For months now, prime brokers have been warning that tougher rules on bank capital and liquidity will force them to charge more for financing and cut the amount of leverage they provide to clients. Few hedge funds are listening though, and it is not hard to see why. Despite the dire predictions, the cost of financing has barely budged for most of them.
"Lately, we've heard a lot of ‘sky is falling' talk from prime brokers, but when you really get down to it and ask them if they want you to move margin balances elsewhere, they start backtracking. They're renegotiating fees at the margin, but we haven't really seen much of a change in financing rates," says an executive at a hedge fund in New York.
Prime brokers admit a jump in the cost of borrowing is only one possible outcome – funds could help to defray the expense by giving prime brokers more execution business or by finding ways to reduce the burden placed on banks. The latter course of action is already being explored by larger funds, which is driving the development of more sophisticated treasury and back-office functions, and creating demand for services to help funds track or optimise financing costs (see box, Investors tell funds to confront new risks).
Whatever the solution, banks insist things need to change.
"Capital reserves, liquidity buffers and funding costs are going up for everyone in this business. We're all contemplating how and when to address it. The way we run the business, price our services and work with clients will have to change," says Jon Yalmokas, head of Americas prime brokerage at Bank of America Merrill Lynch (BAML).
Chris Hagstrom, head of US prime brokerage at UBS in New York, says the bank is taking a partnership approach to addressing the problem: "It's less of a repricing discussion, and much more of an education process around what drives balance-sheet consumption and how we can work together better."
That is the diplomatic, public line. In private, some bankers are talking tougher and warning some strategies may simply not work anymore, such as relative value fixed income, which relies heavily on borrowed money to generate big returns from small pricing discrepancies.
"I won't be shedding any tears for those guys. In terms of access to leverage, they've had a great run for the past 12 years," says a business head at one international bank in London.
According to research from Barclays, the average hedge fund could see a drop in returns of around 10–20 basis points if financing rates for less liquid assets rise by 25–50bp.
The way we run the business, price our services and work with clients will have to change
Fixed income arbitrage funds – which have generated annualised returns of around 10% since 2009, according to BarclayHedge – would be hit hardest, with returns falling an estimated 40–80bp. Multi-strategy hedge funds, especially those active in credit and convertible arbitrage, would also feel the squeeze, with an estimated performance drop of 15–30bp.
So, where is the pressure coming from? For US banks, in particular, some of it stems from the March instalment of the Federal Reserve's stress-testing regime – the Comprehensive Capital Analysis and Review (CCAR). Five banks – including Citi and subsidiaries of HSBC and Royal Bank of Scotland – failed the tests, while Bank of America and Goldman Sachs were ordered to cut planned shareholder payouts. The Fed also directed seven banks – among them, Bank of America, Citi, Morgan Stanley and Wells Fargo – to either raise around $65 billion in new capital or shrink their balance sheets commensurately.
This caught many senior bankers by surprise. "The CCAR process has focused attention on balance-sheet stability and resulted in much tighter constraints on balance-sheet growth at Fed-supervised entities," says the head of prime brokerage at one bank in New York.
But the CCAR process is accompanied by tougher day-to-day capital and liquidity requirements. Secured funding businesses such as prime brokerage, which consume a lot of balance sheet, are very much in the firing line.
Basel III's leverage ratio has a particularly adverse effect on prime brokers; even more so for the largest US firms, which are subject to the supplementary leverage ratio (SLR), set at 5–6%. This effectively caps bank leverage at 33:1 or 20:1.
Under the rules, securities financing transactions are grossed up when calculating the total exposure against which banks must hold capital. That is a big change for a business where gross leverage ratios routinely exceed 100:1.
"Prime brokers are going to have to put up four or five times as much capital" to support their balance sheets, says Bob Sloan, managing partner of S3 Partners, a financial analytics firm in New York. He was global head of prime services at Credit Suisse before establishing S3 in 2003.
Basel III's liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) bring additional costs.
The traditional model of prime brokerage was based on maturity transformation. Banks offered hedge fund financing for 30-, 90- or 180-day terms, and funded themselves in the overnight repo markets or through ‘internalisation', using the re-hypothecated long securities of one client to cover the shorts of another. According to a study by Barclays, prime brokers obtain anywhere from 30–60% of their funding from internal efficiencies and 20–50% from short-term repo markets.
The LCR puts a stop to this. Banks will have to hold a stockpile of high-quality, liquid assets to cover net cash outflows over a 30-day period in stressed conditions. The rules assume prime brokers will experience a 100% loss of short-term collateralised funding and customer-free credits in a crisis, and that any term commitments offered to clients will be fully drawn down. There is also a 50% liquidity charge on internalisation – or, as the regulatory text puts it, "customer short positions covered by other customers' collateral"
The bottom line is that term financing commitments with a maturity of at least 30 days must be match funded. Indeed, regulators want prime brokers to adhere to a weighted-average maturity benchmark of 30 days or more, regardless of the duration of their assets.
This means prime brokers – which were effectively self-financing businesses and even generated excess cash for other parts of the bank – will now be net consumers of liquidity.
