Breaking Free from Collateral & Cash Drag: How Brokers Unlock Capital for Returns
Breaking Free from Collateral & Cash Drag: How Brokers Unlock Capital for Returns
Previously we explored how the collateral required to hedge FX exposures with banks or prime brokers creates cash drag, eroding private credit returns.
But why is it so hard for private credit funds to access hedging lines?
The answer lies in regulation.
Banks are constrained by Basel III and Dodd-Frank rules, which require them to provision capital against uncollateralized exposures and register as swap dealers. Structurally, this prevents them from extending meaningful credit lines to private credit funds for FX hedging.
So what’s the alternative?
Specialist brokers, like my own firm, are regulated differently, and may have less constrained balance sheets, and ROIC (Return on Invested Capital) that are higher than lenders. Most importantly, they may have specialist underwriters willing to go the extra mile in due diligence while servicing the commercial requirements of their clients.
Often specialty brokers are able to furnish clients with hedging lines that require less upfront collateral (and at times, no collateral), with flexible or no margin requirements, and have maximum tenors that can extend for years.
This creates an entirely different economic outcome for funds. Instead of tying up 5-15% of capital to support hedges, 100% of fund capital remains deployable into yield-generating assets.
Historic Rate Rolls (HRRs): A unique tool
Prior to the Global Financial Crisis era, Historic Rate Rolls (HRR) were quite common. Instead of being obligated to a cash settlement at expiry of a forward or swap, the swap could be extended with the execution rate adjusted to reflect the new forward rate (typically with a charge for the embedded credit extension). Since this charge is based on wholesale lending rates, fund managers would often opt for the HRR rather than tie up cash in the settlement of an OTM position.
Post GFC, HRRs have become scarce. The banks that used to provide these sorts of facilities have stepped out of the market. Instead, cash settlement at mark-to-market has become mostly mandatory. It’s rare that a fund manager would be happy to call investor capital to settle hedges, but sometimes they are left with no choice. Admittedly, that’s an extreme example; but even then the ability to roll hedge expiries to more effectively match short term liquidity means funds can stay closer to fully invested.
Why does this matter?
Returns matter. Every dollar immobilized by margin requirements or reserved to settle hedges is a dollar not earning a return. In a market flush with capital, where fund managers need to compete, brokers offering solutions that improve liquidity management offer a structural advantage: uncompensated risk reduction via FX hedging without sacrificing returns via cash drag.
Read the previous article in the series: Cash Drag: The Hidden Cost of Protecting Returns
Read the next article in the series: SPV Banking & Currency: The Hidden Bottleneck in Alternatives
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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