Finadium’s Investors in Securities Lending conference is next week. In advance of, we take a look at how hedge funds and prime brokers are adapting to market dynamics and balance sheet constraints.
Regulatory changes since the financial crisis have boosted stress liquidity and capital, while changing balance sheets in ways that continue to affect operations. And that’s translated to a change in how hedge funds approach prime brokers about what being “balance sheet efficient” means, said Kieran McCann from Prime Services at Scotiabank.
Across the board, clients are asking for portfolio metrics, which are then analyzed among other metrics for return on assets (RoA) and internal funding needs (RoIF), he added. RoA is a closely watched figure, but the broader picture requires careful analysis: “You also have to look at your overall book and how these clients all work together to make sure that not only individual client RoA, but the overall efficiencies and the overall book of business works well together.”
In other words, it’s not ideal to be overweight in difficult to fund strategies, even with high RoA. Rather the preference is for a diversified portfolio of clients with strategies of quant, event, long/short, converts, and credit, etc, which helps to blend in potential efficiencies and return characteristics from a financing platform perspective.
The firm’s underpinning technology is a proprietary database and software which includes all client financing needs, as well as all internal and external sources and uses of collateral across all asset types, and “having that information all in one place helps to ensure we offer our clients the best solutions possible”, he added. What hedge fund clients want to know are the economics of a client relationship, what kind of partnership is represented, and how they fit relative to other counterparties.
Prime brokers face a “balancing act” to ensure that, along with preserving capital in times of stress, as regulations require, they are also maintaining profitability of their financing businesses, said John McGuire, managing director and global head of Business Development at State Street.
“No two balance sheets are alike and different firms might be operating under, depending on the business units and lines that they operate in, different constraints,” he said, adding that the market has been anticipating a “retooling” as market participants weigh factors versus constraints .
At the same time, there’s been a push to innovation, like Peer to Peer, as financing clients seek to secure access to diversified pockets of liquidity, he added. Specific to hedge funds, McGuire said that the prime broker decision is probably the most important one they will make.
“The prime broker’s ability to provide (hedge fund) financing, whether it be through cash financing or stock loan, that’s the lifeblood of their strategies and if they don’t get that decision right, or those prime brokers abruptly stop doing business with them, or reprice them, those are significant impacts to those funds,” he said.
Some of those impacts were keenly felt during Covid volatility, which McGuire described as a good wakeup call for market participants to understand how they can access liquidity in a volatile period, and which also led to investors wanting to have a better understanding of their prime broker’s risk management. This was further boosted by a recent upset in the market when a family office left a handful of prime brokers with big losses.
State Street’s prime brokerage unit, dubbed “Enhanced Custody”, launched just before the financial crisis and at a time when hedge funds were easily categorized as risky. McGuire noted that now 12 years into the business, it’s become clear that “a lot of the large hedge funds have some of the most sophisticated risk management structures around.”
In the late Q1, markets were surprised when Archegos, a family office, caused major losses for a number of prominent prime brokers. Across the board, finance pros have raised questions about the amount of leverage involved – estimated between 20x and 30x – considering the checks and balances that would be expected.
In the fallout, it seems clear that regulators will take a closer look at how and why total return swaps (TRS) are being used, particularly as the synthetic products have become more profitable than physical trades. McGuire noted that a few market participants feel that the same situation would not have happened in Europe because of SFTR transparency reporting.
There are benefits for investors to use TRS. In Asia, some users build up positions in the name of the prime broker, for example. Also, TRS provides access to markets that would otherwise be unavailable due to the organization’s size or the lack of a physical market and there are balance sheet netting benefits for the prime broker depending on scale, he said.
“I think the jury’s out on what’s going to happen with (regulatory action on Archegos), but one thing seems certain, a lot of my colleagues in the industry would say that there’s probably going to be some scrutiny on the use of total return swaps, and what are the reasonings behind investors as well as the banks wanting to use it versus physical shorting?”
Scotiabank’s McCann and State Street’s McGuire will be joined by colleagues from the Alternative Investment Management Association and Two Sigma on May 13 for a panel discussion on financing and funding trends