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The latest BIS Quarterly Review is out, and it includes an interesting tidbit about prime brokerage firms, the cornerstone of investment banks that serve hedge fund clients.
PBs are one of the main links between traditional banks and shadow banks, providing services such as custody, margin loans, derivatives, research and presenting to companies and investors. In return, they hope to receive thiccc trading commissions.
However, risks can also flow in both directions. The affected investment bank could snatch credit lines from hedge funds and send its woes to the markets. Conversely, the collapse of a major hedge fund could cause chaos at the bank.
As the Bank for International Settlements says, with Alphaville emphasis in bold below:
Prime brokerage is designed to be a low-risk activity, but wrong-way risk (WWR), lack of transparency of money 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's counterparty increases at the same time that the probability of the counterparty's default increases. Ambiguities arise when a PB does not have the necessary visibility into fund positions, for example because they are registered in different entities, the assets are complex or the assets do not have easily verifiable market values. The resulting risk exposures often become apparent only when the Fund experiences severe difficulties.
If this sounds unbelievable – or like something from the '90s – remember that Credit Suisse's death spiral started with the whole Archegos Capital debacle. Here's the BIS again:
The fund had large, concentrated positions in a small number of stocks. When these stocks suddenly fell, the fund's financial strength took a hit, while the fund's exposure to publicly traded companies rose, exacerbated by leverage – a case of WWR. What explains the ambiguity is that Archegos investors were not fully aware of the size of the fund's positions with other banks, and thus underestimated its overall leverage and impact on the markets in which it was active. These risks were exacerbated by the fact that Credit Suisse, the main bank most affected by the Archegos failure, did not set sufficiently conservative terms for the leverage it provided. This resulted in excessive credit exposure for the Bank and over-leveraging of the Fund
As the Bank for International Settlements points out, the prime brokerage business is incredibly concentrated. While large hedge funds have relationships with multiple desks — for example, in London, Hong Kong and New York — the trio of Goldman Sachs, Morgan Stanley and JPMorgan dominates the rankings.
It is also inherently pro-cyclical. When times are good, everyone wants to court the big hedge funds and capture the massive revenues they can generate. When markets vomit, banks often want to reduce their exposure, especially to their more opaque hedge fund clients.
As the Bank for International Settlements says:
Hedge funds tend to make more margin loans to hedge funds when markets are buoyant: borrowing secured by hedge funds is closely linked to stock market valuations, just as leverage on traders' balance sheets is procyclical. The credit quality of hedge funds as perceived by traders deteriorates during weak market conditions, when the value of assets held by banks as collateral against the funds declines. This constitutes a positive correlation between the probability of default and net credit exposure WWR. As for ambiguity, the assets of a quarter of hedge funds are not fully independently valued, which includes 38% of hedge fund assets, which makes it more difficult for hedge funds to have confidence in the fund's stated asset values, especially in adverse market conditions.
LFOs accommodate hedge funds' requests for better terms on margin loans during quieter market periods, only to tighten those terms during periods of stress. The Archegos incident is an extreme example: Long before the fund's problems, those at Credit Suisse who wanted to maintain the relationship with Archegos reportedly resisted efforts by risk management to demand more margin. Evidence suggests that such customer absorption efforts occur in the overall market, promoting procyclicality. When hedge funds seek more flexible trading terms with their partaking swaps, such as better pricing or lower margin requirements, fewer traders report tightening margin loans. Traders tighten such conditions when markets become volatile.
These vulnerabilities call for sound risk management by engagement offices, which are overseen by proactive risk-based oversight. Moreover, the global nature of financial intermediation demonstrates the value of international supervisory cooperation.
There are plenty of charts to highlight points too, if you're interested in that kind of thing.
Interestingly, organizations such as the Bank for International Settlements have begun to focus on specific areas of banking that can demonstrate a contagious relationship. Alphaville is not aware of anything similar from BIS like this in the past. However, this falls squarely into the 'known' risk group.
In fact, what's even more interesting is that no major hedge fund has had a problem for a while (not taking Archegos into account), and no PB problem has appeared in a long time (CS was, well, CS) — despite a lot of… Bad mistakes. Shocks over the past decade or more.
Yes, things would have undoubtedly been tougher if the Fed hadn't gone completely apeshit in 2020. But that was mostly a violent public shock, not the classic kind of systemic hedge fund blow-up that people have been worrying about since LTCM.
Might this suggest that the people involved are generally doing a better job than they get credit for from regulators and financial journalists? Of course, after writing this, someone big is sure to be doing a face transplant tomorrow.
