10/20/2015 Basel III: How Hedge Fund Managers Must Leverage Prime Brokers

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Basel III: How Hedge Fund Managers

Must Leverage Prime Brokers
SEPTEMBER 1, 2015 BY CHRIS KENTOURIS — LEAVE A COMMENT

“How important is this relationship to you?”

That question is often asked by concerned spouses or

romantically involved parties to get a status check on just
how well their relationship is faring. For the first time ever,
hedge fund managers could be forced to pose the same
question to their prime brokers, thanks to the Basel III
Accord.

The reason: “The new metrics required under the global

directive could make it more expensive for prime brokers to offer their services to hedge fund managers
and they will likely be passing along those costs,” says Jonathan Greenman, a senior advisor at New York
risk management consultancy Capital Markets Advisors. “No longer can prime brokers afford to take on or
retain hedge fund managers just to increase their client base.”

With many of the largest prime brokers, such as Barclays, Credit Suisse, Bank of America Merrill Lynch,
Deutsche Bank and JP Morgan, shrinking their prime services division and dumping less profitable clients
because of Basel III, now is the time for hedge fund managers to “optimize” or make the most of each
relationship. Hedge fund managers need to make a preemptive strike, starting with an evaluation of which
banks serving as prime brokers they want to keep and how much of their business to allocate to each. If
they don’t, their prime brokers will make the decision for them and they might not like the results.

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Are hedge fund managers prepared to make the tough choices? The London-headquartered Alternative
Investment Management Association (AIMA) and financial analytics provider S3 have just launched a joint
survey to find out. Based on previous surveys, hedge fund managers have not seemed to be paying as
much attention as they should be. A study published by global custodian State Street in October 2014
showed that 47 percent of the 235 hedge fund managers questioned didn’t foresee the Basel III Accord
increasing their cost of financing, while 29 percent weren’t certain. When asked about whether Basel III
would significantly change the way their firm managed their service providers, 37 percent disagreed and 26
percent were unsure, according to the Boston-headquartered bank.

Such ignorance or denial won’t be good for hedge fund managers. In addition to helping them execute
orders and safekeep their assets, prime brokers help them with leverage, securities borrowing and
financing. “At its core, the Basel III Accord is designed to ensure that banks have sufficient liquid assets to
operate under the worst short- and long-term economic conditions based on the risk profile of each of their
business lines” explains Greenman. “The methodology they must use to make that determination is brand
new and, depending on the answers derived from crunching the numbers, a prime broker could ultimately
decide to either drop the hedge fund manager as a client, increase its fees or not even offer some services.”

The Tough Trio

Of all the new ratios the Basel III Accord requires banks to calculate and monitor, three in particular — the
liquidity coverage ratio (LCR), the net stable funding ratio (NSFR) and the leverage ratio (LR) appear to be
the ones keeping prime brokers awake at night, prime brokerage operations specialists tell Finops Report.
Banks have until 2019 to fully implement the LCR and until January 2018 to do so for NSFR and LR.
“Although the mathematical parameters and absolute ratio levels applied by regulators across the globe
might differ, the impact to prime brokers and hedge fund managers cross-Atlantic will likely be similar
because the rules are the same,” says Greenman. The key difference: Regulators will require that global
systemically Important banks put aside a few additional percentage points of incremental capital to ensure
safety and soundness.

The LCR is designed to ensure that banks have the necessary assets to cope with a short-term liquidity
disruption. That means banks must hold sufficient high-quality liquid assets (HQLA) to cover a worse-case
scenario for thirty days. The NSFR has a similar purpose; banks must hold a minimum amount of stable
funding over a one-year period based on liquidity risk factors assigned to assets, off-balance sheet liquidity
exposures and contingent funding. The LR aims to restrict the buildup of leverage so banks must hold
sufficient Tier One Capital relative to their exposure to ensure that the ratio never falls below three percent.

“The types of financial instruments the hedge fund manager trades, the number of trades it executes with
the broker-dealer, the value of assets safekept with the prime broker, the amount of leverage provided, and
the value of securities lent, all fit into generating the answer of just how the hedge fund manager will be
valued,” explains Herman Weintraub, principal of the alternative investment practice at New York
consultancy GFT Technologies.

The prime broker’s decision will be based on a comparison of just how much it will earn versus how much it
will cost the prime broker to service the hedge fund manager. The cost to the prime broker will be reflected
in the prime broker’s calculations of the LCR, NSFR and LR. Here is one way the LCR alone can be affected:

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Bank regulators have decided to dramatically reduce the ability of prime brokers to rely on the market
practice of “internalization” That means prime brokers can’t benefit as much as they did in the past from
rehypothecating or giving the collateral posted by one client to another who has sold the same securities
short. The LCR also presumes in calculating net outflows that hedge fund managers will immediately
withdraw 100 percent of their free credit balances during an economic downturn. Combined, the two
scenarios will increase funding costs for prime brokers which they could ultimately decide to pass onto
their prime brokerage clients in the form of higher fees, say prime brokers.

Among the three critical ratios, the LR and NSFR will have a greater impact on hedge fund managers than
the LCR say prime brokerage executives from Nomura International in an article published in January 2015
on the AIMA’s website reflecting a seminar on Basel III. Prime brokers appear willing to absorb the higher
financing costs which could be incurred with the LCR ratio, say hedge fund managers attending the
seminar, although they are moving away from funding hedge fund managers’ positions overight to thirty
days. The LR and NSFR ratios are directly causing prime brokers to require fund managers pass the “hurdle
rates” of various return metrics or minimal profitability requirements if they want to say on.

