JPMorgan prime brokerage head prepares for the year of leverage

After several years of deleveraging and capital strengthening at all top-tier US banks, JPMorgan’s balance sheet strength no longer stands out as it once did. Instead, along with its rivals, the bank must think carefully about how to use capital resources that are set to become scarcer again in the face of new regulations. This is particularly significant for the business of financing hedge funds, says Teresa Heitsenrether, JPMorgan’s global head of prime brokerage.

“If 2013 was the year of liquidity, this is the year of leverage. Prime financing does not involve heavy consumption of risk-weighted assets because of the collateralised nature of our financing activity, but it is more significant for capital consumption under the leverage ratio given the emphasis on balance sheet,” she says.

Competitive position

The US is set to impose a tougher leverage ratio standard than that required under the global Basel III capital accords – 6% rather than 3%. In reality, the capital level required will not be double the Basel standard, because US accounting principles allow for greater netting of derivative positions. In any case, Ms Heitsenrether says American banks are already accustomed to the notion of the leverage ratio as a dominant constraint for their business, as US regulators have long placed more emphasis on this concept than on Basel risk-based capital. Consequently, although the US leverage ratio is higher, she believes US banks are generally better prepared for its introduction than their competitors in Europe.

That competitive position is important for JPMorgan, as the firm launched a European prime brokerage presence in 2011, with Ms Heitsenrether at the helm. That was an inauspicious time to be expanding in terms of the market environment, but it suited the bank. The Bear Sterns acquisition in 2008 had transformed the firm’s potential, adding a leading US equities prime broker to JPMorgan’s own strength in rates and fixed income.

“There is an equity focus among many European hedge funds, and we had not been able to serve those clients fully before. We put capital resources and investment into providing synthetic financing and cross-margining outside the US, and the traction has been better than expected,” says Ms Heitsenrether.

The positive experience has encouraged JPMorgan to step up its on-the-ground coverage of Asia as well, building up direct market access to Asian equities over the past year. Ms Heitsenrether says that so far, the strategy is geared toward providing Asian access to global hedge funds, in addition to selectively serving local funds.

New relationship

In 2013, the regulatory agenda was dominated by the unveiling of the US interpretation of Basel’s liquidity coverage ratio, together with the growing drive to move swap trades onto central clearing. Both elements have resulted in increased demand for high-quality collateral – for derivative margining, and for banks to hold in their liquidity buffers. Ms Heitsenrether says this raised a number of concerns for hedge funds.

“Both the liquidity rules and mandatory clearing were digested reasonably smoothly with minimal market dislocation. Volumes were down a bit, but the adjustment process was helped by the flat yield curve environment. What concerns hedge funds more is who will be there for the long term if fewer dealers are prepared to finance and make markets in a certain asset class, and what impact will that have on their trading strategy?” she says.

The leverage ratio will put a spotlight on the relationship between banks and their hedge fund clients. Ms Heitsenrether says there has been a change in focus since the immediate aftermath of the Lehman Brothers collapse. Then, the attention was on counterparty risk, and funds wanted to operate multi-prime broker models to avoid concentration risk. Today, thanks to stronger balance sheets and new rules on central clearing and margining, counterparty risk is lower down the agenda. The willingness of banks to commit financing to their clients is a higher concern.

The return of the hedge fund

Those discussions on balance sheet and pricing are likely to become more intense because the hedge fund universe is growing again, with alternative investment fund research firm Eurekahedge estimating total alternative assets at $2100bn in May 2014. This is close to the pre-crisis peak, but bank balance sheets are significantly smaller.

“Hedge funds are beginning to think much more clearly about how the leverage ratio will affect their business model. They are increasingly asking how to be strategic to their chosen prime brokers, which often means rationalising the number of those relationships,” says Ms Heitsenrether.

Larger funds have long been astute at allocating their wallet to maintain good counterparty relationships. That has traditionally meant considering banks’ markets divisions alongside the financing business to selectively distribute commission fees for their trades. JPMorgan has an extra tool in its kit through its market-leading custody and securities services offerings. While recognising the possible efficiencies of joined-up prime brokerage and custody services, most hedge funds have tended to use standalone custodians such as State Street or Citco. But Ms Heitsenrether says that is beginning to change.

“Custody and fund administration were not previously part of the conversation, but they are reliable annuity streams that are not balance sheet-intensive. Now that funds have fewer concerns over counterparty risk, they have realised that these services can be a valuable part of the relationship with financing providers, although admittedly changing fund administrators is not an easy task,” she says.

The need to assign capital more carefully has also changed JPMorgan’s own approach to coverage, with the team arranged around client segments rather than product sales. Ms Heitsenrether says it is important to offer any part of the bank that is relevant to a particular client, and the cross-product view is also essential to make sure the team can holistically track the return on capital from serving a particular client.

Improving trend

The backdrop for alternative investments is certainly supportive at present. Hedge funds are witnessing the highest inflows of new money for many years, and Ms Heitsenrether says JPMorgan’s client benchmarking surveys show a strong appetite for alternatives. The money comes mainly from the US, with some pockets of activity in European and Asia.

“We are seeing continued commitments or intentions to increase allocations to hedge funds, and more of this is coming directly from family offices, endowments and pension funds, rather than through funds of funds,” she says.

After the strong market rally in 2013 and increase in volatility this year, institutional investors are looking to alternatives to provide downside protection, while pension providers continue to seek higher returns to meet their liability profiles in a low interest rate environment. There is also growing interest among hedge funds to offer their products to retail investors in a mutual fund format under the Investment Company Act, similar to the European Undertakings for Collective Investment in Transferable Securities concept. Inevitably, this will be closely monitored by the Securities and Exchange Commission.

The effort by hedge funds to diversify capital sources carries with it administrative burdens. Institutional funds require in-depth due diligence, and regulatory scrutiny is growing as well. The European Alternative Investment Fund Managers Directive that came into force in 2013 is the most obvious example of that scrutiny. Consequently, Ms Heitsenrether says the hedge funds themselves continue to undertake a process of institutionalisation that may also lead to consolidation around the larger managers.

In terms of themes, Ms Heitsenrether says fundamental value funds are seeking uncorrelated credit opportunities from the sales of assets by European banks that are continuing the reshaping of their balance sheets. Political risk – always the most difficult to predict and analyse – has made a dramatic comeback due to events in Ukraine. So far, however, this has been partially offset by the continued support to markets from very accommodative monetary policy in the US and Europe.