Prime broker rage

Hedge funds

The oft-touted claim that a good hedge fund manager can generate positive returns in even the most volatile of markets has been thoroughly tested by the unprecedented events of 2008. Funds of all sizes have taken a pounding in the second half of the year amid a spike in volatility and correlation and an evaporation of liquidity, forcing large-scale deleveraging and a surge in redemption requests by investors.

Of the 16 strategies indexes monitored by Chicago-based data provider Hedge Fund Research (HFR), only three have seen positive returns in the year to October. The HFR macro (total) index and macro systematic diversified index posted positive returns of 4.11% and 14.75%, respectively. The HFR short bias index performed even better, posting returns of 22.62% over the same period, despite the temporary bans on short selling by the US Securities and Exchange Commission (SEC) and the UK Financial Services Authority in September.

The positive performance of these strategies has been the exception in a disappointing year for hedge funds generally. The HFR weighted composite index was down 16.05% in the year to October, with convertible arbitrage one of the biggest casualties with a performance of -33.96%.

On top of these crippling losses, some hedge funds have been further stung by the loss of collateral seized by administrators in certain jurisdictions following the collapse of Lehman Brothers in September. While only a relatively small number of funds have been directly affected through their exposures to Lehman's prime brokerage business, the failure of the broker-dealer has reverberated throughout the hedge fund industry. In particular, counterparty credit risk concerns have raced to the top of the agenda.

In the run-up to and immediate aftermath of Lehman, many hedge funds became anxious about the risk of collapse of other prime brokers and looked to establish new relationships with other firms. Prime brokerages run by Goldman Sachs and Morgan Stanley each saw large outflows of business in September and October amid concerns about the future of the investment banking model. Firms such as BNP Paribas, Credit Suisse, Deutsche Bank and JP Morgan, meanwhile, saw an increase in business as hedge funds looked to establish second or even third prime broker relationships with banks that had commercial banking arms.

While fears of collapse among other investment banks have abated following news on October 14 that the US Treasury will inject $125 billion into nine US banks, the trend towards broadening the number of prime brokers used by hedge funds has continued.

"The hedge fund world has pivoted completely in the past six months, with the shift especially pronounced post-Lehman Brothers," says Alex Ehrlich, global head of prime brokerage at UBS in London. "There was a massive redistribution of market share that began a few weeks before Lehman collapsed, then accelerated even further in the aftermath, during the height of the concerns about the viability of the investment banks. I think the concept of the full-service prime brokerage model really became temporarily worthless in the eyes of hedge funds for a short period of time."

Volatile market conditions and losses across most strategies have prompted investors to pull huge amounts of cash out of hedge funds in the past few months. According to HFR, losses across the hedge fund sector totalled $365 billion between July and October. A whopping $294 billion of that comprised losses on investments, with $71 billion coming from investor redemptions.

Losses from the collapse of Lehman Brothers have also been severe - although localised to those funds that used the firm as a prime broker. As of the end of the second quarter of this year, just 2.1% of the 7,800 funds tracked by HFR used Lehman's prime broker services. That represents 0.95% of hedge fund assets under management, or $1.931 trillion. In comparison, Goldman Sachs provided prime brokerage services to 20.65% of all funds, representing 20.15% of all fund assets (see figure 1).

Despite the comparatively small market share held by the firm, PricewaterhouseCoopers (PwC), the appointed administrator for Lehman Brothers International Europe (LBIE), has confirmed that approximately $40 billion of hedge fund assets have been frozen as a result of the broker-dealer's bankruptcy. With investor redemptions expected to increase at the end of the year, the assets locked down by Lehman's administrators could, for some hedge funds, mean the difference between continuing as a going concern and failure.

So, what is the likelihood of funds being able to recover their assets? That depends on the legal entity the hedge fund was facing. "The type of entity a fund manager is dealing with and the nature of the financing they are doing with the prime broker will dictate how a fund would fair in the bankruptcy of the counterparty," explains a head of sales for equity prime brokerage at a New York-based broker-dealer. "In the case where you are facing a US broker-dealer, your assets will be dealt with under SEC rule 15c3-3. If that broker-dealer is merely acting as agent for a non-US broker-dealer, however, those assets will be dealt with under the rules and jurisdiction of the country that broker-dealer is domiciled in."

SEC rule 15c3-3 stipulates that a dealer must segregate the client's wholly owned securities in a customer account, which is distinct and separate from the bank's own assets. That means while the prime broker maintains possession and control of margin securities, the client retains full ownership. In practice, in the event of a bankruptcy of the prime broker, any securities or cash wholly owned by the hedge fund but held in custody would be returned to the fund and would not be counted as part of the broker's estate.

Crucially, however, if the fund has borrowed against the collateral it has posted, the prime broker is entitled to rehypothecate the client-owned securities in the margin account, confusing matters in the event of an insolvency.

Rehypothecation is the process by which a prime broker finances the credit it extends to a hedge fund by lending on the collateral it has posted to another party. Under SEC rule 15c3-3, US broker-dealers can rehypothecate up to 140% of the customer's margin debt balance - that is, the loan the fund has taken from the broker. For example, if a fund has $20 million of assets in a collateral account, and wishes to borrow $10 million in cash, a US prime broker is entitled to lend up to $14 million of the securities held in the custody account to help finance this loan.

