March Madness

Now seen as the month that changed the world, Joe Parsons takes an in-depth look at how hedge funds and prime brokers responded to the economic crisis that ensued in March, and what the ‘new normal’ could for be the HF-PB relationship.

On 12 February, the three main stock indexes in the US – the Dow Jones Industrial Average, the Nasdaq Composite, and S&P 500 – all finished at record highs.

Tech and energy stocks were among the best-performing sectors, while the airline and hospitality industry saw their share of price climbs. At the time, investors largely shook off concerns about how the COVID-19 virus would impact corporate profits and the global economy.

Boy were they wrong!

A week later, stock markets worldwide reported their largest one-week decline since the financial crisis. Global markets became extremely volatile entering March, and on 9th of the month, most reported severe contractions in response to the pandemic and an oil price war between Russia and the OPEC countries, led by Saudi Arabia. This officially became known as ‘Black Monday’.

In response, regulators across Europe and Asia initiated short selling bans to quell the market freefall, while exchanges enforced circuit breakers, extended trading holidays, and shorterned trading hours.

Comparisons with the global financial crisis came thick and fast, and attention quickly shifted to those firms that experienced both heavy losses and profits.

Most hedge funds, including those run by industry titans such as Ray Daliio and Michael Hintze, were unable to protect investors from the market turmoil. According to data compiled by Bloomberg, three in every four hedge funds lost money, with some down as much as 40% in March.

Assets in hedge funds also plunged below $3 trillion for the first time since 2014 as investors withdrew net of $33 billion in the first quarter, the most in more than a decade according to Hedge Fund Research.

The turmoil resulted in a delicate dance between hedge funds and their prime brokers. As markets collapsed, it triggered margin calls to be collected by their banks. In a report conducted by Northern Trust and treasury management technology vendor Hazeltree, margin calls among hedge funds jumped 86% in March versus just two months prior in January.

Relationships had to be managed carefully with regular conversations around counterparty risk, credit risk, deleveraging, and financing, all in an environment where the entire financial services industry shifted to remote working. “Communication between clients and prime brokers had increased because of concerns over understanding how liquidity and how financing would be maintained,” says Mark Aldoroty, head of prime services, BNY Mellon’s Pershing.

So how have hedge funds come through the other side? And what could the long-term impacts be with prime brokerage relationships?

De-risk and de-lever

As markets began to tank and margin calls skyrocketed, the first move among many in the hedge fund community was to de-risk and de-lever their long market exposure, in order to cover their short positions and repay money to lenders.

The crisis really hit hedge funds that adopt quantitative strategies hard, with one market commentator describing the situation as a new “quant quake”.

Data from Morgan Stanley’s prime brokerage division detailed the quant losses in March. For example, quant funds run by AQR, GAM Systematic, Renaissance Technologies, Two Sigma, and Bridgewater all experienced doubled digit drops in performance in March.

“We saw significant deleveraging, especially from quant funds which shrunk their books quickly, whereas everyone else gradually deleveraged. The short selling bans across Europe and Asia also contributed to the book shrinking in size. As a result, the short book has taken a bit longer to bounce back as hedge funds were quick to take advantage of buying deeply discounted blue-chip names,” says Dougal Brech, global head of prime finance, Nomura.

Those highly leveraged hedge funds that found themselves on the wrong side of the market downturn witnessed devastating effects to both their funds and the counterparties they were exposed to. This was showcased when ABN Amro said in March it would incur a $200 million loss within its clearing business after a single US hedge fund client trading futures and options failed to meet margin calls.

“The crisis showed what happens when you have an asset class disconnect, and how the algos could operate in that space when there is that level of volatility,” explains Anthony Bennett, prime brokerage lead at consultancy firm Capco.

However, not all hedge funds were hit as badly, and some were even able to turn huge profits, sparking ‘Big Short’ comparisons. This was particularly the case with certain credit and macro funds which bet on currencies, interest rates and commodities.

US hedge fund giants including Citadel, Millennium Management, and Point72 Asset Management emerged as some of the industry’s biggest winners from the crisis.

“We’ve seen massive dispersion in performance across our client base including within the same strategy as a result of this year’s dramatic moves in both directions for global equities markets. Some clients were caught offside not de-risking or recalibrating when equities crashed while others were not convicted enough to play the upside when markets rallied,” says John Dlublac, EMEA head of prime services sales and prime derivatives services, Credit Suisse.

Some hedge funds were also able to protect themselves from clients withdrawing their money overnight and were able buy time around how to manage their portfolios.

“Most hedge funds do not have overnight redemptions, so this was not a situation that required immediate adjustment for capital levels changing, there was time to think about how to position their portfolios. Because a lot of hedge funds are naturally hedged, while they faced pressures on the long side they were able to benefit from, for example, shorting indexes,” Aldoroty adds.

What became clear for both hedge funds and prime brokers was that in order to navigate the storm, clear communication lines had to be set up. Near real-time information flows around liquidity, financing, and margin calls were needed in order for hedge funds to manage losses and cover exposures.