“Following the implementation of the leverage ratio in particular, prime brokers are out of necessity to
become increasingly focused on balance sheet usage and more importantly returns expected for
utilization,” write Nomura’s Edward Grissel and John Duckitt. “The emerging industry trend of off-boarding
of clients in recent months indicates that prime brokers are already experiencing resource constraints
where balance sheets are being allocated to higher yielding areas. The NSFR will also raise the profitability
hurdle.”

“Hedge fund managers investing in real-estate, asset-backed securities and non-investment grade and
emerging market bonds may require greater surcharges for prime brokers to comply with capital and
liquidity requirements,” predicts Greenman. “Financing and trading activities will have higher operational risk
charges in contrast to those brokerage relationships that are purely fee-based such as custody and cash
management.”

Which metric or metrics the prime broker uses to measure a hedge fund manager’s profitability and
whether the answers will help or hurt the hedge fund manager’s standing is apparently a secret sauce no
prime brokerage operations manager contacted by FinOps Report was willing to share. In a competitive
market, no one wants a rival to find out just which quantitative measurements are used for fear of losing a
valued client to a competitor. Some prime brokers might consider criteria that is relevant only to the prime
brokerage business line such as return on equity, return on total assets, or return on leveraged assets, while
others might consider broader “franchise revenues” which include custody and other fees.

“Hedge fund managers need to ask the prime broker to explain the methodology used and what the final
ranking ultimately means to them,” says Weintraub. The answer shouldn’t just be a qualitative one as in “You
are one of my most valued clients.” Rather it should be a specific numerical ranking which could ultimately
determine the likelihood that the prime brokerage client will be dumped from the prime broker’s rosters, at
worst, or experience higher fees at best.

What to Do

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Once the answer is clear, rejoicing or drowning in sorrow aren’t the best reactions. If the ranking happens to
be high, the hedge fund manager shouldn’t just sit on its laurels and take the relationship for granted. A
quarterly review might be in order. Rather than bemoan the potential ending of a relationship or an increase
in fees, the fund manager can always try to change the result by asking the critical follow up question of
“What can I do to improve our relationship?” The answer could always “there is nothing you can do,” but
chances are there would be suggestions such as: increase the number of trades you execute with us,
increase the value of assets we safekeep for you, increase the number of securities lending transactions or
increase the leverage we provide.

Of course, giving one prime broker more business means taking business away from another. Ever since
Lehman Brothers’ 2009 bankruptcy, hedge fund managers have been adding rather than reducing the
number of prime brokers they use because they discovered that relying on just one is too risky. But if the
prime brokers are now being more selective about the hedge fund managers they service, hedge fund
managers can’t appear to be taking them for granted. They will likely need to cut down on the number of
prime brokers used. Just how many is enough, no one is willing to publicly say. “One is too few, but five is
too many,” joked one prime brokerage operations expert.

Who can stay on and who will be eliminated is a tough question to answer. If the prime broker is doing a
cost-benefit analysis of what the hedge fund relationship is worth, the hedge fund manager must do the
same. It’s time for the hedge fund manager’s chief financial officer, chief operating officer and chief risk
officer to take a hard look at the quality of their relationships with prime brokers — how much business
across each of their asset classes they allocate to each prime broker, what services they are receiving and
for what fees, and how each service benefits them. The goal is to prioritize the importance of these
relationships, so the fund manager can take action, if necessary, to improve their chances of staying with
their most important prime brokers or ensuring fees won’t be raised.

“Hedge fund managers who are slow to optimize their operations will find themselves pushed out of their
counterparty relationships,” says Weintraub. “Optimization will come down to being able to withstand the
prime broker’s methodology to compare their ranking and fees with their own estimates.” So how an they
do that? Hedge fund managers should rely on data from their front-end order management and trade
execution systems and portfolio systems to determine which prime brokers to use to execute which orders,
keep both cash and securities balances, and offer financing.

Diversifying their financing relationships will help hedge fund mangers avoid concentration risk surcharges
from their prime brokers, says Greenman. Also beneficial to the existing relationship will be relying on higher
quality collateral. Banks are required to hold a minimum amount of capital compared to their risk-weighted
assets (RWA) and higher credit quality bonds will likely require far less capital than lower quality. “If the
collateral is riskier or there is an increase in credit spreads due to a generally riskier time in the economic
cycle, the bank will need to hold more capital to correspond with the higher RWA,” says Greenman. “There
is likely to be procyclical impact, where capital and liquidity charges will increase in recessionary phases of
the cycle and when credit quality is strong Basel III may even require lower charges compared to Basel I for
securities financing trades.”

Hopefully, there won’t be a disconnect between how the hedge fund manager and the prime broker value
each other because if there is, the prime broker will likely have the upper hand. “Prime brokers now have far

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more clout about which hedge fund manager to keep and which one to dump and what fees to charge,”
says one compliance manager at a New York hedge fund.”Hedge fund managers can’t afford to be
arrogant enough as to claim they can easily take their business to a competitor. There aren’t that many
around.”

If all else fails and the prime broker still decides to dump the hedge fund manager from its rosters, there are
always alternatives. Hedge fund managers should take the opportunity to talk to prime brokers outside their
current circle and strengthen a relationship with another. The prime brokerage relationships that remain as a
result of Basel III could end up being a lot more honest — and more profitable– for both hedge fund
managers and prime brokers. What doesn’t break them will make them stronger.

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FILED UNDER: ANALYTICS, COMPLIANCE, CUSTODY, DERIVATIVES, FINANCING, FUNDS, RISK, SLIDER
TAGGED WITH: BROKERAGE OPS, COLLATERAL, COMPLIANCE, HEDGE FUNDS, INVESTMENT OPS, REGULATORS

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