The $6 million remaining in the customer account remains segregated and should be fully recoverable in the event of a bankruptcy of the prime broker. However, the collateral lent on by the failed prime broker is more problematic. The $10 million loan would be netted off against the $14 million in rehypothecated assets, leaving the hedge fund with a $4 million contractual claim against the trustees of the prime broker's estate. In most cases, that would mean the hedge fund would have to get in line with every other unsecured creditor to recover what it can of the rehypothecated assets once the prime broker is formerly liquidated.

The situation was made worse in the case of Lehman due to a lack of clarity over which legal entity the hedge fund was facing. Some hedge funds apparently thought they were transacting with Lehman Brothers Inc and therefore believed they were subject to SEC rule 15c3-3, where only a certain amount of collateral can be lent out. However, Lehman Brother Inc was in many cases acting as agent and arranging the financing on behalf of its offshore broker-dealer, London-based LBIE. As such, the collateral lending was beyond the jurisdiction of the SEC rule.

"The US regulatory rehypothecation limits are very different to the UK system. In fact, no parallel to the SEC rules exist in the UK or Europe generally," says Claude Brown, a London-based partner specialising in derivatives and structured products at law firm Clifford Chance. "The 140% limit is an arbitrary number, but it means that in the US you can't have a situation like in Europe. There, the prime broker, absent contractual restraints, is entitled to rehypothecate the entire collateral sum."

Without access to the documentation detailing the individual arrangements between funds and prime brokers, there is no way to estimate how many US clients of Lehman Brothers Inc were contractually signed as customers of LBIE. However, LBIE's administrator, PwC, has confirmed that of the $40 billion in hedge fund assets frozen as a result of the Lehman collapse, approximately $22 billion had been rehypothecated.

Lawyers reckon hedge funds will be treated as nothing more than unsecured creditors in the vast majority of cases. Once all the details of the estate have been finalised, the administrators will calculate the distribution dividend - the number of cents on the dollar creditors will recover - and allocate the estate equally among prime brokerage clients, swap counterparties, bond holders and all other creditors.

Questions are now being asked about the future of rehypothecation of hedge fund assets. In the first instance, many participants may push regulators to require more explicit clarification of which legal entity a hedge fund is facing within a prime broker agreement. Meanwhile, in Europe and the UK, there is likely to be pressure on regulators to develop rules similar to those applied in the US, where there are limits on the lending of pledged assets.

"SEC rule 15c3-3 was developed as part of the Securities Investor Protection Act back in 1970 and it was basically a deposit protection scheme in some respects. No European equivalent was ever developed, perhaps because these are wholesale markets. The philosophy in Europe was that the players involved knew the stakes and did not need that protection. It is an interesting debate as to whether similar measures will be adopted in Europe or the UK, although the Financial Services Authority has more pressing matters to be dealing with at the moment," says Clifford Chance's Brown.

Some even suggest the Lehman debacle may bring about the end of rehypothecation of assets held in margin accounts altogether. However, many dealers reject this suggestion, noting an ending of the practice would push up the cost of credit extended by prime brokers, while simultaneously restricting the loan provisions brokers are able to make. Hedge funds are unlikely to push for this, given that their cost of borrowing has already increased significantly over the course of the year.

With concerns over counterparty credit risk overriding the cost of funding, hedge funds have been willing to pay more for prime brokerage services over the past few months. "The prime brokerage business was so competitive that loan pricing and collateral requirements had been driven down to a pretty low floor, especially for the largest funds," says Jake Jacoby, head of prime brokerage trading and risk at BNP Paribas in New York. "The difficulties suffered by the parent companies of a number of prime brokers has led to greater focus on counterparty risk, and as such fund managers are now looking to do business with the most creditworthy counterparties. Given volatility and liquidity concerns in the market and the credit and funding environment, fund managers are also being required to post more collateral and pay higher spreads. We'll see how long this lasts. It will eventually swing back a little but I don't think we'll return to where we were anytime soon."

One market initiative that may help to bring funding costs down in the longer term is the plan to establish a central counterparty for credit default swaps. Four clearing platforms are preparing to launch over the next few months, including one initiative from the Chicago-based Clearing Corporation in partnership with the Atlanta-based IntercontinentalExchange, and dealers expect derivatives across asset classes to migrate to central counterparty platforms over the longer term (Risk November 2008, page 9).

With many hedge funds facing prime brokers as counterparties on derivatives trades, the interest in centralised clearing of over-the-counter contracts is understandable, especially given that bilateral posting of collateral between dealers and hedge funds under the International Swaps and Derivatives Association master agreement and credit support annex is far from standard.

"The relationship between the fund manager and prime broker has changed as the dynamic of counterparty risk, which was somewhat latent years ago, has come to the forefront recently," notes Ken Heinz, president of HFR. "Centrally clearing OTC contracts will serve to reduce and largely mitigate the counterparty credit risk element that has become salient over the past three months."

Undoubtedly, 2008 has been a brutal year for hedge funds. Between record performance-based losses and high investor redemptions, the last thing fund managers needed was the collapse of a major broker and the confiscation of $40 billion in assets. As such, it is hardly surprising that rumours are swirling that as many as half of the approximately 8,000 hedge funds operating globally may close within the next year - although the future remains unclear for prime brokers also.

"The biggest question is whether the prime brokerage market is sustainable and whether banks will continue to be the logical home for the business of financing hedge funds," suggests UBS's Ehrlich. "At the moment, there are no alternatives, but there remains a lurking undercurrent of concern around whether the status quo can be maintained for any length of time."

See also:

• Rocked by counterparty risk

• O Brothers, where art thou?