How to Launch a Relative Value Hedge Fund: Financing, Leverage and Liquidity for Arbitrage Strategies

To launch a relative value hedge fund, a manager has to secure the financing before the first trade: repo lines for the cash bonds, securities borrow for the shorts, prime brokerage margin, futures clearing and ISDA documentation with collateral terms, each in the fund's own name. The strategy makes small spreads into returns through leverage, so the operating risk is not the trade itself but whether the financing stays in place when spreads widen. A launch-ready relative value fund therefore pairs its financing stack with an unencumbered liquidity buffer, investor dealing terms that do not promise more liquidity than the financing allows, an offering document that discloses leverage and borrowing powers clearly, and an independent valuation process for convertibles, off-the-run bonds and OTC positions.

Relative value managers know their trades better than anyone. What they often underestimate on leaving a bank or a platform is how much financing they used to receive without having to ask for it. An independent arbitrage fund depends on repo, borrow and margin from counterparties who can change terms at short notice. The structure has to assume that will happen, and its buffers, dealing terms and disclosure should be designed for that day rather than for a quiet month.

David Lloyd, Chief Executive Officer at CV5 Capital

Executive Summary

A fixed income relative value, basis or convertible arbitrage strategy can be moved from a bank desk or a multi-manager pod into an independent fund, but the financing that supported it does not move with the trader. It has to be rebuilt, documented and stress tested for a new, smaller counterparty with no balance sheet history.

• Relative value returns depend on leverage, so financing terms, haircuts and margin determine whether positions can be held to convergence.
• Overnight financing against monthly investor liquidity is a mismatch; term repo, committed facilities and an unencumbered cash buffer reduce it.
• The SEC's Treasury clearing rule requires direct participants of a covered clearing agency to clear eligible Treasury repo and certain cash trades, with published compliance dates of 31 December 2026 for cash and 30 June 2027 for repo.
• CIMA's Rule on the Contents of Offering Documents requires a regulated fund to describe its material risks and indicate the techniques, instruments and borrowing powers it may use.
• CIMA's Rule on the Calculation of Asset Values requires a NAV calculated by a service provider independent of the manager, with priority given to observable market inputs.

Why Financing Is the Operating Risk in Relative Value

Relative value covers a family of strategies that buy one instrument and sell a closely related one, expecting the price gap between them to narrow. Each leg is hedged by the other, so the net market exposure is small, and the spread captured on each trade is small too. Leverage turns that spread into a return that justifies the fund. It also means gross positions are a multiple of capital, financed by counterparties.

The strategies differ in what they finance and where the financing comes from.

In every case, the trade can be correct and the fund can still lose money if a counterparty raises haircuts, calls margin or declines to roll financing before the spread converges. Federal Reserve Board staff have described the Treasury cash-futures basis trade as generally highly leveraged and exposed to both changes in futures margins and changes in repo spreads, and have written that hedge funds unwinding the trade likely contributed to the Treasury market instability of March 2020. That is the risk an independent relative value fund has to be built to withstand.

The Financing Stack an Arbitrage Fund Needs

A trader arriving from a bank desk or a multi-manager platform has often been financed through the employer's balance sheet or the platform's prime relationships. An independent fund starts with none of that. Each channel has to be opened, documented and onboarded in the name of the fund, and each comes with its own terms on what the counterparty can change and how quickly.

Two points follow. First, a single repo lender or prime broker is operationally simpler but concentrates the fund's ability to stay invested in one credit decision. Our analysis of prime broker counterparty risk, rehypothecation and segregation explains how the legal treatment of posted collateral affects what the fund recovers if a counterparty fails.

Second, the documents are where financing resilience is won. The termination events in an ISDA schedule, the notice period in a prime brokerage margin lock-up and the eligible collateral in a credit support annex all determine how fast a counterparty can withdraw support. The governance around them is covered in our guide to leverage limits, margin-call authority and prime brokerage protections.

Term, Haircuts and How Financing Behaves in Stress

Overnight repo is the cheapest financing available, and it is also the least committed. A lender that rolls the fund's repo every morning can raise the haircut, reprice the rate or decline to roll. Term repo, committed prime brokerage facilities and margin lock-ups cost more, but they fix the terms for a known period and push the point at which the fund can be forced to sell beyond the next day.

Haircuts are the lever that matters most. A haircut is the difference between the market value of the collateral and the cash lent against it, and it is effectively the fund's own capital in the position. When haircuts rise across a book, the fund must post more equity against the same positions or reduce them. In a relative value book, those calls often arrive at the same time as wider spreads and higher futures margin, which is the combination the Federal Reserve staff analysis identifies.

Counterparty withdrawal is the third channel. A lender can reduce or close a line for reasons unrelated to the fund, such as its own balance sheet constraints. Spreading financing across counterparties reduces the chance that one decision forces a liquidation.

