus, September, 10 POZSAR, Zoltan, et al. Shadow banking

16 8 Regarding the first question, Schwarcz has simply chosen to adopt the first, broader meaning despite the fact that shadow banks are basically non-banks providing financial products and services. He argues that there is a need to account for the inevitable future evolution of financial products and services. Personally, I agree with his point of view, especially if the definition is made for the purpose of regulation of shadow banking. It is expected that when a new regulation arises, the market will adjust in time and new products and forms of financial service provisioning will develop outside of the regulatory impact. Hence the term covers the future expansion of the system. As for the second question, Schwarcz claims that the key method of provision of products and services is via the financial markets. He based such statement on a fact, that securitization, the leading method of structured finance, is dependent on Special Purpose Entities to issue securities with the ability to satisfy the specific demands (the individually right ratio of risk and profit) of capital-market investors. Also, another important subset of shadow banking, repo operations, operate through financial markets as well and so Schwarcz decided to include financial markets used to provides such products and services into the shadow-banking network. Another definition of shadow banking that I am going to present is from Federal Reserve Bank of New York staff report: Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. These were just a few examples of a long list of possible definitions, however, for the purpose of this paper I will use the one used by Financial Stability Board: The shadow banking system can broadly be described as credit intermediation involving entities and activities outside of the regular banking system. 13 I have chosen this definition mainly because the Financial stability board is one of the key players when it comes to forming an international financial regulation and its policy recommendations are affecting European legislation. This definition is also consistent 11 DAVIS, Henry A. The Definition of Structured Finance: Results from a Survey SCHWARCZ, Steven, L. Regulating Shadow Banking: Inaugural Address for the Inaugural Symposium of the Review of Banking and Financial Law, Shadow Banking Symposium. Journal of Review of Banking and Financial Law, 2012, FSB, Financial Stability Board. Global shadow banking monitoring report Technical Report, November, 2015.

17 9 with European Systemic Risk Board 14, an organisation that largely contributes to the mapping of shadow banking activity in the EU and assessing the systemic risk associated with shadow banking entities. 14 GRILLET-AUBERT, Laurent, et al. Assessing shadow banking non-bank financial intermediation in Europe. ESRB Report, 2016, 10.

18 10 3. Positive and negative features of shadow banking This section presents an overview of the benefits that the shadow banking system provides. Many of the innovations created within this system help to generate efficiency on the markets and thus could be considered as public goods. 4.1 Positive Features Disintermediation Disintermediation brought by shadow banking system is a creator of economic efficiency. The reasoning is as follows: Banks operate as the intermediaries of funds, first they borrow funds predominantly from their depositors or possibly via financial markets, then they lend for higher interest, while trying to keep the spread between the buy and sell price as wide as possible, since as general rule they wish to maximize their profit. The disintermediation by shadow banks allows financial market participants such as companies to obtain funding without paying the mark up to the middle man. A corporation can achieve this, for example, by setting up a special purpose entity and use it to borrow funds. Other non-bank profit making entities might work as the intermediary, for example, hedge funds or investment banks. Even though they frequently produce lower efficiency than traditional banks hedge funds and investment banks are able to gain the high ground by operating outside the bank regulatory environment facing lower regulatory costs and thus becoming competitive thanks to regulatory arbitrage Decentralization Decentralization may help to increase efficiency, however, it may as well increase the risk. In a decentralized system, the financial market participants face a higher variety of financial products available for purchase and thus allowing them to craft the desirable portfolio according to their individual preferences. 16 Moreover, decentralization creates more robust environment towards negative shocks because in a market consisting of a high number of smaller firms, the case of 15 SCHWARCZ, Steven L. Regulating Shadow Banking: Inaugural Address for the Inaugural Symposium of the Review of Banking and Financial Law, Shadow Banking Symposium. Journal of Review of Banking and Financial Law, 2012, ALLEN, Franklin; GALE, Douglas. A welfare comparison of intermediaries and financial markets in Germany and the US. European Economic Review, 1995, 39.2:

19 11 default of some of those institutions will not pose threat to the overall market and thus the too big to fail is failing problem will occur less likely. There is, however, a cost to this. Having a large number of firms makes the higher probability of at least some of the firms failing. Here stands an argument that the result of decentralization is that shadow banks create market fragmentation, interconnectedness and opacity. As a consequence the market participants are unable to correctly sort out the information, the risk stands invisible and accumulates unnoticed. Then when it suddenly becomes noticed the panic spreads due to the size. 17 I conclude that we stand before the question if we can create such tools that will allow us to better recognise the fragmented failures and thus make decentralization a truly beneficial feature of the shadow banking system. 4.2 Negative features In comparison to the positive effect mentioned in the previous section, this section illustrates some characteristics of shadow banking, that are making it undesirable, vulnerable, and potentially harmful good. These aspects are the reasons why there is a need for regulation of shadow banking Regulatory arbitrage One of the key reasons for existence and also one of the key reasons why shadow banking might not exemplify a public good is a regulatory arbitrage. While the traditional banks tend to be highly regulated the shadow banking entities are commonly regulated less. 18 The wider the difference between regulatory levels of banks and nonbank entities providing same or similar enough service, the higher will be the demand for shadow banking. The reasoning why under such conditions shadow banking might not pose as a desirable good from a public perspective is simple, the nonbank structured product may face higher transaction costs than the more regulated bank product, however, thanks to regulatory arbitrage will provide a net gain. 17 SCHWARCZ, Steven L. Regulating Shadow Banking: Inaugural Address for the Inaugural Symposium of the Review of Banking and Financial Law, Shadow Banking Symposium. Journal of Review of Banking and Financial Law, 2012, GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, :