In order to achieve this, a whole new communication infrastructure had to be set up to enable prime brokers to contact their hedge fund counterparty that was now working from home.

“When you go through uncertainty in the market, as we went into working from home, consistent and clear communication was critical to the continued functioning of operations and funding,” says Stephane Marchand, head of international prime finance and clearing sales, JP Morgan.

With record outflows from bond funds and billions more from stock funds during this period, many firms began seeing the value of their collateral fall, further exacerbating the dilemma they faced. According to one Bloomberg opinion article published at the end of March, the author described the situation as a ‘system-wide margin call.’

The big margin calls

The challenge for prime brokers was to guarantee stable lines of communication to individuals in the treasury departments and back-offices of hedge fund clients to ensure they were able to provide collateral in a timely manner.

“The most important thing clients are looking for is stability of financing provision and of your margin regime. During these volatile times, we provided clarity about margin calls and how clients were going to meet them,” explains Jon Cossey, global head of prime finance, JP Morgan. “We quickly worked through some operational obstacles pertaining to the infrastructure of the hedge fund community when there were meaningful margin calls that had to be met.”

More often than not, prime brokers have the last word in deciding what a position is worth, and therefore how much collateral to demand. Yet some of the systems prime brokers use to calculate how much collateral to ask for cannot factor in the extraordinary market conditions firms are facing, and as a result, it led to a rise in disputes with their clients.

“Brokers have been inconsistent in applying some of their more complex, portfolio-based margin methodologies. These agreements typically involve sophisticated calculations that don’t get triggered other than in times of significant market volatility,” says David Nable, managing director, Arcesium.

“Perhaps because these clauses are so rarely triggered, the brokers haven’t tested them in practice as fully as other terms. As a result, we have seen a notable uptick in the number of margin disputes due to incorrectly applied methodologies.”

There are also concerns that once the dust settles, there is a possibility that hedge funds and other buy-side firms will make claims against banks as their positions were closed out due to delays in covering margin shortfalls.

“Usually the client has until the end of the day to cover positions, but where assets have been rehypothecated, for the purposes of leverage and financing and effectively immobilised, accessing collateral quickly will be a challenge for some,” says Dave Grace, managing principal, Capco.

“Some banks would have taken prudent risk management decisions to protect themselves against any potential client default and liquidate positions. The result may be that clients sustain realised losses on their books, and some have started legal proceedings against their banks.”

At the same time, those within the risk management departments of prime brokers may begin to take a closer look at their clients and how exposed they are to those funds that saw big losses. “Across the industry, we are seeing the credit departments of prime brokers beginning to review some clients who saw significant drops in AuM,” says Nomura’s Brech.

But again, not all prime brokers experienced the same operational headache as others. Brech explains that their hedge fund clients were able to meet all of their margin calls, and JP Morgan’s Cossey says, “as with any change in working conditions, there were some bumps in the road but we provided a stable financing platform and a stable framework where margin calls were met.”

Nevertheless, the ABN Amro example and the ‘system-wide margin call’, could force some prime brokers to revisit both their risk management and margin framework. In instances where liquidity and funding solutions dry-up, prime brokers may face questions around how to sustain longer-term financing models in a prolonged crisis, and in doing so, future-proof losses for themselves and their clients.

“The crisis brings risk management practices and processes into the spotlight across the board. It is an opportunity for people to take a step back when they look at their models and to carry out an analysis of what worked and what needs to happen to make sure we are insulated for future shocks,” says Credit Suisse’s Dlublac.

The road to recovery

After the March madness – and the subsequent aftershock in early April – global markets rebounded hard in the months that followed. At the end of April, the S&P jumped 30% from its record low, and hedge funds followed suit in rebuilding risk.

For US-based hedge funds, net leverage a measure of how much risk they are taking as they chase returns – fell during the March selloff to the lowest it has been since 2010, but “both gross and net (leverage) have bounced back,” according to a report by Morgan Stanley’s prime brokerage team in April.

What appeared evident was the bleak comparisons with the 2008 global financial crisis now appear unfounded. March madness differed from 2008, because there were no liquidity issues such as those seen with the Lehman collapse and other industry defaults. In addition, the prime brokers appeared to have learnt lessons from ‘08 and had built up sufficient capital reserves to weather the storm, largely due to post-crisis regulations.

“The leverage in the system was less because the banks were not struggling at the same time. The post-Basel world has worked and delivered a robust infrastructure that allows the market to survive an idiosyncratic stress for a comfortable time,” adds Cossey.

As hedge funds and prime brokers take the necessary steps on their road to recovery, firms will begin to collectively take lessons from their experience during the crisis and how it can shape future relationships.

One of the first lessons is how to keep track of margin calls when asset values are in constant fluctuation.

