Managing Counterparty Risk for Prime Brokers and Hedge Funds

Before the failures of MF Global, Bear Stearns, Lehman and Merrill Lynch, hedge funds and their investors gave no or little thought to the idea of measuring counterparty risk.  Fund managers should perform due diligence at the onset and during their relationship.  The same analysis should be done on any third party service providers such as auditors, fund administrators and lawyers.

Here is how hedge funds manage counterparty risk of their prime brokers:

• Use multiple brokers
• Add "amber" terms to the prime brokerage agreement.  If the credit default swaps spread reaches a certain figure, then the fund's assets should be moved to a separate account.
• Discover the exposures of the prime broker
• Buy credit default swaps on the prime broker

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