20 Systemic risk to financial system If left unregulated, shadow banking has a serious potential to create a systemic risk to the financial system. The shadow banking system includes the transformation of maturity, liquidity, credit and high leverage and thus is vulnerable to panics. A great example is the recent crisis of In the case of repo operations, where high liquidity was present and Securities working as collateral a problem arises when a fast and unexpected change of ratings of the underlying securities happens. The crisis was triggered in August 2007 by a wholesale banking panic in the shadow banking system. Problems in subprime lending became apparent and, because of asymmetric information, investors could not ascertain the exposure of their counterparties to this problem and their solvency. Thus financial firms ran on other financial firms, withdrawing cash from MMMF and/or not renewing repo agreements or increasing the repo margin ( haircut ). This forced massive deleveraging and resulted in the insolvency of the banking system Maturity transformation Shadow banking provides short-term funding for long-term capital requirements. 20 This may lead into situation of liquidity discontinuity, where despite having a healthy portfolio, the shadow bank is unable to meet its short term liquidity needs, which might result even in selling good quality long term assets under price, just to fulfil the liquidity requirements and thus making itself more vulnerable a possibly facing more withdrawals due to worsened reputation on the market and getting into vicious spiral. This situation is similar to well know bank runs Liquidity transformation Liquidity transformation is an inconsistency between access to investment granted by shadow bank to its investors and ability of corresponding assets to be sold without significant negative price impact. Examples are open-ended funds, that trade their shares on demand while being engaged in positions with a lower level of liquidity. This may lead the investors to misunderstand the real degree of liquidity of their investment portfolio. 19 FSB, Financial Stability Board. Strengthening Oversight and Regulation of Shadow Banking Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August, Note:shadow banking might provide both long and short term funding

21 13 ESRB analysis suggests an existence of a trade-off between maturity and liquidity transformation. Funds with primary investment into less liquid assets, such as corporate debt have a tendency to invest in securities with under-average maturity term. Even though the assets are illiquid, because of short-term maturity these funds are able to overturn their portfolio frequently and reduce liquidity risk. On the other hand, funds with primary investment into assets with the above-average date of maturity, tend to invest in more liquid assets, such as sovereign bonds and therefore are able to sell them at any time Credit risk transfer Credit risk transfer means transferring the risk of borrower s default to a third party. Credit risk transfer creates the potential for several market failures, for example, asymmetric information, principal/agent problems and incomplete contracts. As an example, I will use mortgage-backed securities. The bank, the originator of each individual loan conducts a proper due diligence of each individual borrower, based on parameters such as financial history record, education, family status, criminal record, etc. However, when a number of individual mortgages are pooled into one mortgage backed security and offered to a third party on the market, the information available to the third party about the borrowers is often more limited Interconnectedness Interconnectedness is a relationship between different market entities through financial transactions and contracts. The interconnectedness between banking and shadow banking system is essential for funding of credit institutions, that are supported by securitization that transforms illiquid assets into significantly more liquid securities, however, it is also a source of potential contagion. When the extent of collapse of a very large and highly interconnected institution reaches a certain tipping point, it may lead to systemic insolvency of the interconnected entities. Example being the Lehman Brothers failure based on investment into subprime mortgage-backed securities starting the global financial crisis ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, GRAY, Andrew; LEIBROCK, Michael. Understanding interconnectedness risks to build a more resilient financial system. White Paper, October, 2015.

22 14 According to ESRB analysis, the interconnectedness of banking and shadow banking system in the euro area is significant. ESRB found that approximately 9% of credit institutions assets are either loans to investment funds and other financial institutions or shares and debt securities of those institutions. On the liability side, 7% of euro area credit institutions liabilities consist of deposits from investment funds and other financial institutions GRILLET-AUBERT, Laurent, et al. Assessing shadow banking non-bank financial intermediation in Europe. ESRB Report, 2016, 10.

