he dramatic downfall of Bear Stearns and Lehman Brothers and ensuing collapse of the pure investment bank or broker-dealer model in the US has further jolted a global hedge fund industry already reeling from the impact of massive investor capital redemptions, forcing it into a rapid review of prime broker relationships.
Amid heightened concern about counterparty risk, the search for a secure haven for their assets has become hedge funds' top priority. Consequently, there has been both a move away from those investment banks regarded as risky and a drive to diversify exposure by setting up accounts with a number of different prime brokers.
“Hedge funds, with the exception of the smallest ones, are moving to using multiple prime brokers. This has led to huge shifts in prime brokerage market share with Credit Suisse, Deutsche Bank, BNP Paribas and Citi making significant gains from the collapse of Lehman Brothers and Bear Stearns. Goldman Sachs has held firm while Morgan Stanley has lost market share,” says Andrew Shrimpton, a partner in the regulatory, consulting and compliance division of Kinetic Partners, a consulting firm.
When using multiple prime brokers prior to the credit crunch, he adds, there was a tendency to use one prime broker for a single asset class such as equities and another prime broker for fixed income, commodities or FX. Now, a single strategy hedge fund, such as long-short equity, is using multiple prime brokers.
Rehypothecation
For the most part, cash held with prime brokers is not protected by Client Money Protection, on the understanding that investment banks are extending finance and leverage to a hedge fund and in return want to hold as much of the assets as possible. A contractual clause also generally permits prime brokers to appropriate clients assets – a process known as rehypothecation.
So when a hedge fund client is borrowing securities, or employing leverage, rather than posting cash to collateralise, prime brokers look to utilise collateral held in the form of the hedge fund’s long-only assets.
Hedge funds are particularly concerned that blanket rehypothecation rights allow prime brokers to use client assets even when the hedge fund is not borrowing or running leverage in the portfolio. Why, they ask, should prime brokers be able to freely move assets in and out of hedge fund clients accounts to generate revenue for themselves?
Around 100 hedge funds learnt a hard lesson in rehypothecation when assets they held at Lehman Brothers in London were frozen by the administrators, PricewaterhouseCoopers.
“Hedge funds were aware of the risks to rehypothecated assets if a prime broker became insolvent but the shock is that all assets, including cash, are trapped even where hedge funds have tried to segregate the assets,” says Mr Shrimpton.
“There are a lot of battles going on at the moment about custody and ownership rights. Hedge funds want to know their rights in an insolvency situation and are much less willing to rehypothecate so prime brokerage fees will have to rise to compensate for less rehypothecation. In some cases, hedge funds are simply not allowing rehypothecation,” he adds.
Prime broker relationships will change, he believes, particularly around trust arrangements and custody and there will be more clarity on exactly what is rehypothecated.
Protection levels
Mr Shrimpton also maintains that Lehman’s administration has shown that through the Securities Investor Protection Corporation, the US offers much better protection than the UK. This, he contends, is a serious threat to the UK’s position as a centre for prime brokerage activity.
As the liquidation of Lehman Brothers has highlighted, the largest risk to hedge fund managers is trapped fund cash because if funds become illiquid they may have to wind down. In order to reduce this risk, hedge fund managers are starting to ask for daily reports from their prime brokers and are moving cash away from the prime brokers in daily sweeps.
Custodian banks have been one of the main beneficiaries of this recent development.
“We are seeing that very clearly. Hedge funds are looking to split out their financing needs from their safekeeping needs. Long balances of unencumbered assets should be with a custodian in a client-segregated account which nobody else can touch,” says David Aldrich, MD with Bank of New York Mellon.
He claims that that the firm's tri-party collateral management service allows hedge funds to carry on conducting “business as usual” with their prime brokers in the current unstable market environment.
