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Counterparty risk - where do you stand?

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Few of the larger financial institutions have come through the banking crisis unscathed. Many of these same institutions act as major financiers of the hedge fund industry. This raises a number of questions:

- Is diversification of counterparty risk amongst hedge funds compromised because most hedge funds rely on the same 10 to 20 financial institutions to provide finance?

 - Are hedge fund assets held by these financiers secure?

 - Have the higher fund spreads in the market been passed onto hedge funds?

 - Has leverage been curtailed?

Firstly it is important to understand the nature of the contractual arrangements between a hedge fund and their financing banks. This is mostly structured under a “prime brokerage” contract.

Prime Brokerage

Prime brokerage (“PB”) is a term for a package of services typically offered to hedge funds by investment banks. The prime broker acts as a centralized provider of services such as securities clearing, custody, securities lending, cash management, and financing. The PB may also offer secondary services such as capital introduction, office space and IT support, and for many start ups, consulting.

There are differences when dealing with a broker-dealer, a registered bank, a US entity, a foreign entity, or a combination thereof.  The structure of the entity may also be an issue.  For example, the prime broker may use an offshore affiliate to carry out certain transactions and thus may not be covered under SEC rules and protection options.

US broker dealers are subject to a whole series of Federal Reserve Board regulation that govern customer  cash accounts and the amount of credit that brokerage firms and dealers may extend to customers for the purchase of securities including Reg T, Reg X, Reg SHO.   These rules cover topics such as margin requirements, short sells, asset segregation, etc.  Probably the most important item of note here is the difference between the two levels of leverage offered and the ‘platform’ that the fund uses.  This ultimately determines what entity the fund faces at the end of the day.

- Reg T means that the fund is subject to 50% margin.  Thus, barring derivatives, the fund could only go to 2X leverage through prime broker financing.

- Funds can also move to an “Enhanced” program.  Amendments were made to certain regulations that eliminated the requirement that only US registered broker dealers could lend in their stead.  This allowed them to arrange for third parties to lend to the clients.  These third parties are normally affiliates of the US broker dealer and will be registered in a different country with different rules and regulations.

Broker-dealers must maintain a minimum level of net capital and must report to the SEC and NASD if the capital level falls below that minimum.

Risk management by PBs is generally rigorous and tends to be on an individual security basis. The main factor for forced liquidation is non-payment of margin calls. More recently repo accounts have also forced liquidations as face values of securities plummeted. Technical default triggers which are activated do not necessarily lead to liquidation. An example is illustrated by NAV triggers; in Asia there have been a number of instances of these being activated in 2008 but there does not appear to have been forced liquidations resulting from this. PBs historically have taken a pragmatic and long term view of their relationship with the funds.

Established hedge funds are now moving to multi-prime environments to gain access to different service qualities (i.e. better borrows), invite competition, but also to diversify risk, although this can add operational complexities, in particular in data aggregation and additional documentation. Conversely, it is not always easy for a fund in the start-up phase to negotiate with a PB. There may be little incentive for a PB to take on an account that insists on full segregation but funds should negotiate a restriction on the amount that can be re-hypothecated.

Hypothecation is simply a pledge of collateral (i.e. margin). Re-hypothecation is the ability of the prime broker (or any counterparty) to use that collateral. A US prime broker can only use customer assets up to the aggregate amount of consolidated customer indebtedness. However, the prime broker can re-hypothecate up to 140% of an individual customer’s debit balance. The difference in these two statements is due to reserve account restrictions that require the prime broker to deposit cash or equivalent securities beyond 100% of the debit balance.

Based on the organizational structure of the prime broker, there may be differences in how collateral is held/recorded.  For non US LPs, Cayman entities, BVI entities and similar, the prime broking contract is likely to be with an FSA UK regulated entity. In many cases, the UK entities provide the same restrictions as in the US especially if these are specifically set out in the PB agreement.

Custody

Generally, assets are held in the “street name”. In other words, holdings are registered in the name of the prime broker or its nominee. The prime broker will maintain internal records that the hedge fund is the real or “beneficial” owner.   This is normal market practice. Prime brokers do not charge a custody fee for holding long assets, while Custodians/Banks generally do. However, assets at custodians may not be subject to security lending, and will not be subject to re-hypothecation.