"There is a funding curve in prime brokerage now," says Sloan. "Before, it didn't matter whether you lent money for a day or a year. It didn't matter if the assets were liquid or illiquid. It didn't matter if you provided term agreements. Now, all these costs are coming to the fore."
According to industry sources, the cost of funding equity positions for 30 days could be 20-30% higher, relative to overnight rates.
So, what does all this mean? Well, it depends on the strategy and size of the fund. If a strategy consumes a lot of leverage, it is in the firing line; if a fund is smaller, it has less ability to compensate brokers with execution business.
Early conversations between banks and brokers have focused on finding ways to improve the internalisation value of client portfolios, reduce funding consumption and increase the overall return on assets of client relationships. For example, prime brokers want clients to move excess cash out of margin accounts and shorten the duration of term agreements, which can significantly improve a prime broker's position from an LCR perspective.
Hedge funds are also being urged to shift more of their equity financing business to synthetics – such as contracts for difference and total return swaps – as these are generally more balance-sheet efficient and can improve a prime broker's leverage ratio.
But these adaptations will not be enough to save the unfunded standby credit facilities known as dry powder agreements, according to prime brokers. "We didn't charge for undrawn credit facilities in the past because we didn't need to account for them. The new rules say we need to maintain a capital buffer against these facilities in case they are drawn down. There's an explicit cost to undrawn commitments, which makes them uneconomic," says a prime brokerage executive in London.
Term-financing agreements will also have to be repriced to reflect the higher funding costs for prime brokers as the LCR is phased in. "We cannot continue to offer term financing at overnight rates. That sort of activity receives very punitive treatment in the new regulatory regime. We need to move to a term market where 30- or 90-day financing is priced off 30- or 90-day Libor," says Yalmokas at BAML.
That could see some hedge funds paying twice as much to finance long-term postions. As of June 11, overnight Libor was 0.09%, while one-month Libor was at 0.15% and the three-month rate was 0.23%.
This point is echoed by other prime brokers. "The cost of term financing, relative to spot financing, has to go up. This should have happened years ago, but a lot of primes made a strategic decision to subsidise term financing to win business. That's changing as a result of regulatory pressure," says the head of prime brokerage at a bank in New York.
Repricing will affect some strategies more than others. The most liquid hedge fund strategies, such as equity long/short and global macro, are more attractive to prime brokers from an LCR and capital standpoint, and may not see much of a change in rates. Funds running less-liquid fixed income and credit strategies will feel the pinch more, and some are already seeing borrowing costs rise.
"The cost of financing hedge fund strategies will change across a gradient, with the bigger impact being felt at the less-liquid end of the collateral scale," says Richard Heyes, co-head of global financing services for Europe, the Middle East and Africa at UBS.
Prime brokers are asking hedge funds with harder-to-finance strategies to give them more execution and other non-balance-sheet-intensive business in exchange for providing leverage.
"We're focusing on making an appropriate return across the overall relationship. So we're talking to clients not only about prime brokerage services but also the other types of business they do with banks outside of prime brokerage, such as the share of execution business we receive from them. Hedge fund clients are evaluated on the overall revenue they generate for a bank, relative to the amount of financial resources they consume," says Heyes.
This obviously favours bigger hedge funds with the most business to dole out. Indeed, there may not be enough financing capacity to support smaller firms, especially if hedge fund assets continue to grow at their current pace.
According to a recent study by Citi, hedge fund assets are on track to reach $5.8 trillion in 2018 – double the current level of $2.9 trillion. Assuming these funds continue to employ the same strategies and levels of leverage, if assets reach those levels, demand for financing could far exceed the capacity of prime brokers to provide it. Leverage could become a scarce commodity, available to only the biggest and most profitable hedge funds.
"There are a finite number of prime brokers with a finite amount of balance sheet to deploy to hedge fund clients. If the industry continues to grow at this pace, not every firm will have access to the amount of leverage that is available to them today," says BAML's Yalmokas.
BOX: Investors tell funds to confront new risks
In trying to reduce risk in the banking system, regulators are "squeezing one end of a balloon", says Josh Distler, a managing director and head of the corporate development team at Magnitude Capital, a fund of hedge funds manager in New York.
To put it another way, hedge funds will end up accepting more risk as prime brokers shed it – in the form of shorter-term financing or early termination clauses, for instance, or simply because they have to go into riskier, unleveraged trades if they can no longer secure the financing necessary to make an attractive return on less risky arbitrage strategies.
"Hedge funds need to understand how their portfolios are financed and manage the risks in their prime brokerage relationships. The concern is that hedge funds will be exposed to more funding risk as prime brokers adapt to new regulations. We look for hedge funds that put good people into treasury functions and invest in the technology necessary to effectively manage their funding risks," says Distler.
This may make sense from a systemic risk perspective – hedge funds are arguably in a better position to absorb losses than banks – but that is of little comfort to investors.
"You don't just have trade risks anymore. You have leverage provider risks, and not just yours but everyone else's. The way you manage that risk has to change to deal with this," says Ronan Cosgrave, managing director and sector specialist and portfolio manager at Paamco, a fund of hedge funds investment firm in Irvine, California.
