Last week the markets were marginalized by rumors of hedge fund losses and job cuts. The value of stocks held by investors fell and positions classified as net neutral were deep in the red as assets moving in opposite directions and balancing each other all moved in the same way.
In the midst of the chaos, many hedge funds in Asia received calls from their prime brokers – the bankers who offer services ranging from credit and trading to research – and asked for more collateral or announced that financing costs would increase by more than 2 percent points, even if central banks cut interest rates. That may not sound like a lot, but if an equity fund is leveraged six to ten times as many as Hong Kong’s Millennium Asian outpost, that surge can make the difference between life and death.
Prime brokers say that their relationships with their customers are very cooperative. “We feast together and die together,” said a spokesman for one of the largest international investment banks. “We cannot benefit from it [a hedge fund’s] Bad luck.”
“We are all aware of the risk of infection,” added the head of prime brokerage at a European bank in Hong Kong.
But the reality for many is that the relationship may be much more controversial. This is because the prime broker has the final say in deciding what a position is worth – a judgment that can be very subjective – and therefore how much collateral is required.
“Prime brokers can decide which funds are too big to fail or whether they like to get you out of business,” said a senior manager of a large fund of funds that provides money to hedge funds on behalf of clients. “The actual pressure depends on the incentive the prime broker offers, and it is often not clear.”
This means that the one who gets through the storm can go down both on the prime broker’s judgment and on the actual performance of a fund – although even a measurement is essentially meaningless if the markets are so volatile.
Every time the market collapses, prime brokers say that they are careful when they ask for collateral from their customers and increase financing costs. However, the boundary between the prime broker’s regulatory risk management and predatory behavior is far from clear.
Like investors in hedge funds, prime brokers have every incentive to react quickly to the first signs of problems. Both are motivated to run for exit at the earliest – if permitted by investors – since funds use their most liquid assets first to process redemption requests or more collateral. Therefore, market volatility feeds on itself.
Last week’s volatility was particularly hard on computerized quant funds and funds specializing in paired trades. “What really kills leveraged machine trading strategies and the risk parity community is when stocks and government bonds fall in price together,” said Chris Wood, a Hong Kong-based Jefferies equity strategist, regarding the path. Normally, uncorrelated asset classes moved into the same Direction.
“In the past few days, performance has developed strongly towards the south. This brings us back to August ’07 when some quant funds were liquidated and factor performance was turned upside down, ”he and other Jefferies strategists wrote in an article on March 23 to buy their shorts and sell their longs as well as settlement of risk parity trading are clearly the culprits. ”
In any case, prime brokers are insisting that borrowing costs have risen as the lack of dollar funding has worsened over the past week, especially at banks like Goldman Sachs and Morgan Stanley, which do not have a large dollar deposit base from customer deposits.
Without exception, brokers insist that they have a uniform model that they apply to all of their customers. However, all have systems that allow manual overrides.
Past downturns illustrate the zero-sum games that could take place between the two sides. Prime brokers have often reduced the value of their hedge fund clients’ portfolios after getting cheap deals from the market. If a particular client was unable to meet the resulting demands for additional collateral, the broker took over a fund portfolio and liquidated it at great profit.
However, the structure of the markets has changed. Regulations that have been in place since the global financial crisis have reduced banks’ trading activity and risk appetite. The Volcker rule has also meant that many banks have stopped trading on their own account, which may conflict with their customers’ interests. However, this makes the markets less liquid and deepens the losses. In short, there are no easy answers.