The prime broker may not have a custodial presence in every market and so may engage a sub-custodian.  In this case, assets are normally held in an omnibus account at the sub-custodian but should be separate from the prime brokers own proprietary securities. The PB is responsible for undertaking due diligence on the sub-custodian and the assets are still subject to re-hypothecation; however the legal outcome if a sub-custodian fails appears unclear.

Segregation of Assets / Margin

What does it mean that assets are segregated?  In the US, this is covered under SEC Rule 15c3-3.  First and foremost, this means that the hedge fund assets are segregated from the proprietary securities of the prime broker.

However, this does not mean that the fund assets are segregated from other client assets. The normal practice is that assets are custodied in an omnibus account and thus not segregated.  If a fund wants true segregation, they must request a separate DTC account and pay for it - this is actually quite rare.

Another item to consider in asset segregation is the use of collateral.  In fact, it is a basic premise of the prime brokerage business that the prime broker be able to use collateral - where use means the ability to lend, sell, or pledge the pooled assets of the hedge fund clients.    

- If a hedge fund borrows from the prime broker, then certain assets can always be hypothecated (see definition below). A hedge fund agrees to this as it is included in the prime brokerage agreement. Basically, if a hedge fund is using leverage, then at least some assets are not fully paid and so are pooled (i.e. may be sold, loaned or pledged).

- If the hedge fund does not borrow from the prime broker, then the assets are “fully paid” or “free and clear” and should be separated (i.e. may not be sold, loaned or pledged but the PB).  The prime broker can only use the assets with the written consent of the hedge fund (i.e. for securities lending).  There is a cost associated with this and for the majority of funds, assets are not segregated.

- Note though that the prime broker can run a “SEG deficit’ even if the assets are free and clear (e.g. if a trade fails a ‘’seg deficit’’ may arise). This means that at the firm level, the prime broker may not have sufficient securities to cover all client holdings. However, in the event of a prime broker bankruptcy, these assets would be returned to the account/fund in priority and will be treated as customer assets, and not general creditor assets.

- If the hedge fund does borrow but has excess margin, the excess margin cannot be used by the prime broker. Excess margin is defined as anything above 140% of the debit balance.

- SEC Rule 15c3-3 also prohibits prime brokers from re-hypothecating more than 140% of a client’s debit balance or more than 100% of overall client debits.

- There are also structural issues in some markets (e.g. Taiwan and Korea) which constrain the PBs ability to re-hypothecate.

Cash Management

Also covered under Rule 15c3-3 is that the prime broker must maintain a “Special Reserve Bank Account for the Exclusive Benefit of Customers”.  U.S. broker dealers are required to keep clients’ excess cash balance in the special reserve account, calculated based on a reserve formula. Cash within this account can only be invested in government securities such as U.S. Treasuries.  Similar with asset custody, all client cash is pooled, though separate from the prime broker.

While cash is pooled, the prime broker must maintain a certain reserve.  First, the reserve must be at least the net difference between aggregate indebtedness (what clients owe the prime broker) and free credits held (i.e. free cash held in customer accounts).  Second, as per above in the Custody section, the prime broker must deposit cash or equivalents into the reserve account beyond 100% (i.e. excess collateral).

As mentioned below under Prime Broker Insolvency, the cash balances are somewhat protected against a shortfall in the event of insolvency of the prime broker, but often only to a maximum of $100,000 per customer (i.e. per HF).

Note that there are different restrictions between a bank and a broker dealer (i.e. the fund may ultimately face a foreign bank rather than a US broker dealer). Banks and broker dealers will present competing opinions on which is a better place to leave excess cash. There are several points to consider and they somewhat contradict each other:

- The probability of insolvency is probably the first point to consider.  This is best, and easiest, described in credit ratings, CDS spreads, and Tier 1 Capital.  A bank is generally rated higher and will be better capitalized.

- Segregation of cash.  The US prime broker must maintain the Special Reserve Account while at a bank, cash becomes commingled for use by the bank.

So, there is some counterparty risk in leaving cash at a prime broker.  As a result of recent market events, many hedge funds have been moving unencumbered cash away from their prime broker(s) in favour of triple-A rated money market funds and/or placed with banks not affected by sub-prime woes as well as fund administrators.  As per above, there are pros and cons to any of the available choices.  It is also worth noting that with multiple counterparties anonymity may be a concern.  For example, in the event of a large margin call from one of its prime broker, a fund can ‘hide’ the call from other prime brokers if it uses cash held elsewhere.

