The mood music is about to change
By Sam Jones, at Finantial Times, Regulation & Governement, March 23
Prime brokerage has been in the sights of regulators ever since the demise of Lehman Brothers.
As the bank collapsed, its bloated prime brokerage, which depended heavily on financing from short-term and even overnight markets, became a weight around its neck. Hedge fund clients pulled out billions and the bank could no longer stand up.
And as contagion spread throughout the world’s markets, and the safety of other banks, including the likes of Morgan Stanley and Goldman Sachs, began to be questioned, regulators noted that prime brokerages were key pressure points in the interconnected financial system.
In times of both panic and stability prime brokers act as “transmission” mechanisms by which banks’ lending policies can have a direct and immediate impact on the liquidity and animal spirits of key global markets.
Regulators in the past three years have rightly judged that by applying rules that would affect prime brokerages, they might better manage risk in markets themselves, by moderating the amount of leverage the key risk takers – hedge funds – could take.
The impact of far-reaching reforms worldwide – from the Dodd-Frank Act in the US through to Basel III – has yet, however to make itself seriously felt in prime brokerage, but every banker is aware of what lies on the horizon.
In short, new liquidity regimes – by far and away the broadest regulatory changes with which prime brokers must deal – mean banks must strictly match up their financing.
Lending to hedge funds on a monthly basis and financing that by borrowing on an overnight basis, will, under the new Basel rules, be prohibitively expensive in terms of the amount of capital that must be set aside on a bank’s balance sheet.
“It’s true that there are going to be changes and it’s true that some assets are going to become more expensive across the market as a whole,” says Barry Bausano, head of equities for the Americas at Deutsche Bank.
New rules will also mean that esoteric assets – such as mortgage-backed securities, or even convertible bonds – could become harder to get leverage on or may become pricey to trade.
“Things that qualify as tier III [hard to value] assets or that can’t be re-lent in the secured market are likely to become more expensive to finance across the market,” says Mr Bausano.
Others are less circumspect. “The new rules could well have the effect of killing some hedge fund trading strategies off altogether,” says one prime brokerage head.
According to Nick Roe, global head of prime finance at Citigroup, “some of the pricing that exists right now is unrealistic”.
Not that most are minded to regard such rules necessarily as a bad thing. Most brokerages have spent the past two years adapting their funding models to meet the new rules, which have been well flagged by local market authorities.
For some, the new rules require funding models that are not far away from what they were doing anyway.
“Basel and other regulation is forcing recognition of the true cost of financing,” says Marc Gilly, global head of cap intro at Goldman Sachs. “This is something we are welcoming and ready for.”
The impact of new liquidity and financing requirements is also, as yet, hypothetical: for now the demand for leverage, and appetite to trade high-risk or difficult-to-value assets simply does not exist among hedge funds. According to JPMorgan’s latest survey of its clients’ positions, the average leverage employed at the end of January was just 1.8 times – a number that has, for the past two years, broadly remained the same.
The markets in which banks finance their operations – in spite of volatility elsewhere – have also been relatively stable for the past 12 months. “Financing markets really were much calmer than in previous years,” says Mr Gilly.
All banks in the prime brokerage business have nevertheless begun very carefully to assess exactly what lines of business they can compete effectively in, however.
“We look on a client-by-client basis what our risk weighted assets are and what the return on those is,” says Jack Inglis, managing director at Barclays prime services. “There is no one price fits all, however.”
Of more immediate concern to many brokerages are the still-to-be-finalised details of Europe’s controversial Alternative Investment Fund Manager directive, which after much wrangling passed into law in 2010. The directive must be written into the laws of Europe’s individual countries by 2013.
While most of what the directive stipulates has been accepted by hedge fund industry participants, key rules on custodianship – and the liability sub-custodians must bear for the assets they look after – could yet result in significant costs to brokerages.
One prime broker estimated custody rules in Europe could result in costs passed on to clients that shaved as much as 1 percentage point off annual performance.
The worry from most is that it will be a raft of other such low-profile but high-impact rules from national and international organisations in the coming years that will really bite.
Amid a highly-charged political landscape – with US and French elections imminent and increasing hostility in Europe to banks and finance – the environment is particularly hard.
New regulations – from the broad to the boring – will set the tenor of prime brokerage, and the mood music to the hedge fund industry, for years to come.
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