The Return of Prime Broker Counterparty Risk for Hedge Funds

The Greek debt crisis in Europe is causing hedge funds to re-visit their prime brokerage relationships.  In the last debt crisis, Lehman's bankruptcy exposed funds to billions of dollars of frozen trades in London.  The Federal Reserve Bank backstopped the trades in the US to prevent a similar situation.  Hedge fund managers are using credit default swaps (CDS) to measure their brokers' risk of default.  Some sample costs of five year CDS contracts are:

• Morgan Stanley - 320 bps
• Bank of America Merrill Lynch - 300 bps
• Societe Generale - 270 bps
• JP Morgan - 150 bps
• Credit Suisse - 150 bps

Another risk to hedge funds is that prime brokers may also have to pull their financing to protect their parent companies' balance sheet.

In the second quarter of 2011, JP Morgan was the biggest prime broker, as measured by assets under management, with 28% market share.  It was followed by Goldman Sachs (20%) and Morgan Stanley (14%) according to Hedge Fund Research.  Other banks that are taking on more prime broking business are HSBC and SEB Enskilda.

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