The Archegos meltdown, the “meme stock” short-selling squeeze, and new curbs on Chinese education stocks contributed to a “significant stress test” for the prime brokerage sector in 2021, one which potentially heralds far-reaching consequences for the ways prime brokers and hedge funds do business in the future.
The Archegos meltdown, the “meme stock” short-selling squeeze, and new curbs on Chinese education stocks contributed to a “significant stress test” for the prime brokerage sector in 2021, one which potentially heralds far-reaching consequences for the ways prime brokers and hedge funds do business in the future.
Speaking to Hedgeweek, Jack Seibald (pictured), Managing Director and global Co-head of prime brokerage and outsourced trading at Cowen, says the three seismic events have had sizable consequences to the prime brokerage sector, and could prove pivotal in shaping the outlook for 2022.
The dramatic collapse of Bill Hwang’s Archegos Capital Management in March – which led to Credit Suisse and Nomura exiting or scaling back their prime brokerage offerings – revealed a failure of risk control procedures, with an “outrageous” amount of leverage provided to one entity with highly concentrated collateral, according to Seibald.
“That’s basic Prime Brokerage 101 – you just don’t do that,” he says. “You don’t allow outrageous leverage on concentrated portfolios – it’s the basic principle of risk management. With a standard portfolio you provide a certain amount of margin relief, and then as you delve into the portfolio, you tighten up the margin requirements based on factors like concentration, liquidity and volatility,” he says.
Nuance
Building on this point, he explains how considerable amounts of nuance are built into risk models, adding that the Archegos meltdown raised new questions about how effective prime brokerage risk management needs to be.
“How many names are in the portfolio? Is it long and short or very directional? How liquid are the positions? The fact that this one situation was allowed to get so out of control raises a whole lot of questions about whether the proper risk management procedures were followed. If they were, it raises other questions about potential deficiencies in regulatory structures that allowed an entity to use lever up collateral with multiple different brokers? This will very likely lead to a review by the regulators.
“Of the three things that happened in 2021 in prime brokerage, that’s the big one.”
Elsewhere, the so-called “meme stock” frenzy – which in January 2021 saw retail investors pile into video game store chain GameStop, driving its share price up and handing hefty losses to several hedge fund short-sellers – has also led to a reassessment of risk systems among prime brokers and investment managers alike.
“All of us in the prime brokerage business use risk systems that have historical volatility or standard deviation data embedded in them,” Seibald explains.
“The problem is that the advent of the meme stocks rendered much of the historical data essentially irrelevant for those names, because the only volatility that mattered was the volatility on that day, and the day before, and the day after.”
Change
Many prime brokers immediately realised they could not rely on historical models to assess the risk that clients were assuming, whether they were long or short on those meme stocks. Many PBs essentially put arbitrary limitations on their clients’ ability to trade those names for a period of time, particularly in trading certain options on those names.
“The follow-on effect is that many of us realised that we needed to be able to tweak our risk models to be more flexible, so that when situations like this happen we could drop six month volatility data and use shorter term, i.e. 30-day, volatility numbers. This change would allow us to assign greater relevance of a stock’s recent trading profile in the calculation for risk than if it’s just one day out of six months’ worth of days.”
This, adds Seibald, has brought about a considerable degree of change in the business: those PBs who have adapted models accordingly are now in a better position to deal with such situations and have avoided the potential loss of capital when a client “blows themselves up”.
The third event was the “arbitrary nature” of the Chinese government announcing that Chinese education stocks should not be for-profit companies, which triggered falls of some 80 per cent in the stocks.
“This raised yet another red flag for prime brokers over the way in which they provide margin relief on securities of companies that operate in what are effectively high-risk domiciles, like China,” he says.
Complicated
The combination of these events essentially resulted in a “pretty significant stress test” for the prime brokerage industry over the past year, which came rapidly on the heels of the initial coronavirus crisis in 2020.
“We came out of 2020 and 2021 in pretty good shape,” he says, reflecting on almost two years of episodic turbulence.
“But we’re entering 2022 with fewer players in the prime brokerage business because there are those who bore the brunt of the losses and called it quits, or those who chose to no longer commit the resources to this business line.”
