J.P. Morgan warns hedge funds on Basel III implications

Prime Brokerage
14 Feb, 2014

Hedge funds will be forced to reassess their prime brokerage relationships once Basel III capital requirements are imposed on investment banks while some managers should consider developing internal treasury functions to enable direct access to funding markets, according to a white paper published by J.P. Morgan.

Hedge fund financing is being tightened up dramatically. Attempts by prime brokers to reduce their dependency on short-term funding, hedge fund and investor restrictions on re-hypothecation of collateral and Basel III are all going to lead to an increase in the cost of financing. There is also a be strong possibility regulators in Europe could clamp-down on re-hypothecation whereby they will impose a 140% cap similar to that of the Securities and Exchange Commission (SEC).

Building an internal treasury function would only really be viable for $5 billion plus multi-strategy hedge funds, although there would be benefits to investors. At present, financing costs are borne by the investor rather than out of the management fee. However, if financing becomes part of an internal treasury function, it would be paid for by the management fee and would reduce financing costs, which could mean investors receive higher returns, a significant upside given the disappointing performance of some hedge fund strategies in recent years.

The tighter financing costs would also result in hedge funds re-evaluating prime brokerage relationships. “Managers should understand in detail the holistic value of their relationship with the prime broker’s organisation, considering all elements of wallet allocation – long and short financing – along with the non-capital/balance sheet consumptive services such as custody and fund administration as well as execution,” said the J.P. Morgan white paper.

“This may necessitate a review of service providers resulting in a concentration of the total wallet amongst a smaller group of banks that provide the full service suite of investor services. Managers should develop a transparent dialogue with their prime brokers in order to understand the value that their business represents and the metrics prime brokers use to evaluate this business,” added the white paper.

The white paper also urged managers to consider how the pricing landscape will evolve if longer-term funding is required for less liquid assets. Analysis in 2013 by Barclays Prime Services said managers would need to rationalise their borrowing practices, revisit appetite for leverage and reset their return on equity expectations to deal with the rising financing costs.

The Barclays study added managers running illiquid strategies would be particularly hard-hit by the changes as prime brokers will be less willing to lend out illiquid assets due to the Basel III requirements on liquidity buffers. Prime brokers will therefore have to incur a portion of the cost of maintaining these buffers with their share of short-term, less liquid liabilities.

Highly leveraged managers will also be impacted as these strategies tend to be reliant on access to less liquid financing. Barclays calculated these changes would lead to the average hedge funds’ returns declining by 10 to 20 basis points. Fixed income arbitrage – one of the most leveraged strategies at 13 times NAV – would be hurt the most by the changes with returns falling anywhere between 40 and 80 basis points, said Barclays.


J.P. MorganBasel IIISECBarclays Prime Services