The collapse of a hedge fund is newsworthy but never has it been catastrophic for the wider economy. Even so, the traditional market consensus – that hedge funds are the riskier counterparty in the relationship between a hedge fund and its prime broker – has generally prevailed unchallenged. In recent months, however, a number of high-profile market events, in the wake of the global credit crunch, have served to undermine this presumption.
Not least has been the demise of Bear Stearns, a long-time global pillar of the prime brokerage industry, which nearly collapsed when market rumours that it was running into liquidity problems panicked its clients and lenders into withdrawing their cash.
The unprecedented quick-fire sale of the troubled investment bank to JPMorgan Chase, in a Federal Reserve-backed bail-out in mid-March, raised – for the very first time – the alien prospect that a prime broker could in fact prove a major counterparty risk to its hedge fund clients. Rumours of illiquidity at other broker dealers have continued to abound, compounding worries within the hedge fund community that both their cash and assets could be at risk.
The irony of this situation has not been lost on hedge fund managers. In a recent conversation with a hedge fund client, Paul Thomas, head of business consulting at GFT, a technology provider that works closely with the hedge fund community, recalls the striking words of one hedge fund manager, for whom the traditional market presumption regarding hedge fund counterparty risk is a matter of some irritation. Recent market events, the manager argues, have “proved that banks pose a bigger risk to the economy than hedge funds”, not least, he continues, because many banks and broker-dealers lack the necessary visibility and understanding to properly assess credit risk. The fund manager added: “Many banks don’t know the risk attached to the leverage they’ve issued; many banks don’t have information about what’s on their balance sheet; many of the banks don’t understand the instruments that they trade or they sell.”
Spreading anxiety
Whatever the truth of this statement (and sources on prime brokerage desks suggest that it is not wholly inaccurate) the anxiety in the hedge fund community regarding the creditworthiness of their prime broker counterparties is palpable – not least because few had ever envisaged such a reversal.
Yannis Procopis, deputy chief investment officer at CM Advisors, which manages the London-listed fund CMA Global Hedge, says: “It was not something anyone had ever considered: that a prime broker’s problems would affect its hedge fund clients. It is now definitely a concern of the hedge funds.”
Investors at their heels, the hedge funds are now viewing their brokers with a heightened level of caution, in what some prime brokers have described as a “step-change” in the hedge fund/prime broker nexus.
Facing questions
Most notably, prime brokers are now facing a lot more questions. Sean Capstick, global co-head of the hedge fund capital group at Deutsche Bank, explains: “These questions are coming from investors, the people who own the assets. Those people are calling up every hedge fund counterpart and asking ‘what’s going on, how is performance, how is my cash being invested, who are your counterparts, and how are those working?’ That means everyone in the prime brokerage world is getting a lot of questions about how cash is managed, how are your relationships, how secure is your custody, your reporting and your margins?”
Under scrutiny
The use and ownership of hedge fund assets is a key area in which many questions have already been loudly raised. It was not until Bear Stearns wobbled that the hedge fund community began to properly scrutinise how its assets, against which prime brokers are able to issue hedge funds leverage, are in turn used by their prime brokers.
This issue was also starkly underlined in mid-April when Opes Prime, an obscure Australian private client broker specialising in securities lending, was forced into receivership. In a bid to recoup the A$1bn ($937m) owed to them, Opes Prime’s creditors seized and sold on the broker’s portfolio of shares, to the horror of its clients who had not realised that, under their contract with Opes Prime, the assets no longer legally belonged to them.
In particular, the legal clause of rehypothecation, under which prime brokers are allowed to appropriate hedge fund assets and lend them on – one of the key ways in which prime brokers generate revenue – has been called into question by hedge fund managers. Many are now demanding tighter contractual controls on how the assets are used.
Robert Mirsky, a partner in the hedge fund practice at Ernst & Young, first noted this development in February. “Hedge funds were talking to their prime brokers and were trying to renegotiate rehypothecation limits. Some of the managers were concerned about how those assets are being used, how many times they were pledging them over and over to other people, and what they were doing with them. In the case of bankruptcy or failure on the part of the prime broker, who has primary rights to those assets?” The entire debate, says Mr Mirsky, “was quite a change of pace”.
