Bank of England’s Jon Hall says more work needed on prime brokerage risks

With respect to leverage, the FPC supports further work on the role of leveraged investors in the government bond markets, with the aim of ensuring that leveraged investors do not take on such excessive risk that they destabilise markets in times of stress. If necessary, higher minimum margins on derivative positions, as well as higher and more standardised haircuts on securities financing transactions, could be used to reduce those risks. Additionally, prime brokerage firms should ensure that margins are calibrated to cover losses in bad times as well as good. Prime brokerage should be a low-risk business.

Although many hedge funds did reduce their basis-trading risk during the dash-for-cash, those that did not were saved by the fact that central bank purchases caused spreads to contract sharply. This naturally creates a risk of moral hazard, but it would be inappropriate for relative value hedge funds to anticipate similar good fortune in the future. If bond purchases had not been justified for monetary policy reasons, then some hedge fund losses might have been existential. Hedge funds should manage their leverage and liquidity with the expectation that central banks will not come to their aid. Illustrative cases are the infamous collapse of LTCM in 1998 and, in equities, the more recent failure of Archegos Capital.

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