23 15 4. Shadow banking mapping To quote David Wright, secretary general of the International Organisation of Securities Commissions from his 2014 Reuters interview: "In general we don't fully understand how the financial system functions and I don't think you can unless you have the data you need". 24 Since the global financial crisis of 2007 government institutions assigned to regulate shadow banking are facing a challenge, which is the lack of data necessary to build a proper overview of the volume of shadow banking activities and interconnectedness with the overall financial sector. Evaluation of its size, description of the entities involved, assessment of its role within the financial sector is crucial task that need to be completed in order to construct a functional regulatory framework necessary to prevent a risk of another systemic contagion. European Systemic Risk Board, namely its Joint Advisory Technical Committee (ATC)-Advisory Scientific Committee (ASC) Expert Group on Shadow Banking, is currently using two methods to estimate and monitor the risks of shadow banking entities. 25 First method is the entity based approach. This methodology uses the aggregated data from balance sheets of the targeted financial institutions. The data are obtained from financial accounts and monetary statistics using balance sheets of single entities instead of cross-group consolidation. ESRB includes the entire financial sector with exclusion of banks, insurance companies and pension funds. The focus is, however, on entities with higher expectations to create a systemic risk by engaging in activities such as credit intermediation, maturity transformation, liquidity transformation, leveraging or those that have significant interconnectedness with the banking sector. Second method is the activity-based approach, which functions as complement to the entity-based approach. This methodology focuses on shadow banking activities rather than specific entities and thus covers also areas such as insurance companies that 24 HUW, Jones. Regulators lack data to probe shadow banking sector. Reuters [online]. 2 May [cit ]. Available at: 25 Note: Similar work is conducted by Financial Stability Board as well.

24 16 are involved in securities financing transactions. Another extension produced by activity-based approach is the coverage of derivatives, repos and securities. Similar analysis is conducted by Financial Stability Board, however, while ESRB focus on monitoring of the EU market, FSB utilises data available worldwide FSB, Financial Stability Board. Global Shadow Banking Monitoring Report Technical Report,May, 2017.

25 17 5. Shadow banking activities In this section I will introduce a number of important shadow banking activities. I will provide an overlook of their functionality, use and discuss potential systemic risk associated with them. 6.1 Difference between off-balance-sheet financing and onbalance-sheet financing Off-balance-sheet financing differs from the on-balance-sheet financing used in the traditional banking system. Figure 5.1. represents the typical portrayal of the financial intermediation of loans on balance sheets of the traditional banks. In step 1, money is deposited by clients to the bank. Client gains credit on some type of account with a high level of liquidity, that enables him to operate with the money at almost any given time. Typically we are speaking of checking account or savings account. In step 2 the bank further lends those acquired funds to another credit seeking entity and thus works as an intermediary of funds. This loan then appears on the asset side of banks balance sheet until its maturity. 27 Figure Based on: GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, :

26 18 In the past, a common feature of the traditional banking system was the so called bank runs. A bank run is a situation that occurs when a large number of bank or other financial institution's customers withdraw their deposits simultaneously due to concerns about the bank's solvency 28, however, they ended in the USA by the launch of federal deposit insurance in the year In the European Union the first coordinated step against these events was the Deposit Guarantee Directive from 1994, nonetheless, there was already a long lasting tradition of various forms of deposit insurance in individual member states. 29 Having their deposits insured, depositors lack the motivation to withdraw their funds even if the bank shows the signs of possible insolvency. This, however, is the case only for small scale depositors. Large investors, corporations and other institutions such as money market mutual funds, pension funds, municipalities, and large scale nonfinancial companies with significant cash holdings still face uncertainty as the current level of deposit insurance in the United States is capped at $250, and at 100,000 in the European Union 31. It is certain, that storing their funds in the traditional bank with this level of insurance will not be able to satisfy their need for safe, highly liquid and interest-earning investments. The reasonable solution to this problem is provided by the shadow banking, an off-balance-sheet lending system depicted in Figure Figure Investopedia. [online]. Bank Run Definition [online] [Accessed ]. Available from: = Council and Parliament Directive 94/19/EC of 30 May 1994 on Deposit-Guarantee Schemes [2017] L 135/5. 30 FDIC, Federal Deposit Insurance Corporation. [online]. How Are My Deposit Accounts Insured by the FDIC [Accessed ]. Available from: 31 European Commission. A stronger Banking Union: New measures to reinforce deposit protection and further reduce banking risks. Press Release, Based on: GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, :

27 19 In step 1, retail investors buy shares of Money Market Mutual Fund at a constant price of $1. In step 2 MMMF transfers funds to the bank, however, unlike in the case of small scale retail investors, these funds are not fully covered by the deposit insurance, thus another form of protection must be supplied. The solution is similar to deposit insurance, this protection can be achieved by the bank providing collateral to institutional investors (such as Money Market Mutual Funds) in exchange for a deposit. This transaction takes the form of repo operation, MMMF or other investor deposits amount X and simultaneously the bank switches over assets to be used as collateral. The bank also agrees to repurchase the same asset at a certain pre-agreed future time for the amount Y. We can use the formula (Y X) to calculate the so called the repo rate, which is equivalent to the interest rate that small scale retail depositor obtains on bank deposit. It is conventional that the so called haircut is used, meaning that the amount deposited is lower than the current value of assets used as collateral, where the haircut represents the difference between the two. Step 3 simply shows bank transferring liquidity to borrowers and adding the loan to the asset side of its balance sheet. In step 4 we finally get to the off-balance-sheet financing. The bank transfers loans created in step 3 to the special purpose vehicle. In the SPV the loans are pooled and securitized in a fashion that they match the demand for various levels of risk and return. The SPV then transfers back either liquid cash or the created securitized bonds. The crucial outcome of this scheme is such that the products of SPVs securitization are either purchased directly by investors in step 5 or as seen in step 2, used as collateral for loans. In conclusion, the bonds generated by securitization are commonly used as a substitution for deposit insurance. 33 X 33 GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, :