A practical financing resilience framework, set before launch, contains six elements:

1. A maturity map of every financing line, showing overnight, open and term balances by counterparty.
2. A target for the share of financing on term or committed terms, reviewed as the book grows.
3. Concentration limits by financing counterparty, measured across repo, prime brokerage and derivatives together.
4. A stressed margin scenario combining higher haircuts, higher futures margin and the loss of the largest lender.
5. An unencumbered liquidity buffer sized to that scenario and monitored daily.
6. Escalation thresholds that bring financing changes to the board before they become forced sales.

Our article on the leverage and financing oversight board pack sets out how financing concentration, margin to equity and collateral reuse can be reported to directors each quarter.

US Treasury Clearing: What the SEC Rule Means for a Fund's Repo

Any relative value fund trading US Treasuries needs to plan for the SEC's Treasury clearing rule, which amended the standards for covered clearing agencies in Rule 17ad-22 under the Securities Exchange Act. A covered clearing agency that provides central counterparty services for US Treasury securities must require each of its direct participants to submit for clearance and settlement all eligible secondary market transactions to which that direct participant is a counterparty.

The definition matters for a fund. An eligible secondary market transaction includes a repo or reverse repo collateralised by US Treasury securities in which one of the counterparties is a direct participant. It also includes cash purchases and sales between a direct participant and either a registered broker-dealer, government securities broker or government securities dealer, or any counterparty where the direct participant operates a trading facility and stands between buyer and seller. The definition excludes transactions where the other side is a central bank, a sovereign entity, an international financial institution or a natural person, repos with a central counterparty, a state or local government, and qualifying affiliate repos.

In February 2025 the SEC extended the compliance dates by one year, to 31 December 2026 for eligible cash market transactions and 30 June 2027 for eligible repo transactions. A statement by SEC Commissioner Mark Uyeda on 7 August 2026 referred to the same dates and noted that the Commission had determined to reopen comment periods on related notices concerning requests for relief.

For a fund whose repo dealers are direct participants, the practical effect is that its Treasury repo with those dealers is expected to move into central clearing by the repo compliance date. The fund itself is not a direct participant. It accesses clearing as an indirect participant through a member, under one of the access models the clearing agency and its members offer. The rule also requires the clearing agency to calculate, collect and hold margin for a direct participant's own positions separately from margin for transactions submitted on behalf of indirect participants. For the fund, that means new access documentation, clearing house margin passed through by the member and a change in how repo margin is set, all of which belong in the stressed margin scenario.

Leverage Disclosure in the Offering Document

The Mutual Funds Act requires an offering document to describe the equity interests in all material respects and to contain the information a prospective investor needs to make an informed decision. CIMA's Rule on the Contents of Offering Documents for regulated mutual funds sets out specific content. For a relative value fund, the most relevant requirements are a description of the investment objectives, investment policy and any limitations on that policy; a description of the fund's material risks with an indication of any techniques, instruments or borrowing powers that may be used; the procedures for redemption and the circumstances in which redemption may be suspended; and the name of the fund's principal prime broker and its regulator.

For a leveraged arbitrage fund, a general statement that leverage may be used tells an investor little. Good disclosure states how leverage is measured, the limits the fund will operate within and the financing risks described above, including haircut increases, margin calls, counterparty withdrawal and the effect of central clearing.

Reporting several measures is the honest answer for a relative value book: gross notional shows the scale of financing, while risk-based and financing measures show whether it is controlled.

Liquidity Terms That Match Financing Tenor

A fund that finances itself overnight and offers investors monthly dealing on short notice has promised liquidity that its financing does not guarantee. If spreads widen and lenders tighten terms in the same month that investors redeem, the fund meets both demands from the same positions, and the remaining investors bear the cost of the forced sales.

The answer is to set dealing terms with the financing profile in view. Quarterly dealing, notice periods long enough to arrange an orderly reduction in positions, and an investor-level or fund-level gate are commonly used by arbitrage funds whose books can be unwound only gradually. The general problem is set out in our article on the liquidity mismatch problem in hedge funds, and the method for testing terms against stressed redemptions and stressed margin together is in our hedge fund liquidity stress testing framework.

Whatever is chosen has to be written into the offering document, because CIMA's rule requires the redemption procedures and suspension circumstances to be described there.

Valuation of Convertibles, Off-the-Run Bonds and OTC Positions

Relative value profits are measured in small price differences, so minor valuation choices can move NAV. Off-the-run bonds and many convertibles trade infrequently, and swaps and credit default swaps are valued from curves and models.

