The unintended consequence of the Volcker rule provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Basel III that forced banks to close proprietary trading desks, reduce risk assets and maintain higher capital reserves was to dry up the credit market's primary source of liquidity.
Bank prop desks were the counterparties that credit hedge fund managers turned to most often because they maintained the inventory of credit securities on the bank's books in a warehousing function.
With that function long gone, “a lot of trades just don't happen. It's very inefficient. The market isn't supposed to work this way,” said an executive from a large credit hedge fund firm who requested anonymity because of concerns about moving the market.
Regulators made a trade-off when it came to regulating banks, the source said, increasing capital requirements to reduce risk while creating an extreme liquidity shortage and rendering markets much more inefficient.
“Regulation has had a meaningful impact on the markets,” agreed Craig Bergstrom, partner and chief investment officer of hedge funds-of-funds manager Corbin Capital Partners LP, New York.
Even as the size of the high-yield market rose significantly in the past 10 years, “far less is in the hands of market-makers and dealer inventory is much lower than it's ever been,” Mr. Bergstrom said.
Corbin Capital manages $4.6 billion.
“Nothing is trading. You have to make an appointment to trade these days. You used to be able to just pick up the phone any time and make a deal,” said William J. Ferri, group managing director and head of UBS Hedge Fund Solutions, New York.
A few of the casualties of the credit market's illiquidity problem have been fairly spectacular, sources said, pointing in particular to the implosion last year of credit manager Claren Road Asset Management LLC, one of the most institutional and respected hedge fund firms.
Other firms that manage relative-value or long/short credit hedge strategies said they are coping by scaling down or closing these strategies, at least for now, or evolving to master new market conditions.
The regulations that changed old-style trading practices are here to stay, Mr. Ferri said, noting that managers have no choice but to accept less trading.
“The solution? Your job is to adapt,” he stressed.
UBS' hedge funds-of-funds business managed $34 billion as of Jan. 1.