Prime broker solvency

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The Lehman bankruptcy — cue thunder-crack — was a chastening experience for some hedge funds who discovered to their dismay that assets they had bought on margin from Lehman — which they thought Lehman safely held for them in a little shoebox under its bed — were not in a shoe-box after all. They turned out to be rather harder to get back than they expected.

Custody is illusory in a margin lending business

The hedge funds’ assets hadn’t all gone AWOL at Lehman so much as they got caught in the gears of the great steampunk rehypothecation machine.

Sure, it didn’t help that Lehman’s custody records were a bit slipshod. That alone launched the careers of a thousand CASS compliance officers. But the basic vibe of prime brokerage is that it is hyper-efficient financing, rather than outright lending and custody.

To be efficient, the prime broker does not just take security over client custody assets; it monetises them altogether by financing them — that is, lending them out — in the market. Thus the PB is — if it gets its business model right — not so much a lender to its counterparties, but the main manager of its financing arrangements, with an ultimate backstop to itself it if doesn’t get its business model right. And, hey ho, Lehman didn’t get its business model right (though it wasn’t quite so wrong about its prime business as, for example, dear old Lucky turned out to be).

Bank solvency and the airbag—steering-wheel continuum

The global financial crisis generated an intense focus on bank solvency — and no small amount of regulatory fiddling — to the point where fifteen years on the world is a very different place, and our view — coloured by a decade advising prime brokers, granted, seeing things through their tinted spectacles, but still — is that prime brokerage customers should spend a more time managing what is, really, an extreme tail risk, that of their prime broker failing before they do — and less time trying to provide for it in the abstract when negotiating their master agreements.

For what it is worth, the JC says the same to prime brokerage risk teams about NAV triggers too, because, frankly, it is all rather tiresome.

The JC’s unfashionable view: the negotiation industry has settled at the wrong point of the airbag - steering-wheel continuum. It has done this sub-consciously, non-deliberately, but all the same out of unrefined self-interest, however deeply it may be buried in the animal psyche.

A customer can unwind its positions, repay its lending and withdraw its assets at will, on any day: if it has an alternate prime broker, it does not even need to unwind its positions. Where it does not, significant market positions, or stocks with limited liquidity may take days to unwind, but in the context of the potential failure of a SIFI, even multiple days is a blink of an eye.

In a non-distress situation then, as long as you pay the prime broker back, it will just give you back your assets, or, at your choice, their money’s worth, more or less immediately.

This is by far the best way of managing prime broker insolvency risk. Get ahead of it.

Now, seeing as fully capitalised regulated financial institutions do not typically collapse overnight — Lehman was fast, and its final slide was fairly constant and took about seven months; dear old Lucky took years — if you are half-way paying attention there is plenty of time to get your assets out before your prime broker takes them corkscrewing into a ditch.

Hedge fund managers are meant — right? — to understand the equity market. Look at the equity of your prime broker! How is its leverage ratio? All this information is publicly available, real-time.

In any case since 2008 the FCA has significantly tightened its CASS customer asset segregation rules, and now prime brokers must cover any custody shortfall with their own assets.

At the same time the world’s financial regulators introduced broadly similar bail-in and bank resolution regimes, meaning the resolution of failing banks will be a much more managed process than it used to be, with the main goal of protecting the overall financial system from the shock of the failure of a significant credit institution. Again, witness Credit Suisse.

Should a hedge fund, nonetheless, be asleep at the switch and miss its prime broker’s pending implosion, then the prime broker’s solvency regime isn’t really the thing that makes recovering client assets hard.

Rather it will be (i) unwinding any reuse/rehypothecation arrangements and (ii) satisfying outstanding indebtedness and releasing any security interests over the assets. These have nothing to do with the insolvency regime of the broker.

Resolving reuse/rehypothecation

Under an English law reuse arrangement, a customer is an unsecured creditor of its prime broker for the return of equivalent reused assets. Where the return obligation offsets the customer’s liability under its margin loan portfolio, this is a zero-sum game, but generally the reuse multiplier will be more than 100% and may be as much as 140%: for this balance, the customer has prime broker credit risk.

Under a New York law rehypothecation arrangement, this is not necessarily true, because under one of those typically alchemical US legal constructs, a customer retains ownership of rehypothecated assets even while its prime broker sells them outright into the market. So, at least in theory, inside the prime broker’s books and records the customer has a preferred claim to the rehypothecated asset over other creditors of the bank. What this means in practice may be quite different (to what a US customer expects, and quite similar to what an English one would get).

Releasing security interests

Even if the administrator manages to recover all the reused assets and returns them to the custody account, the hedge fund is not yet out of the woods: there is a security interest to be resolved. Charges, pledges and mortgages are, of course, deep magic of the financial markets. There is an element of rite — and no small theatre — in their release. This pantomime itself is likely to delay return of your asset, because no-one wants to give up on credit claims when their are debts to be repaid, and the bank’s administrator will want to make sure that every conceivable debt claim for which the assets are security is recovered first — or applied against the assets — before any security is released.

Here the “kitchen-sink” security model that all prime brokers use will gum things up. For prime brokers take security against not just against loan indebtedness and close-out liabilities due under identified master agreements. They like to cast the net widely. Absurdly widely. You know, “any indebtedness, claim, liability, damage or loss, present or future, direct or indirect, contingent or otherwise, that Client or Client’s affiliates, friends or relations, jointly or severally, may owe to Prime Broker, its affiliates and any of its employees, officers directors, agents or advisors however described”. Right?

Oddly, buy-side legal eagles tend not to argue very hard about this, possibly seeing it as one of those “market conventions” that you can’t get around. They may tend to focus on the impact such a security provision has when the fund itself has blown up, and IBGYBG and all that. True, when the fund has gone tetas arriba, you are welcome to throw any claims you think your Guatemalan subsidiary may have into the 5 billion dollar hole in the ground that used to be a hedge fund. So, sure, have a nice wide security interest. See what difference it will make.

But — in that extreme tail event that is the prime broker going titten hoch, you may be less sanguine. A wide, loosely drawn charge may not materially change how much you owe, but it will slow down the process of calculating how much you owe, and therefore the release of that security, as the administrator will want to make enquiries of the Guatemalan subsidiary to check if anything was outstanding. The Guatemalan subsidiary, having been asked to prove a negative, will sit on the query as long as it can, hoping it will go away, only making enquiries when repeatedly pressed. It could be anything: old commissions, manufactured dividends on collateral coupons — all kinds of odds and sods, and running these down and getting a “no” out of some scared contractor in Bratislava on a zero-hours contract will not be easy. It will take time.

It is said that some banks are still unwinding their MF Global portfolios, eleven years later.

See also

• Airbag - steering-wheel continuum
• Terminating a financial contract