28 Securitization Introduction To properly understand the scheme in Figure 5.2. it is important to understand the step 4 securitization. Securitization is the process of packaging a large number of loans and selling them via capital markets. It is worth noting that conventionally these loans have illiquid character. The packaging process is accomplished by setting a special purpose vehicle. Wide portfolio of loans is sold to SPV where they are bundled together and tranched according to their level of risk. Besides risk, tranches can be further diversified by other aspects such as maturity of their corresponding loans or interest rate. Figure 5.3. illustrates how securitization works. An originating firm (for example bank) lends money to a number of borrowers. A number of these loans are then pooled into a portfolio, which is sold to an SPV, a master trust in the figure. The SPV finances these purchases by selling securities in the capital markets. These securities are classified into tranches, which are ranked by seniority and rated accordingly. The whole process thus takes loans that traditionally would have been held on the balance sheet of the originating firm and creates from them marketable securities that can be sold and traded via the off-balance-sheet SPV. The more senior the tranche the less risky it is and suffers the loss later in comparison with the previous tranche. On the other hand, the junior branches are commonly associated with higher expected yields in case there is no default. The most junior tranche or the bottom tranche is commonly retained by the originator instead of being sold to outside investors Based on: GORTON, Gary; METRICK, Andrew. Regulating the shadow banking system. Brookings Papers on Economic Activity, 2010, :

29 21 Figure 5.3. Securitization is a market of grand significance with the potential of achieving high-efficiency thanks to its structure that enables it to create a large bulk combined with a large number of minor components resulting in desired overall very specific risk/yield ratio Special purpose vehicle To fully recognize the effectiveness of securitization, it is critical to understand the structure of special purpose vehicles. A special purpose vehicle has only one purpose and that conducting the specific transaction it was created for, which also implies that it holds no private decision power, in fact, it employs no labour and has no tangible location. 35 The restrictive rules directing special purpose vehicles are placed in advance and strictly limit their activities. Special purpose vehicles possess two key features. First of all, they are so called bankruptcy remote. Being bankruptcy remote 35 GORTON, Gary B.; SOULELES, Nicholas S. Special purpose vehicles and securitization.the risks of financial institutions, University of Chicago Press, p

30 22 means that the case of insolvency of the sponsor (sponsor in this context means either the bank or the originating firm) has no impact on the special purpose vehicle, which essentially means that creditors of the insolvent sponsor are unable to claim the assets from the SPV. The second feature is that it can not legally bankrupt Securitisation summary Securitisation plays an essential role as credit provisioning tool, it supports funding of the banking system through the use of special purpose vehicles. Securitisation is also a great example of liquidity transformation, as it transforms illiquid assets, such as loans, into more liquid securities. However, according to ESRB SPV s exposure to liquidity risk is generally low with the exception of so called warehousing phase, or unless longer-term assets are being financed, as FVCs do not generally need to meet liabilities by liquidating assets in the market. 6.3 Repo operations Introduction The history of repo transactions can be dated back to the beginning of 20 th century in the United States of America where they served as an instrument of monetary policy. This way the central bank was able to provide liquidity to the market while mitigating the credit risk. Traditionally, the US Government debt bonds were common form of collateral. 37 Today under repo transactions we understand a deal where one party sells an asset to the second party at a certain price and agrees to purchase the same asset (or valid substitute) at given date in the future at given price. It is a loan where the asset is used as collateral and should the seller of the asset default to repay the debt the buyer can resell the asset to the third party to cover the loss. Meanwhile, the buyer has a temporary use of the asset and is able to sell it to the third party but has to buy the same asset before the pre-agreed maturity date. In some FABOZZI, Frank J., et al. Issuer perspectives on securitization. John Wiley & Sons, 37 World Bank. Financial Inclusion. Global Financial Development Report, 2014.

31 23 contracts, it is possible to return a substitute with certain pre-agreed properties instead of the original asset. This kind of agreements are still used as a part of central bank monetary policies, either to provide liquidity to banks or extract it, depending on the target, they are also used for interbank provisions of liquidity. Despite being a typical banking product, I have decided to include repo operations into my analysis. The reason is, that they are frequently utilized by shadow banking entities. 38 An example is hedge funds when they open a short position. Figure 5.4. is an example of a repo transaction displaying sale of a 10-year US treasury bond with a nominal value of $1000 for $1050 on and re-purchase of the same asset on for $1055. The $5 difference between the sale and repurchase is buyers return on the funds he lent to the seller. If calculated as a percentage per annum it is called the repo rate. 39 The reverse repo is a common term describing the same transaction from the perspective of the seller. 38 ICMA, International Capital Market Association. [online]. Is repo a type of shadow banking? P. 35 [Accessed ]. Available from: 39 Scott, David L. Repo Rate Definition. Financial Dictionary [online] [Accessed ]. Available from:

32 24 Figure Use of repos Safe investment opportunity repo buyer earns interest while having the asset as collateral. Repos are a desirable investment for investors with large amounts of unused funds since they frequently supply enhanced return in comparison with bank deposits and provide a safe alternative to uninsured deposits. 40 At the moment the standard deposit insurance across Europe is up to This arguably covers the needs of an average working/middle-class citizens, but not the needs of wealthy individuals, larger corporations or investment groups. Source of cheap credit repo seller can obtain cheap funds backed by security that is highly demanded in the market and use it for reinvestment and thus increase the profit. The way of financing the long position in the same asset similar to the previous example, if the repo seller believes the price of the asset will rise he can use the asset as collateral and obtain funds to purchase the same security. If the generated 40 ACHARYA, Viral V.; ONCU, T. Sabri. A proposal for the resolution of systemically important assets and liabilities: the case of the repo market European Commission. A European Deposit Insurance Scheme (EDIS) Frequently Asked Questions. Fact Sheet, 24 November, 2015.

33 25 interest from holding the asset plus the increased market value of the asset is bigger than the repo rate then the buyer made money. 42 Tool for taking a short position when repo buyer believes the price of the asset will fall he can sell the asset and purchase it later before maturity of the repo agreement for a lower price. In addition, he receives additional income dependant on the repo rate but loses the right to interest generated by the asset until the maturity of the contract. In this case, the investor should also account for the fact that there is a limit on how much the price of an asset can fall, but not on how much it can rise. Strong monetary policy tool for central banks all over the world as mentioned before, the original purpose of repo transactions was a monetary policy that efficiently provides liquidity to the market, primarily in emergency situations during the crisis. The securities used as collateral work to mitigate the credit risk of the loans. Hedging repos are a useful tool to hedge your position via opening a long or short position, in opposition to the currently opened one. An example is the primary debt market. Underwriters in demand of lowering risk of a long position in newly issued debt have an option to use hedging by opening a short position in existing bond with comparable risk properties. The short position is executed with use of repo by borrowing the security in the market. As a result of lowered risk for the underwriter bond issuing becomes possibly cheaper for issuers. 43 An equivalent method of hedging is used also in other markets such as derivative markets. To sum it up repo operations are a powerful tool for raising funds to invest into long positions and establishing short. By their nature, they provide liquidity to the market and are essential for risk management for any type of financial market participants from end-users through intermediaries to monetary policy makers SUNDARESAN, Suresh. Fixed income markets and their derivatives. Academic Press, ICMA, International Capital Market Association. [online]. Why is the repo market so important and why has the use of repo grown so rapidly? p. 3. [Accessed ]. Available from: 44 ICMA, International Capital Market Association. [online]. How is repo used? p. 2. [Accessed ]. Available from:

34 Current repo regulation Repo operations are subject to numerous direct and indirect regulations and laws established and enforced by various regulatory bureaus worldwide. In European union, repo operations are most significantly regulated by EU Financial Collateral Directive and by the Short Selling Regulation, which regulates them directly, and secondarily by indirect regulations under Basel III, or other such as MiFID, MiFIR and Securities Law Directive Risks The primary exposure of repo operations is the counterparty credit risk, moreover, the risk arises from potential default of the underlying security serving as collateral. To decrease the overall credit exposure is good to diversify the risk. This can be done by choosing collateral, that is not directly correlated with the credit risk of the counterparty. The high probability of default of counterparty can be mitigated by liquid collateral, that can be sold easily in times of stress. 45 Evidence suggests, that repo operations are generally short-term contracts and based on trading volumes also very liquid and thus there should not be significant liquidity risk under standard market conditions. 46 The problem arisis during the time of systemic contagion, when both the counterparty and the underlying securities simultaniously default on a large scale. According to ESRB, repo operations contribute to the high level of interconnectedness between monetary financial institutions. The majority of repo transactions that take place are interbank, however, they generate links between banking and shadow banking as well. From the systemic risk point of view, this relationship creates a possible systemic contagion channel ICMA, International Capital Market Association. [online]. Is repo riskless? p. 15. [Accessed ]. Available from: 46 ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, , ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report,

35 Derivatives Introduction The derivative is a type security, whose price is determined by the price of at least one underlying asset and fluctuates along with price fluctuation of the underlying asset. Derivative contracts may be used for hedging purposes, and to create a synthetic leverage, and are widely utilized by shadow banking entities for such purpose. Banks are a subject to strict regulatory requirements under Basel III and other regulations, when there is a lack of acceptable collateral present on the market, shadow banking entities re-use available collateral to back a significant volume of transactions, while much of this capital, for example in the form of margin, is not listed on the balance sheet. 48 There are two basic markets for trading derivative contracts. Derivatives are traded either via an organised exchange or over the counter. The Table 5.1. shows the difference between over the counter (on the left side) trading and trading on an exchange (the right side). Table 5.1. OTC vs Exchange trading Over the counter Exchange trading Contracts Customized Standardized Pricing Margin Liquidity Credit risk Settlement Based on agreement between the buyer and seller according to their internal methodology Usually none In case of easily accessible exchange present, the OCT traded securities are illiquid Exposure is to the counterparty Can be cash or physical delivery of commodity Standardized A % of trade, set and managed by clearing house Considerably higher level of liquidity in comparison with OTC Exposure is to the exchange Primarily cash 48 SINGH, Manmohan. The economics of shadow banking. Liquidity and Funding Markets, Reserve Bank of Australia, Sydney, 2013, p

