Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.

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

The source for this article can be accessed here.

Securities Lending: Considerations for Investors

Everyone knows that hedge funds may short securities to enhance their returns.  This is the simple act of borrowing them and selling them at a higher price.  Then buying them back at a lower price (hopefully).  Where do the prime brokers get the securities to lend to the funds?  They have securities lending desks; can lend out securities in custody from other funds or even retail accounts.  Let's look at the desk.  It negotiates with investors to have access to its holdings.  Why would an institutional investor do this?  They can generate extra revenue for better returns or to offset expenses with their bank.  The investor should consider the following:

There are five program structures:  agency discretionary, client directed, auctions, exclusives and principal.  Agency discretionary is where the investor uses a third party (like a prime broker) to handle the details such as sourcing transactions and record-keeping.  Client directed is when the investor handle transactions on its own and using its custodian to facilitate loans and/of cash collateral transactions.  The last three are agreements with a borrower to give access to their portfolio for a fee, price or period of time.

The investor has to decide on the loan type.  The most common loan is open where the loan can be closed at any time and the fee renegotiated.  The term loan is for a specific period of time with a fixed fee.  A general collateral loan is used for securities that are not popular with the borrowing funds and a specials loans is used for securities with a high demand i.e. those with a high short interest.

The investor has to set parameters for is lending program.  An example would be setting a limit on the amount of securities on loan to borrower(s) as a percentage of the portfolio or market value.  Restrictions can be made on the security or client level.

The investor decides what types of collateral to take from the borrower.  They may take other securities or cash.  The decision should take into account the size of the lending program, liquidity, ownership/control, transparency and risk levels.  They can place the collateral in a separate managed account, commingled account with other lenders, external investment account with another fund manager or "self-invest" where the investor controls the assets.

The source for this article can be accessed here.

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.

The source for this article can be accessed here.

Talent Introduction: Another Service for Hedge Funds

Hedge funds pay about 35% of the trading commissions on the exchanges.  To attract more of this business, prime brokers are adding recruiting to the normal suite of services (such as trade settlement, financing and consolidated reporting) that they provide.  Positions are mainly in the back office and accounting.  The advantage for hedge funds is that they do not have to pay the recruiter's fee.  This has been done for many years but has been formalized only in the last few years.

As with any resource, there are some obvious conflicts.  Banks could hire staff away from one of their clients.  They are privy to inside information on the fund if an important person, say a portfolio manager, wants to leave his firm.  Other departments at the prime broker may act on this information by reducing the fund's financing.

The source for this article can be accessed here.

Basel III Effects on Shadow Banking

What is shadow banking?  The Financial Stability Board said there is no common definition in its Shadow Banking:  Scoping the Issues.  It tries to define it as "lending by any organisation outside the regulated banking sector that creates systemic risk or opportunities for regulatory arbitrage, particularly if long term assets are being funded by short term liabilities, and those assets are securitised and/or re-hypothecated."  This is close to the prime brokerage model for investment banks.  Here banks use the repo markets to fund themselves on a daily basis, using the assets (securities and cash) in the prime brokerage accounts of hedge funds as collateral.  During the crisis of 2008, Bear Stearns, Goldman Sachs and Morgan Stanley could not fund themselves because hedge funds moved their assets from the banks.  Because of the lack of collateral, the repo markets and daily funding, were diminished for them.

Basel III, the new global regulatory standard, will set tighter liquidity and capital ratios for banks.  Banks are also divesting their proprietary trading desks.  These changes will lead to an increased cost of funding for prime brokers and, therefore, for hedge funds as well.

The source for this article can be accessed here.

The Current State of Small Introducing Prime Brokers

In an earlier post, I directed to you to an article about the bulge bracket prime brokers.  I came upon this at the site:  www.finalternatives.com.  The author, Michael DeJarnette of ConvergEx's Northpoint Trading Partners, writes about the smaller prime brokers.  Many of these firms have merged or been acquired by larger financial or technology firms.  The merged firms have become a new category called "mid prime", "integrated prime" or "independent prime".  The link to this article is here.

Prime Brokers and the Hedge Funds They Serve

I have found a very thoughtful blogger who had researched the relationships between prime brokers and their hedge fund clients.  He had discovered that certain investment banks specialize in serving different investment strategies i.e. Barclays cover many funds using Fixed Income Arbitrage.  The article is here.  He has written other posts which, I will admit, are more advanced that what we have covered so far.  If you want to look at hedge funds from an investor point of view, they are all good reading.