Some firms, such as Citadel and DE Shaw, recognised years ago that they needed this capability and have invested heavily in treasury staff. Now, many large firms are following suit. Only last year, Israel ‘Izzy' Englander's Millennium Management hired the former head of Barclays' prime brokerage business, Ajay Nagpal, as its chief operating officer.
"Hedge funds realise financing costs and access to leverage could become a drag on performance. We're seeing more firms establishing internal treasury functions to manage their financing. They're hiring experienced people from banks and allocating more resources to their treasury departments, which puts them in a better position to work with their counterparties and optimise the funding model," says Chris Barrow, global head of sales for HSBC prime services.
This is not just an inward looking discipline, however. Funds running leveraged strategies will increasingly need to understand the type of constraints being faced by their brokers and select providers accordingly. Some banks may be constrained by the leverage ratio or regulatory stress tests, or need to improve their liquidity ratios or return-on-assets metrics. Others will have access to more diverse sources of funding, including customer deposits for universal banks, or may have strategic reasons for supporting certain types of assets. Considering these factors and selecting prime brokers that see the most value in a fund's portfolio could make a big difference, banks say.
Some firms are turning to external specialists and technology companies for help. In January, financial analytics vendor S3 Partners launched a service called Blacklight, which allows hedge funds to compare the financing fees charged by their counterparties to a benchmark rate – called the market composite rate – and negotiate better prices with their providers, or shift the balance to a more competitive firm.
The service is proving popular, with around 40 hedge funds, representing a combined $300 billion of assets, signing up to date. S3's managing partner, Bob Sloan, hopes to license the technology to as many as 200 hedge funds over the coming year.
Enso Financial Management, which is backed by interdealer broker Icap, offers a similar service and has about 50 clients with $300 billion of aggregate assets.
Fixed-income and credit funds have a particularly strong incentive to bolster their treasury capabilities, given the reluctance of many prime brokers to finance these assets. "If hedge fund assets continue to grow at this pace, at some point push will come to shove and the bigger managers will have to go direct. It becomes a competitive advantage to have an internal treasury function and a capital structure," says Sloan.
Paamco's Cosgrave agrees. "If some fixed-income and credit arbitrage funds are able to find cheaper sources of funding than their peers, they could dominate these strategies," he says.
The result could be that hedge funds end up looking and acting like the prime brokers that have historically provided them with financing. The hedge fund of the future may obtain its leverage through a combination of tri-party repo financing, debt issuance, private placements, and non-bank borrowing.
"Fixed-income and credit funds need to have direct access to funding markets. For better or worse, the shadow banking system is going to become a source of funding for certain strategies. A hedge fund with growth aspirations in these areas shouldn't be relying exclusively on prime brokers for financing," says the head of prime brokerage at a bank in New York.
BOX: New entrants spot an opportunity
Increasing financing rates and the retreat of established players gives other companies a reason to step up. This is already happening, with Cantor Fitzgerald, HSBC and Wells Fargo among those seeking to boost their newly launched prime brokerage businesses.
HSBC launched its prime brokerage business in Europe in 2010 and has been expanding its service in Asia and the US over the past couple of years. The bank "has become an additional source of financing capacity for hedge funds, especially to those firms looking for stability of funding in a capital-constrained environment", says Chris Barrow, global head of sales for HSBC prime services.
"We're not trying to be all things to all people. HSBC is a financing-led, emerging markets-focused organisation. Our equities and prime brokerage franchise is in a growth phase, and we're looking to work with hedge funds that complement our overall strategy and focus," he says.
Wells Fargo acquired introducing broker Merlin Securities in 2012, and has been building out its internal clearing and financing capabilities for hedge funds. The service, to be formally launched in the second quarter of this year, subject to regulatory approval, will initially support hedge funds trading US assets – including equities, listed options, corporate credit and convertibles.
Eamon McCooey, head of prime services at Wells Fargo, says the firm will look to steadily increase its footprint in the hedge fund business. "We're a well capitalised bank and one of the safest financial counterparties in the world, so we definitely see an opportunity to be a financing provider to hedge funds, given our strong and liquid balance sheet under the new regulatory framework. We'll use our balance sheet with clients as long as it's for the right reasons. We want to grow with the right counterparties, and ensure the financial and regulatory metrics that are important to the bank and its shareholders are met," he says.
The regulatory pressure on big banks also creates an opening for smaller financial institutions. "These regulations affect everyone to some degree, but the larger banks are the most impacted, so it could certainly be an opportunity for other providers," says Noel Kimmel, senior managing director and global head of prime services at Cantor.
As a broker-dealer, Cantor is much less affected by Basel III's capital and liquidity rules, which Kimmel says gives it more flexibility to "extend balance sheet to clients that are the right fit for us".
Cantor is especially keen to work with mid-sized hedge funds, which will be among the first to feel the pinch once prime brokers start to actively consolidate and rationalise their businesses. "The level and cost of service apportioned to mid-sized clients will be adversely affected by these regulations. Those types of clients are in our sweet spot, so we'll be looking at that very carefully," adds Kimmel.