Hedge funds and the prime finance industry

If leverage, certain positions, and strategies in derivatives and debt markets are considered to be the sources of externalities, systemic risk, and financial instability, the mechanisms used by hedge funds to engage in these markets should be meticulously studied. Prime brokers are hedge funds’ primary incubators, counterparties, and creditors. Hence at this stage an introduction to prime brokerage business, its relationship with hedge funds and its interrelationships within the entire financial system can shed light into its complex and opaque relationships with the hedge fund industry.

In this section, the prime brokerage business as related to the hedge fund industry will be discussed. However, there will be no attempt to describe and investigate every aspect of the prime brokerage. This part will be limited to a brief introduction to prime brokerage business, their relationship with hedge funds, and the possible systemic implications embedded in this relationship. After the pathology of the interrelationships between hedge funds and prime brokers, possible regulatory responses to potential systemic risk embedded in this relationship will be investigated.

Hedge funds have at least three main relationships with Large Complex Financial Institutions (LCFIs) who are engaged in offering prime brokerage services. LCFIs can be hedge funds’ prime brokers, their trading counterparties, and the owners or manager of hedge funds.¹⁰⁸ These three main roles are not mutually exclusive, and one LCFI can simultaneously undertake all three tasks.¹⁰⁹

108 After the enactment of the Dodd-Frank Act in the U.S., major limitations have been imposed on the relationships of hedge funds with banking entities.

109 King and Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, 283-297.

Needless to say, the greatest concern arises when those three roles overlap and concentrate in one LCFI.

The most significant hedge fund counterparties are the financial institutions providing prime finance or prime brokerage services to hedge funds. Prime brokerage is best defined in the 1994 SEC no-action letter as “a system developed by full-service firms to facilitate the clearance and settlement of securities trades for substantial retail and institutional investors who are active market participants. Prime brokerage involves three distinct parties: the prime broker, the executing broker, and the customer. The prime broker is a registered broker-dealer that clears and finances the customer trades executed by one or more other registered broker-dealers (“executing broker”) at the behest of the customer.”¹¹⁰ In other words, prime brokerage services are the services offered by prime brokers who are part of major investment banks and securities firms to their prime clients such as hedge funds and other professional investors. These services include securities lending, repo financing, acting as custodian of customers’ securities, clearing customers’ transactions, capital raising for customers, and providing seed investment for prime clients. Prime brokers also offer execution brokerage services, such as services related to trade execution, transition management, commission sharing arrangements, direct market access (DMA), and research.¹¹¹

To entice hedge funds to become their clients and utilize the services of one particular prime broker or to find promising hedge fund clients as part of the business strategy of a prime broker, prime brokers provide hedge funds with the seed investment. In addition, prime brokers might act as an incubator for hedge funds in their start-up phase by helping them in capital introduction, capital raising and also providing hedge funds with infrastructure they need to operate. On the other hand, with increasing outsourcing in the hedge fund industry, and focus on the risk management and enhancing financial strategies to gain absolute returns, prime brokers recently offered hedge fund hotels which operated as one-stop shop for hedge funds, these prime brokers even provided the hedge funds with office space along with other technical assistance.¹¹² Indeed, prime brokerage services offered by investment banks to hedge funds became so

110 United States Securities and Exchange Commission, Division of Market Regulation, RE: Prime Broker Committee Request, January 25, 1994b.

111 Aikman, When Prime Brokers Fail: The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry, pp.

125-126.

112 Ibid.

profitable that it is estimated that around 15% to 20% of total investment banking revenues is derived from offering services to hedge funds. ¹¹³

It is no coincidence that the first prime broker and hedge fund were created almost at the same time, the former following the latter. The first prime brokerage firm was Neuberger Berman, a prime broker for Alfred Winslow Jones’ hedge fund which was basically created to offer margin lending and consolidated accounts for Jones’ hedge fund. Though these firms were in place almost for half a century, they were not being addressed by U.S. regulators until 1994,¹¹⁴ the year in which the SEC issued its no-action letter.

Based on the structure and nature of the investment services offered by prime brokers, they can be put into two broad categories, standard prime brokerage and synthetic prime brokerage.

Standard prime brokerage involves financing standard market instruments such as equities and bonds. This activity mostly involves providing leverage to hedge funds and other clients for leveraged securities investment, while synthetic prime brokerage involves financing derivatives transactions. Nowadays, the line between these two categories is blurred and the prime brokerage business has evolved into universal prime brokerage offering full service prime brokerage services including both standard and synthetic services such as equities, fixed income, commodities, Forex, credit default swaps, and other unclassified derivatives.¹¹⁵

There are three main categories of prime brokers; elite prime brokers, leading prime brokers (the leading prime brokers includes Merrill Lynch, Credit Suisse, Lehman Brothers, Bank of America,¹¹⁶ BNP Paribas, UBS, Deutsche Bank, Citigroup, and others.), and tertiary regional and smaller niche prime brokers. The prime finance market was historically an oligopoly with major dominant U.S. investment banks such as Goldman Sachs, Morgan Stanley, and Bear Stearns (now JPMorgan Chase) dominating the market. Although the prime brokers’ primary clients are hedge funds, they are not alone in using prime brokerage services. A number of other financial market players including private equity funds, pension funds, investment companies,

113 Alex Weber A., "Hedge Funds: A Central Bank Perspective," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), p. 165. See also Dresdner Kleinwort, "Credit Suisse, Deutsche Bank, UBS – how Important are Hedge Funds for the Investment Banking Industry?" (2007).

