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The Bank for International Settlement’s latest Quarterly Review is out, and it includes an interesting little aside on prime brokerages, the corner of investment banks that service hedge fund clients.
PBs are one of the main links between traditional banks and shadow banks, offering services like custody, margin loans, derivatives, research and introduction to companies and investors. In return, they hope to get thiccc trading commissions.
However, the risks can also flow both ways. A stricken investment bank can yank credit lines from hedge funds and send its problems rippling through markets. Conversely, a major hedge fund collapse can cause havoc at a bank.
As the BIS says, with Alphaville’s emphasis in bold below:
Prime brokerage is designed to be a low-risk activity, but wrong-way risk (WWR), the opaqueness of funds’ positions and poor risk management can create vulnerabilities for PBs. WWR refers to the risk that a PB’s credit exposure to a hedge fund counterparty increases at the same time as the likelihood of the counterparty’s default. Opaqueness is present when the PB does not have the necessary visibility into the funds’ positions, eg because they are booked in different entities, the assets are complex or the assets do not have readily verifiable market values. The resulting risk exposures often become apparent only when the fund is facing severe difficulties.
If this sounds implausible — or like something from the 1990s — remember that Credit Suisse’s death spiral arguably started with the whole Archegos Capital debacle. Here’s the BIS again:
The fund had large and concentrated positions in a small number of shares. When these stocks suddenly plummeted, the fund’s financial strength suffered a blow, while PBs’ exposure to the fund surged, exacerbated by leverage — a case of WWR. Illustrating opaqueness, Archegos’ PBs were not fully aware of the size of the fund’s positions with other banks, thereby underestimating its overall leverage and impact on the markets in which it was active. Compounding these risks, Credit Suisse, the PB most affected by Archegos’ failure, had not set sufficiently conservative terms for the leverage it had provided. This resulted in both an excessive credit exposure for the bank and excessive leverage of the fund.
As the BIS notes, the prime brokerage business is incredibly concentrated. While large hedge funds have relationships with multiple offices — say, in London, Hong Kong and New York — the Goldman Sachs, Morgan Stanley and JPMorgan trio dominate the rankings.
It’s also inherently procyclical. When times are good, everyone wants to court the big hedge funds and capture the immense revenues they can throw off. When markets puke, banks often want to ratchet back their exposure, especially to their more opaque hedge fund clients.
As the BIS puts it:
PBs tend to provide more margin loans to hedge funds when markets are buoyant: secured borrowing by hedge funds correlates closely with stock market valuations, just as leverage in dealer balance sheets is procyclical. Hedge fund credit quality as perceived by dealers deteriorates during weak market conditions, when the value of assets the banks hold as collateral vis-à-vis the funds falls. This positive correlation between default probability and net credit exposure constitutes WWR. As for opaqueness, the assets of a quarter of hedge funds are not fully independently valued, comprising 38% of hedge fund assets, making it more difficult for PBs to trust the fund’s stated asset values, especially in adverse market conditions.
PBs accommodate hedge fund requests for better conditions on margin loans during calmer market periods, only to tighten these conditions during stress episodes. The Archegos episode is an extreme example: well in advance of the fund’s troubles, those in Credit Suisse who wanted to maintain a relationship with Archegos reportedly resisted efforts by risk management to demand more margin. Evidence suggests that such efforts to accommodate customers occur in the market in aggregate, reinforcing procyclicality. When hedge funds seek looser trade conditions with their PBs, such as better pricing or lower margin requirements, fewer dealers report margin loan tightening. Dealers tighten such terms when markets turn volatile.
These vulnerabilities call for sound risk management by PBs, overseen by risk-based, proactive supervision. Further, the global nature of prime brokerage illustrates the value of international supervisory collaboration.
There are several charts to underscore the points as well, if you’re into that kind of thing.
It’s interesting that organisations like the BIS are starting to focus on specific areas of banks that could prove a contagion nexus. Alphaville isn’t aware of anything similar from the BIS like this in the past. That said, this falls squarely in the “known known” risk bucket.
Indeed, it’s more interesting that no really major hedge fund has gotten in trouble for a while (Archegos doesn’t count), and no PB snafus have emerged in a long time (CS was, well, CS) — despite a LOT of nasty shocks over the past decade-plus.
Yes, things would undoubtedly have gotten hairy hadn’t the Fed gone full ape in 2020. But that was mostly a violent generalised shock, rather than the classic type of systemic hedge fund blow-up that people have been fretting about ever since LTCM.
That might indicate that the people involved are generally doing a better job than they get credit for from regulators and financial journalists? Of course, having written this down someone big is surely going to faceplant tomorrow.