36 28 49 The origins of derivative contracts can be traced back to ancient times when contracts for future delivery of commodities spread between Rome, Mesopotamia and Egypt. 50 Since then, the derivative contracts have been used by investors throughout history to mitigate various types of risk. Further, I will illustrate four most common types of derivative contracts used today Options An option is a type of derivative contract sold by the option writer (the seller) to the option holder (the buyer). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). The holder typically pays a premium to the writer. 52 Table 5.2. shows the rights and obligations of parties involved in options contracts. Table 5.2. OPTIONS Option holder Option writer PUT Right to sell stock at agreed price Obligation to buy stock at agreed price CALL Right to buy stock at agreed price Obligation to sell stock at agreed price Futures A futures contract is a legal agreement, to buy or sell particular commodity or financial instrument at a predetermined price at a specified 49 NAPF, National Association of Pension Funds. Derivatives and Risk Management Made Simple. Guidebook, December, WEBER, Ernst Juerg. A Short History of Derivative Security Markets Derivatives Investment. [online]. Understanding The Types Of Financial Derivatives [Accessed ]. Available from: 52 Investopedia. [online]. Option Definition [Accessed ]. Available from: qsrc=0&o=40186&lgl=rira-baseline-vertical

37 29 time in the future, detailing the quantity and the quality of the commodity. They are commonly traded on designated exchange. 53 Figure 5.5. depicts the basic futures contract. In Step 1, on 3rd of March, the jeweller expects he will need 10kg of gold to manufacture a sufficient number of products to satisfy the demand in May. The gold mining company is looking to sell its commodity at a price that would cover the costs of production and generate profit. Neither the jeweller, and, neither the mining company are able to predict the price of gold at May, so they decide to sign a contract specifying that the jeweller will purchase 10kg of gold of given quality at $ per kg, a price at which both parties are profitable. Futures contract thus works as a form of insurance against price movement of the underlying security. Figure Investopedia. [online]. Futures Definition [Accessed ]. Available from: qsrc=0&o=40186

38 Swaps A swap is a type of derivative contract through which two parties exchange financial instruments. The common types of swaps are interest rate swaps, currency swaps, credit default swaps, commodity swaps and equity swaps. Most of them involve cash flows mutually agreed by both parties, while the principal typically stays within the original owner. Swap contracts are typically traded over the counter, between both financial institutions and non-financial corporations. 54 The Figure 5.6. shows an example of credit risk swap. Credit default swaps are similar to insurance, however, insurance is typically subject of considerably more demanding regulatory requirements and when purchasing insurance, the protection buyer must be personally exposed to the risk event, while in case of swap, the protection buyer does not have to own the underlying asset. To sum up the credit default swap, the protection buyer (risk seller) pays preagreed premium to the protection seller (risk buyer), and in return the protection seller has the obligation to compensate the protection buyer in case of default of the underlying security. Figure Investopedia. [online]. Swap Definition [Accessed ]. Available from: src=0&o=40186&lgl=rira-baseline-vertical

39 Forward contracts Forward contracts are similar to the futures contracts, however, they are usually traded over the counter instead of exchange Risks Derivatives are used to build up leverage to enhance the profitability of open positions, however, this synthetic leverage may increase procyclicality. This causes a systemic problem in times of global turmoil by enhancing the effects of the crisis. 56 One of the main risks associated with derivative contracts is a counterparty risk. When the derivatives are traded in OTC setting, there is little regulation present, no standardization of contracts, no centralized entity, such as clearing house, that would oversee the legal structure, proper documentation and estimate credit risk, and to ensure sound cash flow by protecting the position. Due to the non-standardized nature of OTC traded securities, many investors are not able to properly recognize the counterparty risk. It is also important to note, that credit default swaps can be issued by dealers, without actually owning the debt. Such problem occurred in the crisis of 2007 when the collected value of unregulated OTC traded derivatives was estimated to be $600 trillion, with credit default swaps expected to amount $35-65 trillion. 57 Without proper clearing, requirements to ensure that credit default swaps were properly capitalized, and without requirements that would allow investors regularly update pricing of those assets, unaware investors betting on rising property values invested into credit default swaps based on mortgages without recognizing their subprime status. After the sudden decline of house prices, Lehman Brothers, a firm that was involved in approximately over the counter traded derivatives either as a counterparty or as an underwriter did not pose sufficient capital to meet their obligations and thus had to file for bankruptcy. This sparked a chain contagion, markets became uncertain, even the largest financial corporations could not be trusted as it was unclear, which of them were holding worthless assets. from: 55 Investopedia. [online]. Forward Definition [Accessed ]. Available 56 ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, GREENBERGER, Michael. The role of derivatives in the financial crisis.testimony before the Financial Crisis Inquiry Commission, June 30, 2010.