PS  There is also a good comment attached to the article

How Technology Can Serve Hedge Funds

A prime broker is able to offer hedge funds its technology resources to facilitate its daily operations.  The fund managers are allowed to concentrate on running their funds by outsourcing them.  Here are some functions that the prime broker offers funds.

Reporting

Prime brokers offer bespoke reporting with the ability to analyze the fund's whole portfolio.  The reports can measure the performance of the fund, calculate the Net Asset Value (NAV) and provide risk management reports in real-time.  They can run performance reports comparing the cost of a trade against an industry benchmark (i.e. VWAP or TWAP).  Being able to calculate the value across all positions allows for accurate portfolio margining.

Trading

Prime brokers can give hedge funds access to their electronic trading platforms.  These include direct market access (DMA), algorithmic trading and program trading.  The best platforms allow fund managers to execute their trades anonymously and without affecting the market.  Credit Suisse's Advanced Execution Services and Goldman Sachs' REDIPlus are the best that are out there.  The field is very competitive and every firm is constantly improving their services.  Speaking of anonymity, there are a number of dark pools run by investment banks such as Credit Suisse's Crossfinder and Goldman Sachs' SIGMA X.

Research

Prime brokers offer access to research created by their equity, fixed income and derivatives analysts.  This can be distributed through the banks' proprietary web portals.

Custody and Trade Settlements

One of the basic functions that a prime broker performs for a hedge fund is to act as a custodian for its assets and to settle its trades.  The custodian holds the fund's stocks, bonds, commodities, etc. in a separate account.   As a result of the Lehman bankruptcy, there have been discussions of how to safeguard these assets better.  Some funds were unable to retrieve the assets that were embroiled in the bankruptcy procedure.  Because of this risk, managers are having 3 or more prime brokers handle their funds.

The prime broker processes and settles the fund's trades with different counterparties.  Since the broker clears all the trades, it is able to give the fund manager centralized reporting.  The global brokers will be able to handle trades across different countries and products (such as equities, fixed income, commodities, foreign exchange, futures, options, warrants, credit default swaps, equity swaps and other over-the-counter derivatives).  It also handles corporate actions on securities.  These actions include:

• Mergers and spin-offs
• Tender offers
• Dividends and interest payments
• Calls on bonds
• Stock splits
• Annual meetings and proxy communications
• Accounting i.e. calculation of Net Asset Value (NAV)

Collateral Management for Hedge Funds

Let's return to the world of prime brokerage and hedge funds.  One of the advantages that hedge funds have is the ability to use leverage to enhance their returns.  Prime brokers are the main source of financing.  Hedge funds may finance trades on margin.  In securities trading, margin is the amount of money borrowed from the broker to buy the position using another position as collateral.  The hedge fund finances the remaining through the margin deposit.  The deposit is compared against the maintenance margin requirement constantly.  If it is below the requirement level, then a margin call to collect the difference is issued by the broker.  At this time the broker does not care how the call is collected.  It can ask for cash or may sell the fund's other holdings.  Here, it is important for the hedge fund to have a good relationship with the broker.  The broker will have more patience on margin calls in this case.

For commodity futures, the idea is the same except the margin rate is much lower.  The initial futures margin is around 5 - 15% of the value of the contact.  This is compared against the margin maintenance.  If it is below the maintenance level, then a call will be made to bring the balance to the initial margin.  The maintenance margin is usually lower than the initial margin to allow for some price fluctuation.

Another method of financing is the repurchase agreement (repo).  This is merely selling the security while agreeing to buy it back at a future date and price.  The difference in prices (called the spread) is the interest rate.  Hedge funds will take the borrowed cash and invest it.  Hopefully, they will earn returns higher than the interest paid.

Both repos and margining will be under the collateral management desk of the prime broker.

Hedge funds have multiple holdings in their portfolios.  Prime brokers calculate how much leverage to give them by using proprietary formulas based on the riskiness of the portfolio.  The methodologies include running it through stress tests, scenario analysis and mapping it against various risk factors.  The large prime brokers are able to do this across securities, derivatives, commodities, etc.  This takes a sophisticated and powerful technology system that consolidates data and gives funds one-stop shopping for reporting.  This is called portfolio margining.

