Fund of hedge fund managers and their lending partners have developed products that allow the funds to utilize their liquidity facilities to ease liquidity and operational burdens associated with the funds’ foreign exchange transactions. Recent changes in the margin rules in the United States and abroad may raise issues for these solutions.
MASTER-FEEDER STRUCTURE AND FX HEDGING TRANSACTIONS
Funds of hedge funds are often structured as masterfeeder funds. Such a structure allows the investment manager to manage a single portfolio of investments in underlying hedge funds while offering its investors multiple investment vehicles, in the form of feeder funds, that are created to meet the needs of different types of investors. Feeder funds are used, among other things, to provide flexibility with respect to investor tax status, to provide different return and risk models (such as a leveraged feeder fund) or to accommodate other administrative features tailored to the needs of the investors in the master fund.1
In addition, feeder funds are used to permit investors to invest using currencies that differ from the currency in which the hedge funds held by the master fund are denominated. For purposes of this discussion, we will assume a structure with a non-US Dollar-denominated feeder fund (a “Non-Dollar Feeder”) investing into a US Dollar-denominated master fund.2 In this scenario, the Non-Dollar Feeder holds US Dollar-denominated assets (the master fund shares), but is required to make any payments to its investors in a non-US Dollar currency, resulting in exposure to fluctuations in the exchange value between the two currencies (the “FX Exposure”). Because its investors are not typically seeking exposure to currency fluctuations, the Non-Dollar Feeder will hedge this FX Exposure.
The Non-Dollar Feeder will often hedge its FX Exposure by entering into foreign exchange forward transactions (each an “FX Transaction”) with a financial institution, and it will roll these transactions as they expire.3 The Non-Dollar Feeder is not a rated or otherwise creditworthy entity and would typically be required to post both (a) initial margin (usually in the form of an independent amount under an ISDA Credit Support Annex) and (b) any daily mark-to-market of the FX Transactions not in its favor. 4 Because its investment strategy is to remain fully invested in master fund shares, the Non-Dollar Feeder would generally prefer to margin its obligations under FX Transactions by pledging its interest in the master fund shares.
RISE OF FUND OF HEDGE FUND FINANCING TRANSACTIONS
One consequence of the 2008 financial crisis was to highlight both (a) the mismatch between the redemption rights offered by funds of hedge funds and the liquidity of their assets (i.e., their hedge fund portfolios) and (b) the role that liquidity facilities could play to address that mismatch. Prior to 2008, it was not uncommon for a fund of hedge funds that did not employ a leveraged investment strategy to not have a financing facility in place. In the years following the financial crisis and continuing to the present, liquidity facilities have become much more common, to the point where most funds of hedge funds above a certain size now have a liquidity facility in place with one or more financial institutions, and these facilities are often in place at the feeder-fund level— the discussion here will focus on such a facility in place at a Non-Dollar Feeder.
Under such a facility (the “Facility”), the Non-Dollar Feeder pledges all of its master fund shares in favor of the Bank (in its capacity both as lender and swap counterparty) to secure all of its obligations under the Facility. By drafting the Facility to permit the NonDollar Feeder to enter into FX Transactions with the Bank (or one of its affiliates) and to include the settlement amount of such FX Transactions as an obligation secured by the pledged collateral, the parties are able to secure the Non-Dollar Feeder’s obligations under its FX Transactions without requiring the NonDollar Feeder to keep cash on hand or to maintain the operations necessary to meet daily margin calls.5 Note that the same result can be achieved through a facility at the master fund level by having the master fund (x) guarantee the Non-Dollar Feeder’s obligations under the Non-Dollar Feeder’s FX Transactions and (y) pledge its custody account in which its portfolio of investments in hedge funds is held to secure both the master fund’s obligations under the Facility and its obligations under such guarantee.6
Such a Facility provides a solution to the Non-Dollar Feeder’s needs both for a liquidity facility and to hedge its FX Exposure, while permitting it to remain fully invested in master fund shares. From the perspective of the Bank, it has already (in connection with the liquidity facility) taken the risk decision that it is willing to lend against the master fund shares and/or portfolio of hedge funds held by the master fund, so by extending the security grant to cover obligations under the FX Transactions the Bank is able to provide an attractive solution to its fund of hedge fund clients. This solution only works so long as the master fund shares are eligible collateral to secure the FX Transactions.