40 32 As a follow-up, uncertainty caused tightening of credit causing more financial institutions to fail to meet their financial obligations. The problems were facing banks as well as shadow banks GREENBERGER, Michael. The role of derivatives in the financial crisis.testimony before the Financial Crisis Inquiry Commission, June 30, 2010.

41 33 6. Funds 7.1 Introduction The concept of pooling assets for investment purposes can be dated back to 18 th century Netherlands. In 1822, Dutch king William launched several closed-end investment companies, the first known mutual funds, although some speculate that he was inspired by Dutch merchant Adriaan van Ketwich, who established investment trust in The creation of the modern fund is considered to be establishment of the Massachusetts Investors' Trust in Boston in 1924 which went public in 1928, later producing the mutual fund company known as MFS Investment Management. Ultimately, the key idea behind the creation of mutual funds is such, that they allow for wide asset diversification even to investors with limited volumes of capital. 59 The Figure 6.1. shows a simplified scheme of how investment funds operate. In step 1, investors pool money into a fund and thus gaining access to diversified investment. In step 2, the fund manager creates a strategy and purchases securities from the broker. In step 3, securities generate a return by interest gains and portfolio price appreciation. In step 4, the gains are paid out to investors, who may then choose to either spend or re-invest them. Figure MCWHINNEY, James E. A Brief History Of The Mutual Fund. Investopedia [online] [Accessed ]. Available from:

42 Open-end, close-end and exchange traded funds Before proceeding, it is important to understand the difference between openend, close-end and exchange traded funds. Even though they seem similar, there are some noteworthy differences between the three. 60 Open-end mutual fund shares are traded on demand for their net asset value, which is calculated at the close of the trading day according to underlying securities. Close-end mutual fund the number of shares is fixed and they are traded according to demand and supply between investors. Exchange traded fund (ETF) shares are traded similarly to close-end funds, however, the discounts and premiums usually stay within the range of 1% of the net asset value. 7.3 Money Market Mutual Funds Introduction Money market mutual fund (MMMF) is type of investment fund maintaining a fixed net asset value of $1 per share (possibly 1, 1 or other denomination). A money market fund s portfolio is comprised of high-quality, short-term or less than one-year securities, liquid debt and monetary instruments. Money market mutual funds are nowadays one of the key financial market participants. According to ICI data, worldwide assets of regulated open-end MMMF`s are now over $5,15 trillion. 61 Investors can purchase shares of money market funds directly from the firm, independent broker or a bank. The popularity of money market mutual funds was elevated in the 1980s and 1990s when mutual fund 62 investment hit record highs, generating remarkable returns. 60 FOSTER, Michael. 3 fund types: Open-end, closed-end, ETFs. Bankrate [online] [Accessed ]. Available from: 61 ICI, Investment Company Institute. [online]. Worldwide Assets and Flows for Regulated Open-End Funds First Quarter [Accessed ]. Available from: 62 MCWHINNEY, James E. A Brief History Of The Mutual Fund. Investopedia [online] [Accessed ]. Available from:

43 Popularity By definition, money market mutual funds provide an alternative to a common savings account. They belong to the open-end fund category, and their shares are generally tradable on demand on the day of request, in some cases the next trading day, which makes them comparable to a savings account in terms of liquidity. The advantage of MMMF s are the higher returns they provide to investors in comparison with savings accounts, another advantage is for wealthy individuals and institutional investors, who are looking for safe short-term investment. As I stated in the previous chapter, saving accounts are insured up to in the European Union and $ in the USA, which is not nearly sufficient enough. MMMFs thus provide a safe alternative, where the investment is backed by a diversified portfolio of high quality, liquid securities such as government bonds, with the second layer of protection provided by sponsors. Sponsors are the MMMFs asset management firms and their parents and affiliates, these companies have an interest in keeping the promise of constant net asset value per share, so the reputation of the fund remains intact. Figure 6.2. depicts the standard operations of MMMF. In step 1, government and highly rated, privately owned companies issue bonds and offer them for sale through the broker. In step 2, the fund is set up by an entity, that becomes a sponsor, who will provide necessary support to ensure that the net asset value remains constant. In step 3, the investors pool their resources to the fund. In step 4, the fund purchases highly rated, almost risk-free securities from the broker.