Not infallible
Many of the larger hedge funds are now demanding that the prime broker – no longer the infallible partner in the relationship – should also bring collateral to the table, reveals CM Advisors’ Mr Procopis. “Now, a lot of hedge funds are looking at their prime broking contracts and they are seeing that the prime broker never has to put up collateral.”
He says: “If there are losses on the part of the prime broker, then the hedge fund managers would like the prime broker to have to put some collateral in place – given what happened with Bear Stearns. This is definitely a change in the relationship between hedge funds and prime brokers.” In the future, large hedge funds with negotiating muscle will be more careful when drawing up their contracts. He adds: “They will make sure there are more neutral collateral placements.”
Protecting cash, as well as assets, is also becoming a major priority for hedge fund managers. This has been borne out in the rise of client money protection. Indeed, “everyone is now an expert in client money protection,” remarks one prime broker sardonically.
In this arrangement, broker dealers will place clients’ cash in a segregated account, which is then effectively outsourced to a number of other banks. Both PCE Investors, an asset manager that provides services to more than 15 hedge funds, and CM Advisors report that many funds are now pursuing client money protection, even though it reduces the fund’s capacity to leverage.
Growing doubts
Doubts surrounding the liquidity of some prime brokers has also prompted nervous fund managers to move their cash away from their prime brokers altogether and into AAA rated institutional money market funds instead – in order to ensure its accessibility.
Barclays Global Investors, for example, has reportedly experienced an upsurge in interest from the hedge fund community, in terms of both existing and potential clients. Money market funds invest in highly rated short-term (usually no more than 13 months) debt instruments and generally aim to limit exposure to credit, market and liquidity risks. For this reason, hedge funds are increasingly regarding them as a safer and more accessible repository for their cash.
Securing the assets and cash held with any one broker will continue to be important. But spreading the risk of default or illiquidity across several prime brokers will prove an increasingly prevalent strategy. Many prime brokers report increased interest from hedge funds looking to set up additional accounts, in what is a broader trend towards a multiple prime broker model. This is not simply a knee-jerk reaction, however. Traditionally, hedge fund managers have chased multiple prime brokers in order to compress fees and to ensure necessary asset coverage.
Ernst & Young’s Mr Mirsky believes many funds now regard broker diversity as a long-term exercise in due-diligence. He knows of one hedge fund, for example, that recently wrote to its investors “touting the fact that it was well diversified across prime brokers and put in appropriate risk management controls. Moving back to a single prime broker model would be somewhat anathema to the current market environment.”
Russell Hart, chief operating officer at PCE Investors, notes that hedge funds, particularly those primarily using a broker dealer – which are funded by the short-term money markets and client assets rather than long-term deposits – are opting to open additional accounts with banks that have “a bigger balance sheet behind them”. Mr Hart says that a number of PCE Investors’ hedge funds have already made the move for this reason. As such, many of the biggest banks – speaking, no doubt, with some self-interest – argue that the demise of Bear Stearns has cast doubt upon the long-term financial viability of the entire broker dealer prime brokerage model – particularly now that the hedge fund community has been awakened to the potential risks.
Long-term position
Roy Martins, head of international prime services at Credit Suisse, says, making reference to the Bear Stearns bail-out: “Broker dealers will have to assess their long-term position, vis-a-vis banks, to service a growing hedge fund market – well beyond temporary emergency funding lines from the Fed.”
CM Advisors’ Mr Procopis agrees that hedge funds will be guided as much by quality as by quantity, when choosing prime brokers in future. “I would expect going forward for the hedge funds to be more careful who they choose,” he says.
GFT’s Mr Thomas says that in many other regards, however, recent market events have exposed “that hedge funds are not yet mature enough to deal with many of their third parties”, even on a purely operational level. Indeed, hedge funds are, in the words of a trade assistant on the credit derivatives desk at a world-leading prime broker, “their own worst enemy” when it comes to communicating with their brokers.
At top tier
In particular, many hedge funds – including several in the very top tier, The Banker has learned – struggle to deliver the very basic information necessary to their prime brokers in a timely manner.
