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In this discussion of a Citi paper, on the impact of collateral management and rising financing costs for hedge funds, there is a quote from Sandy Kaul's statement:

Sandy Kaul, head of business advisory services at Citi, said EMIR and the implementation of bilateral margining for non-cleared derivatives in 2015 would lead to a steady increase in collateral demands but remained hopeful the challenge was not insurmountable. “I do not believe the collateral shortfall will adversely affect the hedge fund industry. The impact will be felt more strongly in the traditional asset management space. Hedge funds, unlike traditional asset managers, have the ability to strategically deploy their liquid collateral and transform illiquid assets and this should alleviate the challenge,” said Kaul.

Question: What is meant by "the ability of hedge funds to transform illiquid assets"?

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I agree with @emcor that this statement is vague. I believe the key to understanding the intended meaning is this part:

Hedge funds, unlike traditional asset managers, have the ability to strategically deploy their liquid collateral and transform illiquid assets.

The SEC requires mutual funds to limit their investments in illiquid securities to a maximum of 15% of each of their total assets, and in particular 10% for money market funds. As such, it is a general assumption that mutual funds cannot do much that involves illiquid assets anyway.

Moreover, mutual funds are more limited in their use of derivatives, leverage and debt issuance than hedge funds. Any transaction, especially in derivatives, in which the fund may become liable to a third party in an amount exceeding the cost of investment requires that the fund segregates liquid assets having a value equal to the amount of the potential obligations daily mark-to-market. e.g. It may be more difficult to purchase equities in an African country and then enter a total return swap agreement, for whatever reason, to transfer risk on those equities.

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The passage is indeed quite vague. I would interpret it as to say, Hedge Funds in general are subject to less regulations and restrictions, which gives them more flexibility to invest into alternative asset classes, and trade them more frequently and flexible than a usual restricted asset manager. An example might be private equity, where a hedge fund is usually investor and management board same time, which also means they can sell off their investment easier than an asset manager just holding a private equity share without control.

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