Obama proposed banking reform is mixed blessing for hedge funds

The hedge fund industry could be affected both positively and negatively if US president Barack Obama pushes through proposals to break up the banking sector.

In a surprise move Obama announced reforms calling for a ban on banks owning, sponsoring or investing in hedge funds or private equity funds. Proprietary trading would also be banned under the proposals.

Initial reaction focused on what 'proprietary trading' means in practice and to what extent banks' prime brokerage businesses would be hit by the reforms, the most far-reaching since the passing of the Glass-Steagall Act of 1933 passed in the aftermath of the Great depression.

A senior industry source told Hedge Funds Review Obama's plans could result in a flow of assets from banks to independent hedge funds.

"On the other hand the industry would presumably lose out on prime brokers," said the source.

Former Goldman Sachs trader turned hedge fund manager Christopher Clarke said: "This is just another nail in the coffin of banks. Goldman's profits come from proprietary trading. If you take that away, you can guess the outcome."

Clarke predicted people would leave banks for hedge funds, something he saw as a plus for the hedge fund industry.

On the other hand this could seriously affect the prime brokerage businesses on which hedge funds rely. In addition the flow of assets into hedge funds via banks might be affected.

What the reforms may mean for institutional investors, particularly pension funds and endowments, is another unanswered question.

Tullett Prebon's head of alternative investments Neil Campbell said: "I think these proposals will have far reaching effects on the whole industry. So much of it is interlinked in terms of banks' business and the prime brokerage business."

Announcing his proposals, Obama said: "We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidised by taxpayers and that could pose a conflict of interest. And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses."

The proposals could have a wider and more serious impact on the fund of hedge fund (FoHF) operations of US banks. According to research by Preqin, 19 FoHF units of US banks could be hit by the restrictions. These FoHFs represent over $180 billion in assets or around 16% of all US capital flowing into hedge funds, according to alternative assets industry information provider Preqin.

If banks were restricted in their management of FoHFs, this could impact hundreds of hedge funds in the US and internationally, noted Preqin. It would also have an effect on institutional investors such as US public pension funds, endowments and insurance companies which have assets invested in these vehicles.

Preqin said the US banks involved in the hedge fund industry and most likely to be heavily affected by the proposals include Goldman Sachs, BNY Mellon, Credit Suisse and JP Morgan.

“Although the full implications of Obama’s statement remain unclear, the potential disruption that such widespread reform could bring to the alternatives industry is significant, and could affect hundreds of banking institutions in the US investing in alternatives,” commented Tim Friedman of Preqin.

He said there is likely to be a knock-on effect “for the hundreds of investors in funds and funds of funds managed by these firms”.

Although the situation is unclear, he said the proposals could lead to a “widespread spinning out of alternative assets divisions within banks”.

Andrew Baker, CEO of the global hedge fund association Alternative Investment Management Association (AIMA), admitted the proposals from Obama were not clear and gave a lukewarm reception to the ideas.

"Although the proposals could create welcome opportunities for the global hedge fund industry, we are concerned about the possibility of liquidity in markets being reduced and the prime broker relationship being adversely affected," said Baker

The US proposals were welcomed by UK politicians. The Liberal Democrats' shadow Chancellor of the Exchequer Vince Cable said: "We must break up British banks to ensure that taxpayers are not forced to underwrite unnecessary risks and to make the system more competitive. What is clear is that we would not be acting alone. We are already lagging behind the US."

If the UK follows the lead of the US and passes similar reforms, this could also cause a dramatic increase in the number of companies caught by the draft European Union alternative investment fund managers law. In its current form the directive excludes assets held by credit institutions or investment companies authorised by the markets in financial instruments directive (Mifid).