Hedge fund performance forces prime brokers to rethink risk

Prime brokers are stepping up their due diligence of hedge funds, becoming more forensic when looking to bring a hedge fund onto their balance sheet.

Performances within the hedge fund industry last year are causing prime brokers to reassess the credit and counterparty risk of financing.

The $180 million loss within Citi’s FX prime brokerage business in December last year spurred a new debate over whether prime brokers are charging a fair price to finance hedge funds making speculative bets.

As prime brokers have sought to capture greater market share of hedge funds and boost returns, the power over balance sheet pricing has shifted greatly to the buyer of their services, and what many see now as inaccurate rates for the risk they are taking on.

“I think some rates out there don’t make sense to me. I scratch my head and I wonder, do people understand the risk, whether that’s liquidity risk or other financing risks,” said Eamon McCooey, head of prime services, Wells Fargo.

One of the main risks to prime brokerage activities is still the credit risk/counterparty risk of the client. The risk parameters involved in the pricing process include who the counterparty is, the volatility of the product they are trading, redemption cycles, the types of collateral being traded, and whether they are trading in a frontier, less liquid market.

Prime brokers are now stepping up their due diligence of hedge funds, becoming more forensic when looking to bring a hedge fund onto their balance sheet.

“When we take on a portfolio, we look at all of the components of it, how each asset can be used and financed, who they execute with and what the turnover is,” said Dougal Brech, global head of prime finance at Nomura.

In the aftermath of the reported loss for Citi’s FX prime brokerage business, the US bank published a white paper circulated among its clients in which it called for other banks and trading intermediaries (otherwise known as executing brokers) to share the costs of managing risky derivatives trades.

It also highlighted how the incoming uncleared margin rules (UMR) for non-cleared derivatives will greatly impact FX prime brokers, who will have to not only hold initial margin for the client when trading FX forwards, but also post it with the executing broker.

The white paper showed, as an example, how the cost of handling a non-cleared NDF trade with a notional value of $10 billion will rise to 31 times prevailing rates in order to cover the bank’s funding costs and regulatory capital requirements.

The equity prime finance and synthetic prime brokerage business could also be affected by the uncleared margin rules. Prime brokers may be forced to absorb the costs of holding collateral and being exposed to more counterparties through certain equity derivatives. This may also factor into new pricing models.

“If the UMR rules result in more collateral and operational drag, that could cause rates to go up. There would have to be a point where a line is crossed and the prime broker is no longer paid fairly for the value it brings to the client,” explained Mark Aldoroty, head of prime services and collateral funding & trading, BNY Mellon’s Pershing.

Hedge fund clients know they cannot low-ball a prime broker in order to get the cheapest price possible. According to Societe Generale’s John O’Hara, Americas head of prime brokerage and clearing, both their large and smaller-sized clients know prime brokers need to be profitable in order to be sustainable. However, because there is still a lack of a consensus over pricing, there are some hedge funds that are able to take advantage of this arbitrage.

“There are still some well-established hedge funds that can command pricing levels, even when they don’t make absolute sense to the service provider,” said O’Hara. “That is unfortunate since, like them, the banks have an investor base (shareholders) to which it has a responsibility to generate adequate returns. At SG we negotiate from a fairness perspective in terms of credit and pricing, and would rather forego an opportunity rather than misprice or assume outsized risk.”