Securities Lending

One of the advantages of a hedge fund versus a mutual fund is that hedge funds are allowed to short, that is bet against a stock or bond.  In order to execute this transaction, they must first borrow the shares before the trade.  Where do they get these shares?  From their prime broker.

Securities Lenders obtain access to multiple institutions that have stable holdings.  These are generally pension funds and large asset managers.  They would receive some fee from the Securities Lender in exchange for the stock loan.  Depending on the agreement between the fund and prime broker, they may even retain the dividends paid out on the securities.  Here is where an investment bank with a healthy asset management division would have an advantage.

The prime brokers can lend from this pool of securities to the hedge funds to execute their short trades.  The fund can cover their position and return the securities at the end of a profitable (hopefully) trade.

Prime Brokerage Client Services

After the sales force brings hedge funds onto the Prime Brokerage platform, the client is handed off to the Client Services Team for day-to-day management.  It is here that clear and accurate knowledge transfer of the client's needs and goals is vital.  The Client Services representative must know everything.  They will be the fund's advocate and problem solvers for the different capabilities within Prime Brokerage.  These include custody and trade settlement, financing on margin, risk management and accurate reporting of portfolio and positions on a real-time basis.  Most of their day is acting on issues on behalf of their client.

Some firms add a senior executive as a relationship manager.  They serve as an additional advocate for the fund as reinforcement for the Client Services representative.

Prime Brokerage Sales

Prime Brokerage Sales, also known as Hedge Fund Sales, concentrate on bringing new funds onto the investment bank's platform.  They may be new start-up funds or a new fund being launched by a successful organization.

Hedge Fund Sales is selling the capabilities of the bank; tailoring their pitch to the hedge fund's needs.  The fund may be interested in getting access to algorithmic trading or trading in global markets or have special trade settlement and clearing needs.  There may have been an existing relationship between the fund and bank through the Capital Introductions or Hedge Fund Services Teams.  If these prior touchpoints were positive, then the bank would have a headstart in bringing the fund onboard.

Helping Emerging Hedge Funds

The Prime Brokerage Division of Investment Banks helps seed emerging hedge funds through the Capital Introductions team.  There is another team - Hedge Fund Services - that helps start-up funds with the details and logistics of launching the fund.  They help the fund find office space and set up the nuts and bolts of the office i.e. computers, Bloomberg terminals, phones, office furniture and supplies.  The team has a contact list of specialists:  accountants, lawyers, operations and technology professionals, etc. that will work closely with the fund manager.

After the fund has been established and is growing (in assets and people), then Hedge Fund Services will aid in additional areas such as Human Resources or business development.  Like Capital Introductions, there is no explicit fee for this service but it binds the relationship between prime broker and hedge fund even tighter.

Capital Introductions

In the prior entry, I had introduced prime brokers and the special services they give hedge funds.  This affects the entire life cycle of setting up a fund.  One of the services is Capital Introductions.  It is how fund managers meet investors.  The Capital Introductions Team runs an event or round table where managers seeking seed money to initiate their fund meet institutions who are seeking to invest with the best and brightest managers.  The event is run very much like a conference.  The team does its best to match up the managers and investors with the proper investing strategy i.e. a risk averse investor would meet with an equity market neutral manager.  After the event, they would gather feedback from the investors regarding their level of interest for a manager and forward the information.  The two interested parties will then follow-up with each other.

There is no fee paid to Capital Introductions.  This is different than if the investment had been completed through, for example, the Alternative Investment Division.  In the latter case, there is a fee paid to the investment bank.

Hedge Funds

The broker vote is not as reliable a forecaster of market share for hedge funds as for mutual and pension funds.  A hedge fund should have at least 2-3 prime brokers.  These brokers supply financial services such as custody services, securities lending and financing.  We will tackle these items at a later date.  The world of prime brokers used to be dominated by Goldman Sachs, Morgan Stanley and, to a lesser extent, Bear Stearns.  Since the financial crisis in 2008, the space has added Credit Suisse and Deutsche Bank.  JP Morgan has replaced Bear Stearns because of its acquisition.  Please reference this March 2010 article for a fuller understanding of the players.  These prime brokers are also sell side firms.  Since there are already strong existing relationships between hedge funds and their brokers, the market share for hedge fund commissions are skewed in favor of them and may not follow the results of the broker vote.