PB costs to increase for managers, warns Barclays Prime Services report
Prime brokerage costs will increase for hedge funds as regulation forces PBs to bolster their capital buffers while seeking secured financing for longer terms, a report by Barclays Prime Services has said.
Regulators are also pushing prime brokers to better match duration of their assets and liabilities, while there is talk in EU circles about forcing prime brokers to adopt caps on rehypothecation. “So far PBs have absorbed most of the liquidity cost increases but likely cannot continue to do so going forward. They will have to compete for new sources of liquidity and will be forced to set an explicit term structure of offered financing,” read the report.
Hedge fund clients will ultimately bear the brunt of these additional charges. The report said managers will need to rationalise their borrowing practices, revisit appetite for leverage and reset their return on equity expectations to deal with the rising financing costs.
Managers running illiquid strategies will be particularly hit by the changes as prime brokers will be less willing to lend out illiquid assets due to Basel III requirements on liquidity buffers. Prime brokers will have to incur a portion of the cost of maintaining these buffers with their share of short-term, less liquid liabilities.
“PBs will need to incur financing costs to pre-fund intraday, tri-party repo trades. Per recent US regulation of tri-party clearing banks, PBs will no longer have virtually free access to intraday credit for less liquid strategies,” added the report.
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.
The bank said it doubted there would be a massive sell-off if managers decided to de-lever their portfolios “given that harmonisation will likely happen at a relatively manageable pace.”
The report added larger managers would probably be given better access to liquidity namely because of their stronger negotiating position. It also highlighted multi-strategy hedge funds would be less vulnerable to increases in rates due to their ability to cross-finance assets.
As for investors, they have been advised to adjust their hedge fund return expectations. It also predicted investors will allocate to larger, more liquid, less leveraged multi-strategy hedge funds. Furthermore, investor due diligence needs to take into account financing terms “so as to determine financing risk that the hedge fund could be exposed to. This is more than just counterparty diversification which is what most investors are currently focused on,” it said.