Structure, risk and evolving regulatory framework for hedge funds
(Last updated: )
By Josh Hammond – Team Lead at DRS
In today’s financial world, the term “hedge fund” has lost all of its original meaning. Originally, hedge funds were, as you’d probably predict, designed to “hedge” against market downturns by taking both long and short positions, with the aim of reducing overall portfolio risk – dating back since 1949.
However, the modern hedge fund has evolved far beyond this original intention. Today, the defining characteristic of a hedge fund is not necessarily its investment strategy, although that will be a relevant factor, but rather its investor base. They collect money from a limited group of accredited (high-net-worth) investors, and uses sophisticated, often aggressive strategies to pursue high returns for high risk. Hedge Funds are frequently domiciled in tax-advantaged jurisdictions, with the Cayman Islands being a particular favourite. Cayman exempted limited partnerships and exempted limited liability companies offer a combination of tax neutrality, regulatory flexibility, and well-established legal frameworks that appeal to global investor bases. Similarly, Delaware limited liability companies and limited partnerships remain popular for US-focused structures, benefitting from favourable state-level corporate law, flexible governance arrangements, and pass-through tax treatment. These domicile and set-up choices are driven by the practical need to accommodate investors from multiple jurisdictions without creating unintended tax consequences at the fund level. Approximately 60% of US hedge funds are legally domiciled/registered in Wilmington, Delaware, using the exact same handful of registered-agent addresses.
These funds tend to attract significant backing from sophisticated institutional investors, reflecting both the appetite for specialist strategies and the high barriers to entry that accredited investor requirements create. Such funds do not invite or advertise retail participation to the general public; rather, they operate in a domain where minimum investment thresholds, lock-up periods, and investor qualification standards are the norm.
Industry Growth and Scale
The hedge fund industry has experienced remarkable growth over recent decades, with global assets under management now measured in the trillions. This expansion reflects both the increasing sophistication of institutional investors seeking diversified returns and the proliferation of strategies available. The scale of capital now deployed by hedge funds means they represent a significant counterparty presence in derivatives markets worldwide. According to data collected by the Bank for International Settlements, hedge funds account for approximately 15% of non-dealer end-user activity in the global CDS market, while speculative arbitrage – a segment in which hedge funds are amongst the most active participants – represents roughly 36% of total derivatives market applications. More broadly, market research approximates that 58% of total derivatives market volume is attributed to institutional trading, with hedge funds forming a core component of that institutional demand. Their involvement spans equity derivatives, IRS, credit instruments and more.
Risk and Regulatory Considerations
With all forms of growth comes scrutiny. The regulatory environment surrounding hedge funds has tightened considerably since the 2008 financial crisis, with jurisdictions implementing enhanced reporting requirements, leverage constraints, and investor protection measures. From a counterparty perspective, while all buy-side firms pursue alpha or operate against set performance targets, the risk profile of hedge funds presents unique considerations: their pursuit of alpha often involves concentrated positions, leverage, and exposure to illiquid assets, which collectively warrant more careful assessment than might be required for traditional long-only managers. These characteristics demand rigorous due diligence and ongoing monitoring to ensure that counterparty exposures remain within acceptable bounds. Although, the associated regulations for hedge funds are much lighter for mutual funds, largely because, as we spoke about earlier, they are restricted to sophisticated or institutional investors who have been deemed capable of bearing greater risk and conducting their own due diligence. This distinction has historically justified a lighter touch from a regulatory standpoint, affording hedge funds greater flexibility in their investment strategies when compared to retail-facing vehicles such as mutual funds or UCITS for example.
Recent Market Trends
The hedge fund landscape has shifted considerably in recent years, with multi-strategy platforms emerging as the dominance force in the industry. Some US hedge funds have all grown to manage assets well in excess of $50 billion each, operating what are effectively diversified trading businesses under a single institutional umbrella. Many funds deploy capital across hundreds of semi-autonomous portfolio management teams (the platform’s own branded fund teams), each running distinct strategies. Their scale and diversification set them apart from the single-manager hedge funds that defined the industry in past decades. The structural shift has implications for counterparty assessment: multi-strategy platforms tend to have more stable NAV profiles due to their internal diversification, but they also carry substantial gross leverage and complexity (such as compartmentalised arrangements) that can make it more challenging for banks’ credit teams to assess the counterparty’s credit risk.
Prime Brokerage
The vast majority of institutional hedge funds maintain relationships with multiple “prime brokers” simultaneously, a practice which has continually accelerated since the financial crash given the subsequent concerns around single-counterparty concentration risk – particularly following the collapse of Lehman Brothers in 2008, which left numerous funds unable to access assets held in custody. In essence, a prime broker acts as the fund’s principal intermediary with the broader financial markets, enabling it to pursue its strategies at scale and across multiple asset classes. The Prime broker provides access to additional leverage – whether through margin lending against a portfolio of securities or through synthetic exposure via derivatives – the prime broker enables the fund to take positions far larger than its capital base alone would permit. The multi-prime model carries important implications from a credit perspective: no single bank has full visibility over a fund’s aggregate exposures or overall portfolio composition. For banks and dealers, this relationship underscores the importance of robust NAV-related triggers and reporting obligations within ISDA documentation, as well as careful scrutiny of the fund’s constitutional documents and the mechanics of its NAV calculation.
Credit Perspective and ISDA Documentation
For banks and dealers entering into derivatives transactions with hedge funds, the ISDA becomes the fundamental tool for managing risk, from the broker/dealer’s perspective. One area of particular focus is the treatment of Net Asset Value (NAV for short) under the ISDA. We often see banks attempting to implement performance related events, within the ISDA, tied to the decline in NAV of the hedge fund, which would trigger events of default or termination events. There will often be a consideration to include a hard NAV threshold, which will usually be said to trigger an Additional Termination Event, or Event of Default, if the fund’s NAV falls below a fixed figure. Another common provision included involves rolling decline triggers that activate upon percentage drops over defined period, whether monthly, quarterly or annually, all pertaining to the hedge fund’s NAV. Each approach carries distinct implications for how credit risk is monitored throughout the life of a trading relationship.
The rise of multi-strategy platforms demands an even more nuanced approach. The provisions mentioned above, including standard NAV decline triggers and cross-default clauses, may need to be carefully tailored to account for the compartmentalised structures the platforms employ, where losses in one strategy sleeve may or may not affect the fund’s overall NAV or its ability to meet its obligations under a particular trading relationship. The sheer scale of the platforms’ trading activity – and the corresponding volume of financing documents that they generate – means that banks invest significantly in their onboarding, monitoring and periodic review processes.
What Role Can Tech Play Here?
Well, once a NAV drops below a certain figure, everyone’s question is what will happen to the ISDA. AI-powered tools, including DRS’ very own Ark 51, are increasingly being deployed across the documentation lifecycle – from automated extraction and comparison of key ISDA terms and NAV trigger provisions to the identification of anomalies and inconsistencies across large portfolios of trading agreements. Once you have all that information readily available you can easily answer that fundamental question within seconds. For banks making relationships with multi-strategy platforms that generate hundreds of financial documents, AI tools offer the ability to streamline onboarding workflows, flag non-standard or missing provisions (when compared with a bank’s template, for example), and support more consistent periodic reviews at a pace and scale that would be impractical through manual processes alone.
If you’d like to learn more about how DRS can help, reach out to our Director, Rallie Shiderova, at
ralitza.shiderova@drs-als.com