Some fund-linked derivative players are looking to start a secondary market for the underlying funds used in hedge fund indices. The move is being driven by the fact key dealers are close to butting up against risk limits for hedge fund exposure but don't have an effective way of laying off this risk. This means they might have to turn away new business.
European dealers held a meeting last month, led by officials from Standard & Poor's Hedge Fund Index and PlusFunds Group, the index's fund of funds manager, to discuss setting up an inter-bank market for hedge fund underlying. One fund-linked structurer said other index providers, such as HFR Asset Management and Credit Suisse First Boston with Tremont, would likely also be interested in easing hedging of structured products written on their indices.Lisa Hall, spokeswoman for Standard & Poor's in London, and Meir Kahtan, spokesman for PlusFunds in New York, did not return messages by press time.
Officials present at the discussion said dealers have done little since the meeting, explaining while there is still space on their fund-linked books, however limited, there is little incentive for them to help each other out. One fund-linked structurer complained, "There's been a lot of talk, but very little in the way of actual action." He said once top players reach their risk limits this will likely send them scrambling to establish a secondary market.
Some swaps of hedge fund gap risk, which aim to provide protection against a sudden significant fall in the fund's value, have already been traded between dealers, according to officials, but firms are looking for more precise ways to shift their hedge fund index exposure. Several dealers said Banque AIG is setting up to specialize in trading this secondary market risk. One official said this could be one way for firms which have arrived late on the fund-linked bandwagon to get a slice of the profits without doing battle for a position in the competitive primary market.Fabrice Perez, responsible for fund-linked trading at AIG in London, declined comment.
John Godden, managing director at fund of funds manager and index provider HFR Asset Management, said, "There's a lot of talk about banks trading risk around." He added half of structured hedge fund products are now index-linked.
