The prime brokerage revolution

The implications of Basel III on small to mid-sized hedge fund managers must in no way be underestimated. The rules may be directed at bulge bracket banks but the knock-on effects will be reverberating throughout the alternative investment management community.

Basel III subjects banks to Liquidity Coverage Ratios (LCR). This obliges banks to hold enough high quality liquid assets such as government bonds, which can easily be converted into cash to survive a 30 day market stress event. Basel III also introduced Net Stable Funding Ratio (NSFR), which requires banks to hold a minimum amount of stable funding and aims to reduce the risk of liquidity mismatches and over-dependence on short-term funding.  There are also challenges to the banks’ ability to internalise – that is to offset the assets of one client to cover short positions of another client. Basel III states offsets can only be counted at 50 per-cent for LCR purposes under some circumstances. This ultimately is going to result in significant cost increases for hedge fund managers.

Securing financing is going to become harder and more expensive for hedge fund managers.  Papers published by J.P. Morgan and Citi in 2014 highlighted Basel III [plus investor restrictions on the re-hypothecation of collateral] is going to ramp up the cost of hedge fund financing. Strategies that are highly leveraged or illiquid will be the most adversely affected. A Barclays Prime Finance study estimated the average hedge fund would see its returns drop by 10 basis points to 20 basis points. The Barclays study said fixed income arbitrage- a strategy that is leveraged at x13 its Net Asset Value (NAV)-  would suffer the most with returns likely to fall between 40 basis points and 80 basis points.

This will all impact prime brokerage balance sheet capital. Prime brokers are currently analysing how much  balance sheet hedge funds are consuming. They are evaluating whether client short positions and leverage are greater than income and resource use. Many bulge bracket prime brokers have already commenced culling clients they deem to be unprofitable or unlikely to grow. Credit Suisse, Bank of America Merrill Lynch and Goldman Sachs have all exited hedge funds over the last 18 months.  The exiting of hedge fund clients does look short-termist as some of these managers are well placed to actually grow assets albeit not in the current market environment.

The changing nature of the prime broker-hedge fund relationship is going to have a significant impact on the boutique prime brokerage market. Boutique providers such as Linear can assist these smaller and medium sized funds that have been shut out from the bulge bracket providers. Firms such as Linear can offer a lower cost base and enable smaller managers to leverage from their technology and systems enabling these organisations to grow their businesses.

Many hedge funds are also being forced to scale back the number of prime brokers they use so as to secure better financing terms from core providers. However, this does present issues around counterparty risk. As such, fund managers should be reaching out to boutique providers such as Linear so as to spread their counterparty risk in this new prime brokerage landscape.

For more information, please contact Richard Corner.
Phone: | +44 7825 757 333