We were recently asked why prime brokers are reporting different information to their hedge fund clients on why balance sheets have been tightening. The “balance sheet is scarce” story might make sense if all primes were reporting the same underlying reasons. Instead, five brokers could say five different things. We did some investigating into the cause of this information spread in the financing world.
Here’s what we are seeing:
1) Regulatory variations. The biggest single reason for different stories is that regulation is affecting prime brokers differently. A US bank is regulated differently than a UK or Swiss bank. Even a US bank in New York is regulated differently than a US bank based in San Francisco, and a UK bank has different rules than a German bank. As a result, prime brokers are responding to a variety of rules, recommendations and unwritten pressure from regulators to moderate their balance sheet usage. If one prime broker claims that Leverage Ratio figures need to beat the Supplementary Leverage Ratio by a safe margin, they probably aren’t kidding: regulators may have sent that message down through the chain of command.
2) Internal cost of liquidity. Banks are addressing the cost of liquidity in different forms but perhaps no more than two banks can now measure liquidity at the desk level. There is a cost for every trading function but that cost may be consolidated at a fairly high level, say, equities or capital markets. In a June 2015 Finadium report on TARGET2-Securities, we found that internal liquidity costs were ranging from 20-150 bps, which is an absurdly wide spread and will come down as market forces offer alternatives (who would pay 150bps for Treasury liquidity if an outside agent would provide the same liquidity at 25 bps?). Meanwhile though, prime brokers face their own iterations of liquidity charges, and this could help or hinder their business development relative to other prime brokers.
3) Ability to measure the cost of trades. Likewise to having different costs for liquidity, prime brokers have different abilities to measure the next financing or derivative trade that comes in the door. Firms with accurate measurement tools (what we call the Capital Cost Calculator) can tell clients pretty well what their balance sheet availability is. Firms without these tools do their best, but really just have to operate conservatively in order to stay within the bank’s parameters. Measuring the cost of trades is a genuinely hard task; prime brokers are generally working towards this goal but it may take a while still.
4) Importance of the strategic partnership. Some prime brokers are hedge funds work closely together on new market development, trade strategy, financing strategy and other factors. Strategic partners for prime brokers will get priority in balance sheet usage. This is especially true when a hedge fund is willing to take proactive steps to optimize their risk-adjusted portfolio exposure at the prime broker. If the hedge fund can act to reduce their prime broker’s balance sheet exposure, especially when it matters, the prime broker is more likely to step up in the future when the hedge fund is in more genuine need.
5) They’re just not that into you. The flip side of the strategic partnership is that prime brokers may be hinting that a hedge fund relationship just is not that important. A hedge fund might not have met the qualifications of a “tail exercise,” that does not translate into unfettered use of the balance sheet.
Balance sheet utilization of a prime broker will remain a scarce commodity, the cost of which will vary according to supply, demand and regulation. Prime brokers are in fact impacted by different inputs across this spectrum depending on their particular situations, and hedge funds will continue to hear different reasons for balance sheet availability.