One source, who does not wish to be named, says: “All we deal in is information and we have to put information together like a jigsaw puzzle. Sometimes it comes to us in dribs and drabs, and sometimes we have to fight for it. In terms of valuating positions at the moment, that’s very hard to do without the knowledge of the products that I am trading.”
In a key example, traders at the very biggest funds will simply forget to book trades that they have agreed to enter into with another third party. This means that the prime broker, having received information from the third party regarding the trade, is unable to reconcile this trade with the information provided by their hedge fund client.
The source says: “For us, this means we have a broker who insists that they have agreed a trade, but the hedge fund client says they can’t see it. We then have to go directly to the trader, who then says ‘oh yes, sorry, I forgot to book that’”. If the broker fails to push his hedge fund client hard enough for the trade information, the broker effectively takes on the risk. The source adds: “We will have to take the hit because we didn’t fight hard enough for the information: we take on the risk, even if it is their fault.”
The sustainability of this defective operational model is clearly questionable: asset managers also report, for example, that even the most experienced hedge fund managers sometimes struggle to manage the information flow between their various counterparties. This can lead to serious errors.
PCE Investors’ Mr Hart, for example, recalls the case of one seasoned hedge fund manager who opened a position with one of his prime brokers, only to close it with another. The risk attached to such mistakes could prove extremely costly. The aforementioned source adds: “The margin for error is huge because there’s so much information changing hands.”
To a large extent, the problem is a function of the industry’s relative operational and technological immaturity. Although many leading prime brokers have invested significant capital expenditure on building out sophisticated internal technology platforms, the interface between the broker and the hedge fund cries out for standardisation. In most cases, hedge funds operate on a unique system. This can often prove “a nightmare”, says the source, for training purposes on the broker side, or if staff are absent. The problem has proved especially onerous in recent months, he adds, because market volatility has prompted irregular trading activity.
Decreasing dependency
Happily, many funds are now addressing their failings in this regard. Both GFT and Fidessa LatentZero, which specialises in front-office IT systems for the buy-side, report growing IT procurement activity within the hedge fund community.
Richard Jones, CEO of Fidessa LatentZero, says: “In times like this, which are not dissimilar to the post-dot-com era, the whole operational control aspect of asset managers – whether institutional or hedge funds – comes under closer scrutiny and investors start to ask more questions.
He adds: “For a hedge fund, the response has historically been to point to their major prime broker and, to an extent, they can still deploy that argument. But investors are now expecting them to have more controls.”
In the future, says Mr Jones, many hedge funds will move to disintermediate some of the functions performed by their prime brokers, in order to reduce their levels of operational dependency. “The market will see an increase in hedge funds looking to implement systems which will allow them greater control over their orders, trading, and over management of exposure and hedging.”
Implementing systems
Fidessa LatentZero is already working with a number of small and larger hedge funds that are currently implementing systems in order to achieve just this, as well as “to demonstrate to their clients that they’re running a serious business that isn’t going to have a major operational disaster,” adds Mr Jones. Meanwhile, some prime brokers, such as Credit Suisse, are already building out client-facing platforms that will allow clients to better manage multiple prime broker relationships.
In this regard, many of the blow-ups and near-misses experienced by the hedge fund industry in recent months have served, in the large part, to expedite shifts that were under way prior to the credit crunch crisis, and to focus the minds of investors.
In the experience of PCE Investors’ president, George Cadbury, for example, many hedge fund processes have “changed incredibly over the past two years”, as investors have progressively asked more and more probing questions of their fund managers. The kind of information that investors now request as a matter of course, compared to only two years ago, is “so much more focused on what is going on behind the scenes”, says Mr Cadbury.
Most notably, the much-publicised influx of pension fund money into the hedge fund community has long been driving revisions in the way hedge funds operate. Mr Cadbury says such cautious investors are no longer simply concerned to ensure that “the fund is going to stay within its investment parameters, but in ensuring it is an effective engine room that is not going to let them down”.
The quick-witted due diligence seen on the part of investors in recent months, he suggests, reflects a broader long-term shift in mindset. “It is no longer just a case of performance; it is a case of ensuring you’re investing with someone who’s going to be around in three years’ time.”
