Shadow banking is back and is now Hedge Funds

As banks abandon debt trading, hedge funds that bet on bonds and loans are pulling in money from investors and hiring traders. Debt-focused hedge funds drew $41.4 billion from pension plans, wealthy individuals, and other investors in 2012, the most since 2007, according to data from Hedge Fund Research. They managed a total of $639.7 billion as of March 31, HFR data show, surpassing stock-trading hedge funds, with $638.7 billion.

Regulators are demanding that banks curb proprietary trading—betting with their own money—and hold more capital to back riskier investments. That’s allowed hedge funds to expand in businesses the banks are leaving, including distressed-debt trading and fixed-income arbitrage, a strategy that seeks to exploit short-term price differentials. “Hedge funds are playing in asset classes where they previously hadn’t played,” says Jason Rosiak, head of portfolio management at Pacific Asset Management.

Hedge funds specializing in debt trading are still minnows compared with Wall Street’s largest houses. BlueCrest Capital Management, Pine River Capital Management, and Millennium Management, three of the fastest-growing funds, have combined assets of about $67.6 billion, according to people with knowledge of the matter who asked not to be identified because the information is private. JPMorgan Chase’s (JPM) corporate and investment bank had an average of $413.4 billion in assets designated for trading in the first quarter.
Still, the hedge funds are growing rapidly, luring bankers from JPMorgan, Deutsche Bank (DB), Barclays (BCS), Bank of America (BAC), and others. BlueCrest doubled its New York staff in the two years through December, while Pine River increased its global workforce by a third in 2012. Millennium expanded its staff by 32 percent, to 1,250 people, last year. James Staley, the JPMorgan executive who was once seen as a candidate to run the company, quit in January to join $13.6 billion hedge fund firm BlueMountain Capital Management. “There’s a continuous brain drain on Wall Street,” says Rosiak.
One reason for banks’ retreat is the 2010 Dodd-Frank Act’s Volcker Rule, which seeks to curb proprietary trading. While the Volcker Rule hasn’t taken effect because regulators are still working out the details, some banks have closed proprietary trading desks.
Hedge funds, which are considered part of the less regulated “shadow-banking” system, are not subject to the rule. The idea behind regulators’ push to move debt trading from banks to hedge funds is to transfer the risk “into relatively small repositories that will be relatively insignificant if they fail,” says Roy Smith, a finance professor at New York University’s Stern School of Business. “The regulatory posture in the U.S. and in Europe is unequivocal. They want to transfer risk to the shadow-banking system.”
Yet moving risk to hedge funds does not make it go away. In 1998 hedge fund Long-Term Capital Management lost more than $4 billion after a debt default by Russia, mostly as a result of a fixed-income arbitrage strategy. The Federal Reserve was so concerned about the impact that it arranged a bailout paid for by banks. “If the hedge fund firms fail,” says Smith, “the real question is, to what degree will the market suffer from it?”