CIMA's Rule on the Calculation of Asset Values for regulated mutual funds sets the framework. A fund must maintain a written NAV calculation policy disclosed in its offering document, which identifies price sources for each instrument type and an escalation procedure for exceptions. It must give priority to unadjusted market prices and, for hard-to-value securities, to observable inputs over unobservable ones. Pricing models must be calibrated to the extent appropriate to the risk of material error. The NAV must be calculated by a service provider independent of the investment manager and the operators. Where the manager supplies prices, it must provide supporting information, and the NAV calculator must take reasonable steps to verify them. Any material involvement by the manager in pricing must be disclosed in the offering document, and the operators must approve and review the policy and any pricing models at least annually.

For an arbitrage book, the practical questions are consistent pricing of both legs of a trade, the treatment of bid, offer and mid prices, the sources used for convertibles and off-the-run issues, and how model inputs for OTC positions are agreed with counterparty collateral valuations. Our guide to credit hedge fund liquidity terms and valuation policy covers the pricing hierarchy and valuation committee in more depth.

Common Mistakes

• Assuming bank or platform financing terms will be available to a new independent fund on the same basis.
• Relying on overnight repo from a single lender for the whole book.
• Offering monthly liquidity on short notice to investors in a book financed overnight.
• Disclosing only gross notional leverage, or only a general statement that leverage may be used.
• Leaving Treasury clearing access to be arranged after launch, close to the compliance date.
• Letting the manager's own marks drive NAV for convertibles and off-the-run bonds without independent verification.

The CV5 Implementation Perspective

CV5 Capital is the Cayman-headquartered institutional fund infrastructure platform for hedge fund and digital asset managers who need to launch quickly, operate properly and satisfy serious investors from day one. It operates CV5 SPC for traditional strategies and CV5 Digital SPC for digital asset strategies, both registered with CIMA under the Mutual Funds Act. Each manager receives a segregated portfolio with an independent board and coordinated fund administration, audit, banking, custody and compliance arrangements. CV5 Capital is not the investment manager of the strategies on its platforms.

For a relative value manager, the Cayman hedge fund platform for emerging managers provides the regulated vehicle, the independent board and the administration and valuation framework, so the manager's launch effort can concentrate on what is specific to the strategy: the financing counterparties, the documentation that protects the book under stress, the liquidity buffer and dealing terms, and the disclosure that explains all of it to investors.

Key Takeaways

• Treat financing as the core operating risk and design the fund around it before the first trade.
• Spread financing across counterparties and channels, and move part of the book onto term or committed terms.
• Hold an unencumbered liquidity buffer sized to a combined stress in haircuts, margin and counterparty withdrawal.
• Plan Treasury repo clearing access now against the published compliance date of 30 June 2027, and monitor the SEC for changes.
• Disclose leverage through several measures, with limits and financing risks, in the offering document.
• Match notice periods, dealing frequency and gates to the financing profile, and value both legs of each trade independently.

Frequently Asked Questions

What is a relative value hedge fund?

A relative value hedge fund buys one instrument and sells a closely related one, aiming to profit as the price difference between them narrows. Common examples are fixed income relative value, the Treasury cash-futures basis trade, swap spread trades and convertible arbitrage. Because the spreads are small, these funds use leverage, which makes the availability and terms of financing central to how they operate.

Why is financing the main risk for an arbitrage fund?

An arbitrage fund holds large hedged positions funded by repo, prime brokerage margin and derivative collateral. If lenders raise haircuts, clearing houses raise margin or a counterparty withdraws a line, the fund must post more capital or reduce positions, sometimes before the spread converges. A correct trade can therefore produce losses if the financing is not resilient.

When does the SEC Treasury clearing requirement apply to repo?

After a one-year extension adopted in February 2025, the published compliance dates are 31 December 2026 for eligible cash market transactions and 30 June 2027 for eligible repo transactions. The requirement applies to direct participants of a covered clearing agency, so a fund's Treasury repo with a direct participant is expected to be cleared, with the fund accessing clearing as an indirect participant.

What leverage information must a Cayman fund's offering document contain?

CIMA's Rule on the Contents of Offering Documents requires a regulated mutual fund to describe its investment policy and its limitations, its material risks, and the techniques, instruments or borrowing powers it may use. For a relative value fund, clear disclosure states how leverage is measured, the limits applied and the financing risks, including haircut increases and margin calls.

What liquidity terms suit a relative value fund?

Dealing terms should reflect how quickly the book can be reduced and how long its financing is committed. Funds financed largely overnight face a mismatch if they offer monthly dealing on short notice. Quarterly dealing, longer notice periods and gates are commonly used to give the fund time to reduce positions in an orderly way during stress.

Who values a relative value fund's positions?

Under CIMA's Rule on the Calculation of Asset Values, a regulated fund's NAV must be calculated by a service provider independent of the investment manager and the operators. Where the manager supplies prices for convertibles, off-the-run bonds or OTC positions, it must provide supporting information, and the NAV calculator must take reasonable steps to verify them.