So with potentially fewer participants in the prime brokerage business, what does this mean for the hedge fund industry more broadly?
“It means that there will be less balance sheet available to them,” Seibald suggests. “Things are more complicated now. Just because Credit Suisse’s and Nomura’s balance sheet go away from the market, doesn’t necessarily mean that that balance sheet becomes available anywhere else. While other prime brokers will certainly absorb some of the business from these banks, they are not suddenly going to extend their balance sheet to absorb all of that business.”
He believes the broader PB business will ultimately disperse, in many instances to the benefit of some of the larger bulge-bracket primes. But in certain other instances, some mid-tier firms – such as Cowen – are now in a “really interesting position” to absorb business.
“We’ve seen a flurry of that inquiry in the last couple of months and are acting on it accordingly,” he adds. “The mid-tier managers that I’m referring to are not always going to have an entrée into some of the larger bulge bracket firms. So firms like ours, for example, are better positioned to grab some of that business and provide these managers with the institutional caliber solutions they’re used to.”
Looking ahead to 2022, Seibald believes major challenges now confront the prime brokerage business in the aftermath of the recent upheaval.
“We need to be ever more diligent about understanding the collateral that our clients are posting with us, and understand and test the veracity of our risk management systems,” he observes.
Hedge fund managers, meanwhile, are faced with an environment in which the PB balance sheet is going to cost more than it did previously.
“You can’t have a situation where two large primes evacuate the market, and expect all that business to get absorbed at the same low rates that the clients were afforded by the exiting primes. That’s another trend that I suspect will we will hear more of as the months go on.”
He continues: “From a potential profitability perspective, it could be somewhat more beneficial to prime brokers – certainly those who are in a position to take on some of those balances and are willing to do so.”
“There certainly is an opportunity, and whether we’re able to capitalize on it or not, or the degree to which we can capitalise on it, remains to be seen.”
Committed
Underlining this point, he notes that Credit Suisse’s prime business had a considerable number of mid-tier clients for whom the Swiss bank functioned as a primary, if not the sole prime broker. “Those types of clients are not necessarily going to find the door easily open at some of the other bulge-bracket PB firms, such as Goldman Sachs or Morgan Stanley.”
“The issue facing hedge fund managers is really the question of whether their prime broker is committed to the business,” he adds.
“If there’s anything I’ve learned over my many years in this business it’s that you don’t shrink yourself into prosperity. You’re either committed to a business, and you dedicate the resources to be a meaningful player in the market you’re targeting, or you’re just wasting time and resources.
“You have to provide the solutions that reflect how clients behave in the market, and not only those that reflect your internal capabilities. The old ‘we do equities but we don’t do fixed income’ or ‘we do cash but not swap’ approaches do not work anymore,” he says.
“Fund managers today operate in a global market – if they are a sector player, they’re trading their sector on a global basis. If they’re a macro player, they’re playing macro on a global basis. If you cannot accommodate those needs, a client might engage you for a specific need on very narrow margins for a period of time, but that’s all you’re going to get.
“That’s just not a recipe for long-term success in the prime brokerage business.”
Elsewhere, Seibald also sees a growing interest in consulting among fund managers, with existing firms exploring alternative solutions in areas such as trading, middle- and back-office functions, and capital raising.
“There’s definitely much broader use of consulting services,” he says. “It’s probably indicative of a number of things. One is that the solutions being offered in the marketplace are much broader and far better today than they were before, particularly as it relates to the outsourcing of functions.
“Also, managers are trying to make sure that they’re fully informed of not only what solutions are available and what needs they can solve for them, but also, from a cost perspective, whether they can be beneficial or not.
“There’s much broader inquiry on solutions. We think that’s a healthy evolution, because managers are looking to avail themselves of the best possible solutions out there. It probably means that, ultimately, investment managers could be operating more efficiently in the future and therefore having potentially longer runways on which to build their business with the same amount of capital. This is particularly relevant for emerging and mid-tier sized managers.
“That’s a healthy evolution for both the prime brokerage and hedge fund businesses.”