114 Aikman, When Prime Brokers Fail: The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry, p.

215.

115 Ibid.

116 After the acquisition of Merrill Lynch by Bank of America, now it is called Bank of America Merrill Lynch.

sovereign wealth funds, and other national and multinational corporations constitute the broad range of prime brokers’ clients.¹¹⁷

Hedge funds are also trading counterparties to LCFIs in the trade across full range of financial instruments. They participate in the primary and secondary markets for securities underwritten by LCFIs which means that hedge funds and LCFIs are often exposed to similar risks arising from similar underlying financial instruments. For example, these common risk exposures were highlighted in the global financial crisis through a default by a prime broker that transmitted problems to hedge funds. This occurred in the collateralized debt obligations (CDOs) markets and the Lehman Brothers bankruptcy. The crisis in particular highlighted the risks for hedge funds originating from the exposure to one prime broker.¹¹⁸

Last but not least, LCFIs can also be the owners and managers of hedge funds. Moreover, some prime brokers such a Bear Stearns sponsored hedge funds which operated under the brand name of the prime brokers.¹¹⁹ Although the losses in the hedge fund are normally borne by hedge fund investors, sometimes due to reputational risks to the prime broker, or due to the fact that the prime broker has the same positions as those of the hedge fund, it might not be in the best interest of the prime broker to let the hedge fund fail. This is mostly because the liquidation of such positions might have a negative price impact on the holdings of the prime broker.

Therefore, in these cases, prime brokers might have incentive to bail out the sponsored hedge fund.¹²⁰ This happened in 2007 when Bear Stearns and Goldman Sachs injected capital to their hedge funds.¹²¹

117 Ibid. As mentioned above, in the prime brokerage function, LCFIs offer a range of services including financial, administrative, and operational services. Their main financial service is secured lending. The range of services that prime brokers offer to their hedge fund clients arms them with vast knowledge of hedge fund business. Again, these constant interactions with hedge funds and the knowledge derived therefrom make them the first suitable candidate in the list of institutions that can be delegated with the function to perform the indirect regulation of hedge funds.

118 King and Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, p. 290.

119 This practice is banned by the Dodd-Frank Act which will be expanded in the fifth chapter.

120 Michael R. King and Philipp Maier, "Hedge Funds and Financial Stability: The State of the Debate," Bank of Canada Discussion Paper 2007-9 (2007), p. 291.

121See King and Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, p. 291.

Admati and Hellwig also express concerns about the leakage of subsidized capital of banks to hedge funds. See Admati and Hellwig, The Bankers' New Clothes: What's Wrong with Banking and What to Do about It.

The transmission of shocks and risks in the relationship between hedge funds and prime brokers can go both ways. Although collateral requirements and counterparty risk management can mitigate the risks to LCFIs stemming from their prime brokerage business, the failure of a prime broker can have severe consequences for hedge funds, particularly those hedge funds having substantial collateral deposited at the failing prime broker. Such a collapse can force hedge funds to liquidate their positions. If large hedge funds’ positions experience forced liquidations, this might result in market price dislocation. To better address this risk which might have systemic implications, it is suggested that regulators should focus on the counterparty risk management practices of the financial institutions offering prime brokerage services to hedge funds, with a particular focus on the adequacy of collateral and suitability of margin requirements. In the absence of such regulation, the fierce competition between prime brokers to attract hedge funds may lead to loosened requirements and greater risks to LCFIs.¹²²

3.1.1. Economies of scale and scope and network effects in prime finance industry As described in the first chapter, the market for the prime finance industry has the feature of two-sided markets. Due to this feature of the market, prime brokers enjoy significant economies of scale and scope. In addition, network effects exist in the prime brokerage business because it is more profitable for a prime broker to match one hedge fund with other hedge funds and clear the transactions if a single prime broker has greater number of hedge fund clients in its network.¹²³ On the other hand, if the prime broker is larger, it will have access to more funding because of its broad spectrum of hedge fund and non-hedge fund clients. The prime brokers have developed and expanded relationships with many hedge funds, other prime brokers, investment funds, and sovereign wealth funds. These developed networks of counterparties in larger prime brokers will provide hedge funds with the opportunity of having access to financial instruments which are normally considered hard to borrow.¹²⁴ Therefore, because of these network effects, prime brokerage has a tendency to become too big. Indeed, not only is it efficient for hedge funds to

122 King and Maier, Hedge Funds and Financial Stability: The State of the Debate, p. 292.

123 Aikman, When Prime Brokers Fail: The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry, p.

50. 124 Ibid.

