Finadium Research Report

Proposed Financial Regulations and the Prime Brokerage
Industry in the US and Europe

October 2009

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Hedge funds and the prime brokerage marketplace have been the subject of intense regulatory scrutiny over the last year. The credit crisis, massive stock market declines, collapse of Lehman Brothers and the Bernard Madoff scandal showed how closely that prime brokers and their hedge fund clients are intertwined. The further potential for hedge funds to cause systematic market failure and fears that overleveraging can damage market integrity have spurred regulators to action. They are now poking holes in the prime brokerage model looking for flaws and hope to improve the fundamental tenets of the system.

This report is a scenario analysis of several regulatory initiatives currently under consideration in US and European financial markets. While many of these proposals will undergo modifications before they are finally approved, several basic structures are now in place and regulators have begun issuing discussion papers. Some of these changes are substantial and promise to significantly alter the operations and profitability of the prime brokerage business model.

In the US, regulators and legislators continue to manage the balance between investor protection and promoting a free marketplace. Along the way, some of the basic definitions of securities lending and short selling are under review, including how risks to individual firms threaten the health of the broader market. Regulatory scrutiny may result in an awkward definition of securities loans for legal purposes, including the possibility that loans will be classified as an OTC derivative along with Credit Default Swaps and similar products.

European regulators have gone furthest by announcing two proposals that fundamentally change the nature of liability in prime brokerage. For the first time, prime brokers would become responsible for failing to supervise the assets they custody, leading these firms to mount extensive audits of their clients. Custodial banks holding long only assets would also be affected. Along with proposed hedge fund and private equity regulations, these proposals would create substantial change for both prime brokers and the entire financial markets industry.

This report should be read by prime brokers and their service providers, clients and counterparties.

This report is 26 pages with 7 exhibits.

■ Executive Summary

■ An Era of Regulatory Scrutiny
■ Revisions to Basel II
– How Basel II is Organized
– Liquidity, Leverage and VaR Calculations

■ The Mess in Europe
– Implications of AIFM and the UCITS Consultation Paper

■ US Exchanges and Posting Short Sale Volumes

■ Securities Lending and US Regulators
– CCPs and the Cost to Borrow

■ New Regulations and Prime Broker Profitability

■ About the Author

■ About Finadium


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