Safety of Collateral

Fundamental to most hedge funds is the use of leverage.  When borrowing from a prime broker, the hedge fund must post collateral. In the normal course of business, the prime broker may pledge the collateral to lenders or sell to purchasers and in fact, this is one of the pillars of their business.  Because the prime broker uses the collateral, the hedge fund may not have priority claim on assets that are used as margin in the case of prime broker insolvency. Specifically, in the event of bankruptcy, the parties that the prime broker sold or lent the securities to might have priority claims such that those assets are no longer available to be distributed to the hedge fund. Thus, the prime broker might only return the equivalent value of the margin and not the actual collateral itself.  Further, since we have not witnessed the bankruptcy of a prime broker, nobody knows how long the distribution would take, meaning that assets could be tied up for some time.  In reality, it would take some time to go through the bankruptcy proceedings, examine the balance sheet, resolve claims, and settle litigation.

Financial standing of the Prime Broker

The Securities Investor Protection Act of 1970 (SIPA) of the US covers the liquidation of a broker-dealer by a Securities Investor Protection Corporation (SIPC). A full discussion of the Act is beyond the scope of this article, but suffice it to say that customer claims are senior to general unsecured creditors.

In the event of a bankruptcy, a client’s claim of assets that are in the Omnibus account is pro-rata, even if they are fully paid for.  If there are insufficient securities in the Omnibus account and the PB does not have enough cash back to repurchase the shares, clients with a credit balance or a debit balance will get pro-rated claims, although bankruptcy claims for the clients will be different.

HF clients who have given up the right of use to securities (e.g. by lending those securities) will have no recourse over their securities, and pro-rata standing does not apply so they will fall to a general creditor status. Clients may need to get collateral for sec lending (standard practice), or ask for a trust account from banks.

In the event of a broker bankruptcy, there is the possibility of a shortfall when distributing assets to the customers (i.e. hedge funds). There is some insurance in place, being SIPC.  In such a bankruptcy, SIPC would distribute securities to customers but in the event of any shortfall, will only cover a certain amount per customer ($500,000 on securities and $100,000 on cash).  Anything in excess might fall in the general creditor line.    

If a prime broker insolvency is ever encountered, SIPC will try to distribute securities back to the clients if they can.  But there are still two key risks:  1) Visibility risk - clients can get back cash/securities or a combination of both, but it is not entirely clear what exactly they will get back.  2) Bankruptcy risk - clients may be in the middle of some trades while bankruptcy “Stay” occurs, which means the prime broker will cease activities in order to give the trustee the ability to analyze the books, interrupting the client’s transactions.  Also during a bankruptcy distribution, assets are not marked to market.  They are paid out based on the asset value on the date of bankruptcy or the filing date - this may lead to mark-to-market risk for clients.

During a bankruptcy proceeding, the SIPC trustee has 2 options:  1) Sell the accounts to another broker dealer which could take up to 3 weeks.  This should create little interruption to client accounts.  2) Assuming no other broker dealer wants the business or if the bankruptcy is due to fraud, then an unwind process will begin.  This process may take up to 3 months or longer.  In any case, there has never been large scale SIPC Insolvency in the U.S., so these are estimates from SIPC, and not from historical events.

There is also “excess SIPC” protection available in addition to the standard SIPC coverage.  However, there are items to consider here such as the total dollar amount of the excess coverage, per customer limit or the aggregate limit.  Excess SIPC is available through CAPCO, or could be via private insurers such as Lloyds of London.  Protection through CAPCO generally has no aggregate capital limit, while protection through a private insurer may have an aggregate limit.  Note that if the prime broker is a foreign bank, then they may not necessarily carry excess SIPC since they would normally leave minimal balances at the US broker dealer entity.

SIPC does cover registered securities such as stocks and bonds.  SIPC does not cover unregistered contracts such as forwards or swaps. This is because these types of contracts are not executed with the prime broker entity and are covered under an ISDA agreement.  Note that it is unclear whether or not repos are covered under SIPC. Lastly on excess SIPC, the source of the policy may also be a concern, depending on the credit status of the insurer.