have many hedge funds as their clients, but also it saves prime brokers significant amount of time and money in terms of search, and operational, as well as transactions settlement costs.¹²⁵

3.1.2. Prime brokers & hedge funds: lending & borrowing-incentives and concerns At the heart of the relationship between prime brokers and hedge funds lie the lending and borrowing of cash and securities, which to a greater extent involve debt markets rather than equities. Although in its primary stages the prime brokerage service mostly dealt with equities and debt instruments, it is no longer limited to these instruments. With the increasing combination and packaging of the debt and equity instruments through financial innovation, this traditional classification became far less important. Nowadays, prime brokers are active in debt, equities, commodities, derivatives, and foreign exchange markets. Therefore, the services offered by prime brokers are of such a nature that most financial institutions are in need of using their services. Accordingly, the spectrum of prime brokers’ clients extends from almost all banks, brokers, dealers, broker-dealers, mutual funds, pension funds to private equities and hedge funds.¹²⁶

With subtle differences, these business transactions of prime brokers are quite similar to transactions in the interbank lending and borrowing market, i.e., the interbank repurchase agreements. In the interbank repo, the duration of financing is usually very short, often overnight, while in the relationship between hedge funds and prime brokers, it could be short as well as long. In addition, because of the possibility of long-term financing of hedge funds by the prime brokers, long term illiquid assets could be used in these transactions which makes them slightly different from the interbank repo in terms of risks associated with relatively illiquid and long term financing compared to very liquid assets used in the financing of a repurchase agreement in the interbank market.

125 It is also argued that SIFIs can increase shareholder value if they can generate ‘top-line gains’ in terms of market-extension, higher market share, wider profit margins, and higher cross-selling. In addition, they can do so by focusing on ‘bottom-line gains’ in terms of decreasing the costs because of economies of scale, better operating efficiencies, and better tax efficiency, or if they can reduce the firm-specific exposure to risks due to the enhanced risk management or diversification. See Ingo Walter, "Universal Banking and Financial Architecture," The Quarterly Review of Economics and Finance 52, no. 2 (2012), p. 122.

126 Aikman, When Prime Brokers Fail: The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry, pp.

233-234.

In these types of transactions, however, the primary concern for the lender is the evaluation of the risks associated with the collateral. This concern could be of great importance if the collateral involves illiquid assets or financial derivatives. On the other hand, the borrower’s concern is mostly about the terms of financing, solvency, and possible default risk of the lender.

In a standard scenario, prime brokers play the role of lenders, lending financial instruments such as cash and securities to hedge funds. This way, they can be a source of financing and leverage for hedge funds. The cash and the collateral provided by hedge funds to prime brokers’ functions as a source of capital for the prime brokers and because of the possibility of rehypothecation of the collateral by prime brokers, it could be considered as the asset part of their balance sheet.

Hence, this could be seen as a source of liquidity for the prime brokers. Some hedge funds often lend cash and securities to prime brokers.¹²⁷ The primary purpose of prime brokers in engaging in transaction with hedge funds is to collect the fees for the services they provide for hedge funds and interests or premiums on the loans. In other words, prime brokers are market neutral and they do not engage substantively in transactions and do not take market positions. As mentioned above, the prime brokers can hypothecate hedge funds’ collateral for borrowing securities.

Basically rehypothecation means that the collateral received by the prime broker can be used in another transaction as collateral for financing other transactions, whether related to the first transaction or not.¹²⁸ Rehypothecation of hedge fund assets by prime brokers introduces new risks in financial markets to which the thesis will return.

However, as for the direct counterparty exposure of core financial institutions to hedge funds, the Financial Stability Forum (FSF) (2007) estimates that the potential counterparty exposure of core firms to hedge funds is approximately between 3 percent and 10 percent of Tier 1 capital. Thus, the FSF concludes that “the size of direct exposure would not be alarming” even assuming a wide margin of error.¹²⁹ More recent empirical work by Ang, Gorovyy, and van Inwegen suggest that until early 2008, the exposure of hedge funds to investment banks was approximately 65%

of the total asset base of investment banks and their exposure to the finance sector was 30%

127 The relationship of hedge funds and prime brokers are not necessarily a one-sided relationship. On the one hand, hedge funds acquire leverage through prime brokers. On the other hand, hedge funds are sources of financing and liquidity for prime brokers through providing cash and securities as rehypothecable collateral in their transactions with prime brokers.

128See Gorton, Slapped by the Invisible Hand: The Panic of 2007, p. 44.

129 Kambhu, Schuermann and Stiroh, Hedge Funds, Financial Intermediation, and Systemic Risk, pp. 11-12.

during the same time period. They document that the events of the 2008 financial crisis reduced hedge funds’ exposure to 40% of the total asset base of investment banks and 15% of the total asset base of the finance sector. They conclude that the exposure of the hedge fund industry to the finance sector before and especially after the financial crisis is modest compared to that of the listed financial intermediaries.¹³⁰