THE US MARGIN RULES
The Commodity Futures Trading Commission (CFTC) and the US prudential regulators have adopted margin regulations (the “US Margin Rules”) for uncleared derivative transactions. Generally, under the US Margin Rules, the exchange of margin is required with respect to uncleared derivatives entered into with CFTC registered Swap Dealers or Major Swap Participants on or after March 1, 2017. The US Margin Rules also prescribe the types of collateral that may be delivered to satisfy the requirements thereof. Master fund shares are not a permissible collateral type under the US Margin Rules. The US Margin Rules generally apply to all types of uncleared derivatives (including FX Transactions); however, there are exceptions for certain deliverable foreign exchange derivative transactions.
THE EU MARGIN RULES
The variation margin rules under the European Market Infrastructure Regulation (the “EU Margin Rules”)7 also went into effect on March 1, 2017. Generally, under the EU Margin Rules, the exchange of margin is required with respect to uncleared derivatives entered into between “financial counterparties” (or “FCs”) and “non-financial counterparties exceeding the clearing threshold” (or “NFCs+”) on or after March 1, 2017. However, entities classified as “non-financial counterparties below the clearing threshold” (or “NFCs–”) are outside the scope of the requirements.
The rules apply to all types of uncleared derivatives (including FX Transactions), but they include a few time-limited exemptions for certain types of trades. While the list of eligible collateral under the EU Margin Rules is quite broad, shares in the master fund would typically not qualify as eligible collateral.
POINTS FOR CONSIDERATION
In light of the US Margin Rules and the EU Margin Rules, fund of hedge fund investment managers and financial institutions currently engaged in or considering entering into transactions like the FX Transactions or any other uncleared derivative transactions should consider the following points to establish the scope of the margin obligation and its practical consequences:
• What is the applicable set of rules?
- Am I incorporated, or otherwise regulated, in the United States or the European Union?
- Is our trading relationship completely offshore and, as a result, not in scope of the US Margin Rules and/or the EU Margin Rules?
- Is there any reason that would make an otherwise offshore transaction subject to the US Margin Rules or the EU Margin Rules (such as an inter-affiliate guarantee)?
- In addition to the US Margin Rules and the EU Margin Rules, can any other regimes also be relevant?8
- Is there any risk of a transaction or relationship falling foul of the anti-evasion principles under the US Margin Rules or the EU Margin Rules (or any other relevant regime)?
• Is my trading relationship in scope?
For US Margin Rules:
- Is my counterparty a CFTC-registered Swap Dealer or a Major Swap Participant?
- Am I a Financial End-User?
For EU Margin Rules:
- Is my counterparty an FC or an NFC+?
- Am I an FC, or if I am not an EU entity, would I be classified as an FC had I been incorporated in the EU? 9
- If I am not an FC, is the aggregate volume of derivatives entered into by my global consolidated group sufficiently low for me to be classified as an NFC–?
• Is the relevant transaction in scope?
- Is the product that I am trading in scope of the relevant set of margin rules?
- Are there any exemptions available?
- Does the transaction include any features that would take it outside the scope of any relevant exemption?10
- If an exemption is available, is it time limited?
• How do I ensure compliance with the US Margin Rules or the EU Margin Rules?
- Do I have the necessary documentation in place (such as the ISDA Master Agreement and an ISDA Credit Support Annex)?
- Is the documentation fully compliant with the new requirements?
- Are the shares in the master fund within the scope of eligible collateral?11
- Do I otherwise have access to assets that are eligible collateral under the relevant rules that I may be able to post to my counterparty?
- Am I operationally able to comply with the relevant requirements?12