Market regulation is starting to impact the way prime brokers do business with their hedge fund clients. The need to store away more capital and strengthen their balance sheets under Basel III regulations and other requirements imposed by central banks are set to redefine the way primes view their clients, with the return on assets they earn from them likely to become the de facto parameter.
Simply put, prime brokerage divisions are increasingly going to assess hedge funds based on the extent to which their portfolios use the bank’s balance sheet.
More specifically, primes will increasingly be sensitive to the nature of hedge fund portfolios: whether they are paired off with long and short positions, the extent to which they employ financing, and, perhaps ironically, the extent to which they hold cash in their accounts.
“Managers are likely to face a less hospitable prime brokerage environment and higher costs. We’ve been monitoring this growing regulatory issue since early 2014 when we were approached by a couple of large European prime brokers who were looking for ways to discretely offload some of their clients with the least amount of disruption,” comments Jack Seibald (pictured), managing member at Concept Capital Markets LLC, one of North America’s leading introducing brokers.
Seibald continues: “They were looking at their capital requirements and what Basel III would mean for them in terms of balance sheet utilisation. This led to a client review process that covered two sides: one being the extent to which a client’s fund was utlilising the bank’s balance sheet, including how much leverage were they using, how much short selling was being employed, etc.; the other being a review of the client’s revenues relative to the degree of balance sheet utilisation and the resources that were required to service that fund.”
Seibald says that the effects of tighter bank capital requirements are now visible at the US-based clearing firms Concept Capital deals with. And, as reported by the Wall Street Journal in August, large prime brokers have started to cull their hedge fund clients.
This is not a size issue. As Seibald explains: “It’s a function of the asset classes held by the fund – the extent to which they are paired off on the bank’s balance sheet, – the fund’s net exposure and the leverage employed on the one hand, and the various revenue streams the prime earns from the client, be it stock lending, general collateral interest, or trading on the other.”
“Regardless of the size of the fund and the overall revenues it generates, it will still come down to how those revenues stack up against the balance sheet resources it consumes”.
Seibald says that in addition to general collateral finance rates rising, managers should expect the cost of carrying short positions to increase as well.
“We’ve had a low interest rate environment for quite some time and the spreads the banks charged clients (above LIBOR or Federal Funds) have been tight. Regardless of when interest rates finally rise, I think the financing spreads they charge clients will increase. That’s probably the first area of the client pricing sheet the primes will look to adjust,” opines Seibald.
Hedge funds are about to discover just how important they really are to their prime brokers.
