In advance of a panel discussion at the HFM European Operational Leaders’ Summit on the balance of power in the hedge fund-prime broker relationship, Stuart Bloomfield, Managing Director, Head of European Prime Services Sales at Scotiabank, looks at how the relationship between hedge funds and prime brokers has evolved – and what factors contribute towards a sustainable and successful partnership.
Some powerful lessons were learned during the global financial crisis of 2008. One of them was that counterparty risk cuts both ways. It also showed that relationships with your key counterparties are highly important, and need to be nurtured. Optimizing your Prime Brokerage relationships in good times can help you weather more difficult market environments when they inevitably occur.
Prior to 2008, it was the Prime Brokers who worried about the creditworthiness of the funds they serviced. Hedge funds worried less about the risk of their Prime Brokers.
With the bailout of Bear Stearns and subsequent Lehman bankruptcy, credit sensitivities changed. Asset managers became concerned about the creditworthiness and stability of the banks, with many hedge funds suddenly reconsidering their longstanding Prime Brokerage relationships, adding new names with a stronger capital base and higher credit rating to their roster.
Stability has returned, but the relationship between banks and hedge funds continues to evolve. New regulations have driven changes which fundamentally affect the way Prime Brokers operate, and in turn how hedge funds allocate their business.
Regulatory reform and increased focus by ratings agencies on liquidity risk led to a decline in banks’ reliance on wholesale unsecured funding, and a corresponding shift towards secured funding markets and quality underlying collateral. Rehypothecation of hedge fund assets, once optional, became key to a bank’s funding strategy. Banks now seek to maintain broad and diversified funding sources across products, programs, markets, currencies and creditors to avoid funding concentrations.
The regulatory reforms required by Basel III aim to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. They look to achieve this through three streams:
1. Capital Requirements: Minimum risk-based capital ratios required to absorb unexpected losses that arise during the normal course of the bank’s operations. There is significant scrutiny of assets held by banks. Counterparty credit profiles, haircuts applied on collateral, and even settlement fails rates directly impact Risk Weighted Assets and, subsequently, capital ratios.
2. Leverage Constraints: A minimum non-risk-based leverage ratio. This acts as an additional constraint on the size and growth of balance sheets. Institutions must include all balance sheet assets, including on-balance-sheet derivatives collateral and collateral for securities financing transactions. This has driven increased focus on finding efficiencies, either internally or through positions with clients that offset existing longs and/or shorts. The more a Prime Broker can find such accretive, efficient assets to offset existing positions, the more financial resource efficiencies improve.
3. Liquidity Requirements: Liquidity Coverage ratio (LCR) and Net Stable Funding Ratio (NSFR). LCR addresses short-term liquidity by requiring banks to hold High Quality Liquid Assets to cover net cash outflows over a 30-day market-wide stressed environment. NSFR addresses longer-term asset-liability mismatches, requiring stable deposits to fund stable assets over a one-year stress scenario, limiting reliance on short-term wholesale funding. (Banks are preparing now to comply with NSFR.)
These changes have arguably made it easier for new players to break in to Prime Brokerage – especially those with financial resource availability, product and the bandwidth to establish market share – filling the void left by established players who found themselves more constrained. Some new entrants offer the potential to become very strong and stable counterparties.
Seven Rules for Successful Partnerships
At Scotiabank, we believe the strongest relationships are those built in the spirit of partnership. A lack of symmetry in a relationship can lead to a lack of sustainability. Ideally, everyone strives to find a sweet spot which results in a mutually beneficial relationship.
So how do we go about achieving that with clients, and what should they expect from us as a Prime Broker? In drawing up the following guidelines, we canvassed opinion from a number of our core clients, to ensure they are representative of the hedge fund community.
1. Transparency in the relationship was often mentioned as key in developing trust. Don’t make the relationship about short-term gain and point-scoring – strive for a long-term partnership that is sustainable. For Prime Brokers committed to the space, pricing sustainability can be as important as the risk of the underlying portfolio. Scale, strategy, leverage, wallet, asset type and provenance together establish the degree to which a manager’s business is attractive to a Prime Broker.
2. Managers need to understand that not all business is good for a Prime Broker any more. Pursuit of efficiencies, driven by regulation and financial resource scarcity, means that a particular allocation of business might work for one Prime Broker but not another. Revenue was once the only metric, but efficiencies and finding a Prime Broker focused on your business is now more important. Relationships based on an honest exchange about what business works, or does not, are likely to be the most sustainable.
3. Optimize the allocation of your business in a way that works best for all. This isn’t necessarily easy. It means juggling allocation based on pricing and margin rates as well as the appetite of providers – which may vary depending, for instance, on what other positions they are already running. The appetite may also be impacted by what other business you do with the Prime Broker, e.g. execution, repo, bank loan TRS, etc. A bank has to clear hurdles to justify balance-sheet allocation; keeping that in mind can allow for a more meaningful conversation when deciding who to reward with “easy” business.
4. Try not to make assumptions about your incumbent Prime Brokers, or indeed potential new brokers, and what their competencies might or might not be. For instance, we, at Scotiabank, may be well known for strength in Canada but we’re very active in other places too – such as Europe, Asia, the U.S. and Latin America. So don’t take all Prime Brokers at face value and take time to understand their pockets of strength.
5. Think holistically about your relationships with a Prime Broker as counterparty, and the multiple teams that support that business line. Forge good relationships not just with sales and coverage, but also risk and, most importantly, senior management directly, so that you can rely on that connectivity in a time of stress. The closer the connectivity clients establish across multiple streams, the more resilient business should be through good times and bad.
6. Diversification is key. Create a diverse set of Prime Brokers, and then consider allocations between them. Think about their geography, regulators and financial resources and try to select relationships that are less likely to be at the mercy of a changing strategy or commitment to the Prime Brokerage business-line. This is, of course, tough, as you want to remain meaningful to all of your providers. So talk about it and ask what the sensitivities are and whether minimum fees or thresholds might apply. Our clients told us that nothing is more destructive than being off-boarded by a Prime Broker, so do not be too dependent on a single provider.
7. Finally, make sure you understand the details of your agreements with Prime Brokers and what the documentation provides for. Consider the mechanics of your agreements, including pricing and margin lock agreements, so that you fully understand how business might operate if notice is served under them.
The relationship between Prime Brokers and their clients will continue to evolve. By creating a diverse mix of providers and maintaining an open dialogue with each of them, the hedge fund manager can ensure access to liquidity and therefore manage a sustainable business, even during periods of market stress.
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