Whilst the provisions in the US are prescriptive and transparent the scenario outside the US is different.  Where the contracting parties are UK entities, the safeguards are:

- the FSA’s capital requirements

- Basel II capital requirements

- perceived national bail-outs if the entity is a bank (this is not proven unlike the US where there is some precedent)

- the extension of Fed funding to broker dealers in the US (the UK entities of US broker dealers are subsidiaries and often have full guarantees from the parent)

- Lloyds policies to cover loss although there is often a cap on pay-out of around $600million

- sovereign guarantees although details are not always available

Many realise the importance of maintaining the integrity of the financial systems, which explains why the Fed is doing its utmost to facilitate funding and why countries may still bail out their homegrown institutions.  Sovereign funds, private equity funds and other cashed up investors may recognize this more than most and are buying stakes in troubled financial institutions. This has boosted confidence in the larger players in the PB arena regardless of whether they are banks affected by the subprime crisis or broker dealers in the US.  Marginal players will suffer as uncertainty persists over their financial standing.

Derivative Intermediation

Also known as “derivative prime brokerage”, “give-up”, etc, this is essentially the same as prime brokerage on traditional asset classes (i.e. equities) in that the hedge fund will enter a deal with a counterparty and then give-up the trade to the prime broker. This is used for several OTC assets including forwards, interest rate swaps, and credit default swap (CDS), which is where AIG recently ran into difficulty. Here, we will use CDS intermediation to illustrate the mechanics.

First, the hedge fund will enter an intermediation contract with the CDS prime broker. Both the CDS prime broker and the hedge fund should have a list of approved counterparties but ultimately, the hedge fund will only be able to give-up CDS trades if done with an approved counterparty of the CDS prime broker.

At the time of a new CDS transaction, the hedge fund will inform both the counterparty and the CDS prime broker of the give-up. Once the give-up is done, the CDS prime broker now legally takes on the trade and associated risks and the hedge fund now faces the CDS prime broker, not the original counterparty. For this service, the hedge fund pays a spread and some clearing fees to the CDS prime broker.

Investors should be aware of a certain risks. 1) The margin is with the CDS prime broker and is not segregated. This margin is at risk in the case of bankruptcy.  2) The mark-to-market is at risk. If the CDS prime broker were to go bankrupt, ultimately any P&L could be lost.  While these are the risks on any type of counterparty trade, we should highlight that these risks are now amplified through counterparty concentration.

We should note that there are certain efficiencies gained in this arrangement. a) The fund enjoys streamlined processing as they only face one counterparty b) Margin requirements are netted.

Note that there is currently a discussion in the market about the creation of a CDS clearing house such that some of this issue could disappear.  This is probably a few years away.

How do prime brokers finance themselves?

Spreads for term funding and uncollateralized borrowing have risen significantly for many financial institutions. However, the market for short term collateralised borrowing has remained more orderly. It was extremely important that this was the case which is why the Federal Reserve opened the discount window to broker dealers and became more flexible on collateral accepted. Institutions may not have needed to use the discount window but this sent a message of stability to the market that the Federal Reserve would act like “the prime broker of last resort”. Therefore, the major money centre banks have still been providing collateralized funding at relatively tight spreads to the PBs. This has had the effect of mitigating the passing on of higher borrowing cost to the hedge funds.

However, should a hedge fund wish to be exempted from re-hypothecation, the chain of collateral financing breaks down and significantly higher costs would need to be passed on to the fund, or the PB may not wish to have their business. Therefore, the treasury unit of the PB will monitor closely assets available for re-hypothecation to ensure they can cover the funding needs of their PB portfolio.

The situation has also been alleviated short term by the de-risking of hedge fund portfolios and the relatively high cash levels. It is likely that this risk remains low until hedge funds feel that sufficient stability has returned to PB financing  before leveraging up again.

Conclusions

While there is reasonable framework to protect hedge fund assets, it is clear that the more a hedge fund borrows, the more it becomes exposed to counterparty risk. This may be in the form of more assets being re-hypothecated or more margins paid under an ISDA or Repo agreement. Therefore, funds with more sophisticated financing needs are more inclined to spread the risk over many PBs.

Stability in hedge fund financing has been maintained to some degree as the collateralized funding market has continued to function between financial institutions. What has changed is the reluctance for financing any illiquid assets as they prove more difficult to on finance. Haircuts have increased especially for CDOs and emerging market bonds and other instruments.

Ultimately, the hedge funds can not get away from the risks systemic to the financial system. The failure of a PB with have catastrophic knock on effects starting a chain of collateral liquidation. This risk is very well understood by both global central banks and regulators.

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