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Higher scrutiny welcomed by the industry

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By A Paris – Just four months into 2021 and the hedge fund industry had already experienced two major events affecting prime brokerage – the GameStop run and the Archegos collapse. Though these incidents may have rocked some firms, others have held strong and are almost appreciative of the greater scrutiny resulting from such episodes.

“As a result of the GameStop experience, prime brokers have been forced to be far more vigilant with their clients’ exposure to names they were trading,” notes Jack Seibald, Managing Director and Global Co-Head of Prime Brokerage & Outsourced Trading, Cowen. “We changed our margin and risk rules almost on a daily basis to protect the clients and the firm, fully understanding that if clients blow themselves up, our capital is next in line for collapse.” 

The jury is still out on whether it was amateur trades who drove the GameStop run or whether Wall Street infiltrated the online chatter and sought to take advantage of the circumstances. Whatever the cause, the incident almost put hedge fund Melvin Capital out of business and prime units across the industry saw a large pile of unwound bets.

However, although this event has had reverberations across the prime brokerage industry, the resulting increased scrutiny is being welcomed. Barsam Lakani, Global Head of Prime Services Sales, Jefferies says: “Redirecting the spotlight on the importance of risk, liquidity, and margin management is a good thing. It’s healthy for the entire industry. Ultimately, it’s certainly beneficial for the hedge fund players, their prime brokers and the end investor. The entire ecosystem benefits.”

Reputational damage 

The second episode to hit the headlines was the collapse of Archegos Capital Management – a family office run by hedge fund manager Bill Hwang. Evidence shows the organisation collapsed following the overuse of leverage, in a bid to chase higher returns.

Several large prime brokers, most notably Credit Suisse and Nomura, were badly hit by this collapse, haemorrhaging money as a result. 

Seibald outlines: “The Archegos collapse raised some bigger questions related to counterparty risk. There were prime brokers relying on their clients to be truthful and disclose their full exposure to certain securities. This was proven to be a sub-par risk management tool and some firms got hit quite hard.

“For some of the worst hit firms it is a blemish which will be hard to overcome from a client relations perspective – if one of these prime brokers were one of your principal counterparties, you may wonder whether your assets are well protected.” 

Dale Klynhout, Managing Director, Lazarus Capital Partners, comments: “The well-publicised Archegos losses across a number of tier one prime brokers will further adjust the relationship dynamics. Prime brokers who had been proactive about risk mitigation and collateral management prior to the sell-off were better positioned to weather the unprecedented spike in volatility, which resulted in fewer clients being forced sellers prior to the recovery in equity markets. 

“We have found that our ability to guide clients through the crisis has led to new levels of trust and respect, which has enhanced our ability to uphold collateral and margin standards during a rising market where a client’s attitude towards risk becomes complacent towards the threat of a downturn.”

In Seibald’s view: “As it relates to the large bulge bracket prime brokers, I think there will be a reassessment of the relationships they have with clients to which they’re extending enormous amounts of credit. The prime brokers are going to want greater transparency, as to the clients’ exposure to the underlying securities, that the bank is financing at that moment in time.” 

Prime brokers which are not heavily dependent on providing hedge funds with large amounts of leverage at cheap rates will largely be unaffected by this turn of events.

Lakani observes: “We were having these conversations around diligence and risk management before this episode hit the news. It’s not new and clients are always monitoring this and asking questions related to the controls that exist in our industry, especially for us as a prime broker. Historically, at Jefferies, we’ve always been very transparent with clients. We are very clear and communicative around how we manage our prime brokerage business and how we intend to operate as a prime broker. 

“So, we welcome the increased level of questioning. We think these conversations are healthy and important. We have never shied away from these topics and certainly today we’re being even more vocal and engaged on these items.”

Talent moves and career risk

Events like this also have repercussions on talent and recruitment. Reportedly, several managing directors at Credit Suisse, one of the firms hardest hit by the Archegos collapse, have either left or are in the process of leaving.

Seibald says: “It has definitely caused many talented people to consider their options since their careers were at risk of being ruined by poor decisions made somewhere else in the bank.” 

These moves are understandable, given that career risk is a significant concern among hedge fund managers. A study by State Street Global Advisors found 52 percent of industry professionals worry about career risk. Further compounding these worries, a research study by the Center for Studies in Economics and Finance at the University of Naples in Italy found that poor performance followed by fund liquidation can lead to high level employees suffering permanent career setbacks, including lower salaries for years. 

This paper, entitled Career Risk and Market Discipline in Asset Management, was first published in 2017 and re-issued in 2020. It studied the impact of fund liquidations on asset managers’ careers. 

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