Financing gives prime brokers (PBs) a critical role in the implementation of most absolute return strategies. It follows, then, that if margin relief, access to balance sheet and financing levels were to become unstable or unpredictable, the investment strategy is at risk of disruption. That ultimately impacts end-investors. So, the question for independent boards is: ‘How is the investment manager hedging this risk?’

The risk faced by hedge funds with PBs is not limited to Lehman-type risk (collapse with an attendant custody freeze, credit exposure and disruptions to credit intermediation). At a more mundane, day-to-day level, the risk is the possibility of unilateral changes to key inputs, such as margin methodology, margin rates, leverage, and access to balance sheet. These variables have the potential to shock the portfolio and cause unexpected strategy disruption.

Most strategies need these things to be stable and predictable, e.g., for margin, within the range contemplated by the PB’s margin rulebook. The leading PBs have robust margin systems which make overrides less likely, but the possibility remains. Such rights are, after all, expressly reserved to the PB in the prime brokerage suite of agreements. The December 2021 ‘Dear CEO’ letter from the PRA/FCA supplies the reason why. There is a regulatory expectation that PBs need to reserve for themselves the tools necessary to manage counterparty risk. PB margin methodology may be robust, but it is also a backward-looking exercise. It is not until a new scenario reveals itself that the model is upgraded. This contrasts with their hedge fund clients,for whom portfolio construction and risk measurement is a forward-looking exercise.

How should managers approach the risks, beyond margin hedging (where margin calls on one side of the portfolio are offset by excess equity on the other) or crash/platinum hedging (where the paper value of the portfolio is hedged to manage the convexity effects of major events)?

• After Lehman, ‘multi-prime’ e., diversification, was seen as a critical tool for managing risk attached to prime brokerage. But managing the risk of PB1 collapsing is not the same as hedging the risk of PB1 overriding margin terms. Diversification assumes that the risk approaches of PB1 and PB2 are not correlated. Without modelling how PB2 will analyse the transferred positions, and how positions already at PB2 will affect that, diversification cannot be said to be prophylactic. That analysis is incomplete without also understanding how any resultant transfers might affect both PBs revenues and returns on balance sheet. Diversification is not, without more, a margin hedge.
• In any event, as the transfer of a mixed bag of financial instruments is unlikely to occur in a single big-bang moment, it could end up splitting pairs, at least temporarily, and creating short-term margin pain at PB1.
• Term commitments, cross-product margining agreements and similar arrangements require specialist legal input to ensure they are tailored to the portfolio and the Carbon copies of agreements used for other hedge funds with different portfolios, different leverage and different strategies are often ill-conceived and carry latent risk.
• Would flipping to a different instrument to express the same view improve or worsen margin and leverage, cost of financing ? The best PBs will often engage in such an analysis and facilitate any flip.

This communication is issued by Chancery Advisors Limited for informational purposes only and does not constitute legal advice or establish an attorney- client relationship.

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