The collapse of Archegos and the GameStop short squeeze has radically upended the hedge fund prime brokerage space over the past year, raising fundamental questions over PBs’ lending activities and business models.
The collapse of Archegos and the GameStop short squeeze has radically upended the hedge fund prime brokerage space over the past year, raising fundamental questions over PBs’ lending activities and business models.
The implosion of Archegos Capital Management in early 2021, coupled with the “meme stock” short-selling squeeze which saw amateur investors drive up the price of selected shorted stocks – handing hefty losses to certain hedge fund managers in the process – has brought renewed upheaval to a prime brokerage sector that had only recently adapted to the challenges of Covid-19 and a landscape of lower revenues and falling trading volumes post-2008.
The sudden meltdown of Archegos – the New York-based family office led by Bill Hwang, a former ‘Tiger Cub’ who previously managed money at Julian Robertson’s Tiger Management – led to USD10 billion in losses for its brokers.
Amid the USD30 billion fire sale, triggered by a series of defaults on highly-levered margin calls by several investment banks, Credit Suisse suffered a USD5.5 billion hit, leading the Switzerland-headquartered banking group to shut down most of its Prime Services operations. Japanese lender Nomura also dramatically scaled back its cash prime brokerage business in the US and Europe following a USD2.9 billion loss.
The withdrawal of Credit Suisse from much of the prime services sphere saw the Zurich-based lender recommend hedge funds and other clients of its prime services business to BNPParibas as part of a referral agreement between the banks – a shake-up which brought “significant incoming business” for the Paris-based investment bank, explains Ashley Wilson, global head of prime services at BNP Paribas in London.
Before joining BNP in June 2021, Wilson had previously run prime services at Deutsche Bank, coheading all trading risk across the equity division. He later oversaw the transfer of the electronic equity executing, prime financing and the Delta 1 units across to BNP Paribas in 2019 when Deutsche Bank exited the sector after the German firm overhauled its investment bank business.
“Archegos had been a very large client of ours – we unwound three large block trades to get out of the positions that we had. To come away unscathed from Archegos sent quite a powerful message to the hedge fund community that we knew what we were doing,” Wilson says of the episode.
Beyond the immediate shake-up of competing banks’ prime services businesses, the rapid Archegos collapse also flagged up more fundamental questions surrounding the oversight and supervision of excessive leverage and risk limits within prime brokerage lending activities. Joel Press, founding member of hedge fund consultancy firm Press
Management in New York, and former senior partner and head of the global hedge fund practice at Ernst & Young, notes that prior to the Archegos implosion, it was relatively rare for a prime broker to lose money.
Aftermath
“What’s changed? The market volatility has changed. The Deltas of what is risk, and how you control risk, have changed dramatically, and I don’t think anyone has a full handle on it,” Press says. “That’s where prime brokerage has changed. What is leverage? How do they look at loan-to-value when derivatives are part of the structure? How do they determine risk with the current levels of volatility?”
In the aftermath, the US Securities and Exchange Commission has set out a raft of new measures covering certain instruments, particularly around equity derivatives swaps which were at the centre of the Archegos debacle. Plans include new disclosure thresholds on swaps and securities for hedge funds and other investors, and extra reporting requirements for sizable trades involving bonds and credit default swaps, among other things.
The fall-out came on the heels of the coordinated billion-dollar raid on hedge funds’ short positions in US video game store chain GameStop by amateur traders – many from Reddit’s WallStreetBets discussion forum – in January last year. By deliberately driving up the price of certain “meme stocks” through online trading platforms, they handed steep losses to several hedge funds, including Gabe Plotkin’s Melvin Capital and Light Street Capital, led by another former Tiger cub Glen Kacher. The so-called GameStop/Reddit saga had a substantial impact on the way that hedge funds were transacting shorts and shorting securities.
In the attendant chaos, many prime brokers discovered they could not rely on historical volatility models to assess the risk that clients were assuming, whether long or short, and instead tweaked their models to use 30-day volatility patterns rather six-month windows. The so-called “meme stock” frenzy – which also drew in other retail stocks including AMC, BlackBerry, and Bed Bath & Beyond – saw several PB lenders reportedly tightening up risk controls and collateral requirements for certain short positions.
In a key step-change for their PB businesses, lenders adapted their models accordingly and are now seen as better-placed to address periodic bouts of volatility which risk the potential loss of capital resulting from an Archegos-style blow-up.
“Being a relatively nimble organisation allows you to address crises quickly when they arrive. During the ‘meme stock’ saga, for example, we were quick to act in a manner that protected our clients as well as our balance sheet,” says Jack Seibald, managing director and global co-head of prime brokerage and outsourced trading at Cowen in New York.
Meanwhile, in another shift, there was a pull-back from certain harder-toborrow shorts which had traditionally been a good source of income for securities lending desks and prime brokers.
“Retail investors put pressure on some highly shorted positions that hedge funds held, and as a result, you saw a pull-back from that market segment of the securities lending universe – the small-cap names that had been heavily shorted,” says Eamon McCooey, head of prime services at Wells Fargo. “That revenue went away in the first part of the year – you started seeing managers hedge more with indices or pull completely away from certain stocks, so they weren’t exposed to specific names. “That was prevalent throughout most of 2021, though you started to see more shorting come back into some of those names in the latter part of last year. That has continued into the first part of this year.”
Stress tests
“I think larger funds continued, if they had a short view, to maintain their positions because they had the capital to afford to wait out the volatility. But the smaller hedge funds that typically trade in those small-to-mid cap names were potentially really impacted in terms of their investment strategy.” Daniel Childs, managing director at Jefferies in London, believes the relationship element of the prime brokerage business has become critical in the aftermath of last year’s upheaval surrounding Archegos and GameStop.
“As a prime broker, what that means is you need to be close to the funds themselves to really understand their business and strategy,” Childs, a former international chief operating officer at Citadel, tells Hedgeweek, adding that relationships are a core part of Jefferies’ DNA.
“The industry is growing, the assets are growing, the wallet is growing – but the number of providers has shrunk. So there will be opportunities as a consequence; we’ve certainly seen growth there.”
As the dust continues to settle on a remarkable couple of years for the industry, recent events have underlined the need for closer scrutiny and better understanding of the collateral that clients are posting, and spotlighted the importance of risk management systems and relationships within prime brokerage businesses.
“The last two years have provided prime brokers with a series of consecutive stress tests, including Covid, the meme-stock short squeeze phenomenon, the huge losses resulting from excessive margin extension, and the swoon in many Chinese stocks. Most firms navigated these volatile times and are the stronger for it, but some well-known ones elected to retrench or leave the prime brokerage business entirely,” Seibald says.
“As an industry, we have a responsibility to help our clients navigate through such volatile periods, but also an obligation to our employees and shareholders to manage our exposures during such periods to ensure business continuity.”
Read the full Charting New Territory: The future of hedge fund prime brokerage Insight Report here.