44 36 Figure Breaking the buck Breaking the buck is an expression used to describe a situation when net asset value per share of money market mutual fund lowers below $1 (buck being a slang term for US dollar). There are only two reported cases of such situation occurring. Since the SEC (Security and exchange commission) adoption of new rules governing MMMFs in 1983, the first fund to break the buck was Community Bankers US Government Fund in The second case happened on September 16, 2008, when the Reserve Primary Fund (the Reserve Fund ) broke the buck due to its exposure to Lehman Brothers debt securities amounting $785 million, which totalled over 1.2% of net assets of the fund. According to analysis executed by Federal reserve bank of Boston in 2012, based on data collected from MMMF end of fiscal year financial statements, 21 funds would have broken the buck since 2007 and at least 31 in the fully extended period, if it

45 37 was not for the intervention of sponsors, however, in the two critical cases the sponsors were unable to provide sufficient support Risks The core risk in MMMFs arises from the so called runs fueled by liquidity transformation. An example of this situation is the previously mentioned fail of the Reserve fund in After suffering heavy losses, since there are no restriction or penalties for instant redemption, investors started to cash their shares in high volumes. As a consequence, the fund was under pressure to fire sell assets and since it happened during an already stressful period, even the highly liquid assets were sold under their value resulting in even higher losses. Other investors recognizing the threat started cashing their shares in other funds exposed to Lehman Brothers Securities and situation started to spiral Hedge funds Introduction With almost currently operating with combined assets over 3 trillion USD worldwide, hedge funds are a significant part of Shadow Banking. 65 The original creator of a Hedge fund was Alfred Winslow Jones in Jones es strategy of the hedge fund is to find assets that are expected to outperform the general market and use them to open long positions and find assets that are expected to underperform the market and use them to open short positions in similar volumes. This strategy thus provides a shield against unexpected market movement. In case the overall market rises, the loss from short positions is mitigated by gains from the long positions 63 BRADY, S.; ANADU, K.; COOPER, N. The stability of prime money market mutual funds: Sponsor support from 2007 to Federal Reserve Bank of Boston, Risk and Policy Analysis Working Papers, RPA, 2012, BRADY, S.; ANADU, K.; COOPER, N. The stability of prime money market mutual funds: Sponsor support from 2007 to Federal Reserve Bank of Boston, Risk and Policy Analysis Working Papers, RPA, 2012, RITHOLTZ, Barry. Hedge Funds Are the Ultimate Survivors. Bloomberg [online] [Accessed ]. Available from: 66 HedgeCo.Net. [online]. The History of Hedge Funds [Accessed ]. Available from:

46 38 and in the case of unexpected slump of the overall market, the loss from long positions is mitigated by the gains from the short ones. Nowadays the strategies vary, however, they have certain common features which make them a potential threat to the stability of the financial sector. Hedge funds are significantly engaged in liquidity and maturity transformation, have a high level of leverage and are currently not subject to regulatory leverage limits 67. Although, it is fair to mention that in recent years, especially after the crisis of 2007 hedge funds are facing noticeably stronger regulatory requirements. In EU particularly under the Directive on Alternative Investment Fund Managers (AIFMD), that was approved by the European Union in This directive enhances reporting requirements and gives power to Financial Services Commission to impose leverage restrictions. This, however, applies only to special cases and thus the majority of hedge funds remain exempt from regulatory leverage requirements Leverage Hedge funds obtain leverage using a range of sources. Ability to acquire and utilize leverage depends on the solvency of the fund, type of traded securities and the exchange, on which the securities are traded. According to Ang, Inwegen and Gorovyy (2011), the majority of hedge funds gain their leverage through short-term funding. Some are able to issue long-term debt or secure long-term borrowing. A number of hedge funds use services of prime brokers, who commonly provide leverage as part of their package. 70 Another method of obtaining leverage is through use of derivatives. The good illustration is option contract, for example, if the fund manager believes that price of certain stock will rise significantly. Let s say the stock trades for 100, instead of buying shares and risking up to should the price of stock unexpectedly plummet, he may purchase call option for shares that would allow him to 67 ESRB, European Systemic Risk Board. EU Shadow Banking Monitor. ESRB Report, 2016, MFA, Managed Fund Association. [online]. Global Hedge Fund Regulation. Issues and Policy, [Accessed ]. Available from: 69 FSC, Financial Services Commission. Alternative Investment Fund Managers Directive AIFMs managing leveraged AIFs. Information page, ANG, Andrew; GOROVYY, Sergiy; VAN INWEGEN, Gregory B. Hedge fund leverage. Journal of Financial Economics, 2011, 102.1:

47 39 purchase shares at pre-agreed future date at today`s price and thus risking only the premium in case he chooses the option to expire after the price drop Operations Figure 6.3. depicts a simplified version of an operating hedge fund. In step 1, corporations wishing to sell their assets, such as stocks, bonds, commodities, currency, derivative contracts or other provide their assets to a broker. In step 2, hedge fund pools money from investors, who are expecting a positive return on their investment. Typically, the investors must be accredited, meaning that they have certain minimum level of resources, which means common investors are institutional investors such as pension funds, insurance companies or wealthy individuals. 71 In step 3, hedge fund raises resources to leverage its position in order to enhance potential gains. This is usually short-term financing, however, some hedge funds are able to issue a long term debt. Step 3 may happen directly, or by issuing bonds to be sold via broker. In step 4, hedge fund purchases assets from the broker, the types of assets depending on the strategy of the particular fund. In this step, the fund manager may also borrow the security and sell it to open a short position. More detailed description is provided in the repo operations section. Figure 6.3. Pub. 139 (2/13) 71 SEC Office of Investor Education and Advocacy. Hedge funds. Investor Bulletin, SEC