Prime brokers could face new pressures to demonstrate enhanced transparency over their margin frameworks, as well an increase in focus on real-time and intraday margin pricing. In addition, prime brokers may also have to deploy tools that will enable them to monitor who they are providing funding to and whether it is being used to finance illiquid assets.

“The big impact the crisis has had is on the amount of financing available for non-investment grade credit which had evaporated. The big managers can still get it, but mid-tier and smaller firms are suffering because there is less appetite from lenders for that credit. Primes have learnt you have to monitor the illiquid assets on your book and that the ratio to liquid assets is the right one,” says Nomura’s Brech.

The crisis also proved to be one of the strongest tests for prime brokers’ relationship management. One prime brokerage executive commented, “Our relationship management was tested more in the past six months than it ever has been.”

The industry has never faced a situation where both prime brokers and their clients faced fragmentation of personnel and fragmentation of visibility and information flows. Going forward, prime brokers will look back on how they managed their communications with hedge funds and the value in providing continuous transparency on information flows and how clients absorb it.

Growth strategies

As normality slowly begins to return and the industry looks to move forward, prime brokers will once again revisit their growth strategies. Over the past few years, banks have tended to focus on those funds that play to their core strengths, and the crisis may buttress this as primes aim to compete on product lines.

“We could see a big asset rotation coming, moving from equities to relative value fixed income and credit, and offering the necessary offsets and to provide custody and financing to clients who want to engage in those strategies. A lot of roles are being posted from those sectors for the prime’s risk team,” says Capco’s Bennett.

The asset class rotation among hedge funds could encourage prime brokers to invest significantly in specialising in servicing credit and multi-asset strategies, as well as creating an infrastructure that can service the entire trade lifecycle. “We are seeing more demand for a multi-asset prime wrapper, and we have to ensure our infrastructure continues to be the best, our ability to service assets providing financing is correct, and that our cross- margin regimes are broad enough to adapt to client strategies,” says Marchand.

Prime brokers also appear to be more willing to bring on increased hedge fund balances following the crisis. Firms including Goldman Sachs and JP Morgan saw their hedge fund balances boosted by increased trading activity from managers looking to capitalise – or limit their losses – from the volatility during the first quarter.

JP Morgan’s Cossey explains that the US bank’s prime brokerage strategy has not changed despite the pandemic, with its sales teams utilising digital and virtual technologies to win new mandates.

“We remain focused on delivering value and scale, with a client acquisition mindset and continuing to expand our client footprint. Our strategy hasn’t changed during this time, and we have either kept market share or grown it. There have been some mandates won entirely virtually, carried out by our sales and relationship management team through Zoom or Microsoft. It has been a surprise that the pipeline has been so active,” Cossey says.

BNP Paribas also remains undeterred by the coronavirus as it accelerates its integration of Deutsche Bank’s prime brokerage and electronic execution business. The French bank has said its migration plan to bring Deutsche Bank’s hedge fund clients onto their prime brokerage platform, as well as its electronic execution technology, is ‘on track’ and has not been affected by staff working from home during the COVID- 19 pandemic.

How prime brokers approach pricing of financing and factor in gaining market share will also be vital in their post-COVID growth strategies. Over the past few years, pricing power has largely rested in the hands of hedge funds, who have used their influence to enact downward pricing on their prime brokers. In addition, some prime brokers have turned to pricing their services cheaply to gain new hedge fund balances.

Whereas some may assume prime brokers may look to increase the cost of their services off the back of the crisis, it is not that quite simple.

According to one prime brokerage expert, with clients deleveraging massively and balance sheets across the Street falling by up to 40%, banks may turn to cheap pricing as a lever to make up for this.

That being said, prime brokers may look to revisit pricing of financing illiquid asset classes, including private equity, real estate, and emerging market debt.

“Equity prime pricing remains very competitive and there is still some price compression for the right type of clients. As you get into more illiquid collateral, the pricing power has shifted back to the primes. There is a lot of shopping around, and the price is varying as much as 50 basis points, with different banks having different appetites and some are having no appetite at all any longer,” adds Nomura’s Brech.

“Primes were previously lending too much without understanding the assets they were lending against, maybe because they had priced it too cheaply. There is going to be some re-pricing so they can guarantee returns.”

While pricing could be used as an initial short-term solution to regain balances and win market share, the COVID-experience for all firms has shown the importance of relationship management, communication, and a robust infrastructure. Hedge funds will want their prime brokers to guarantee access to financing, as well as the wider prime wrapper such as trading and research.

Hedge funds may also be more prudent when selecting their partners, not just prime brokers but all of their third-party providers, with an emphasis on data.

“We see hedge funds taking an ‘as-a-service’ perspective to their primes, their custodians, fund administrators, and outsourced trading providers. It boils down to whether a prime broker can provide their client immediate access to the data they need, can it be consumed via APIs, and can it meet the needs around what the market is calling for in terms of transparency. This prime-as- a-service model will only accelerate with the move to more agile working, more structured real-time data decisions, and more flexibility,” concludes Bennett.