Scepticism about PBs' claims on making very little/no money out of clearing
Market participants have expressed scepticism in the latest COOConnect poll that OTC derivatives clearing will not be a money maker for prime brokers.
Some 53% said they “laughed out loud” when their prime broker insisted clearing reform would not be a cash cow. Another 27% said they “would check their invoice” before reaching any conclusions. Nevertheless, 20% displayed less cynicism and took their prime brokers’ word about profitability – or lack of – surrounding OTC derivatives clearing.
Those with suspicions about prime brokers’ motives are right to be suspect. Prime brokers would not be interested in OTC derivatives clearing lest there is money to be made. The traditional economics of the prime brokerage model – in which hedge funds put all their cash and securities in custody with the prime broker, who in turn, was allowed to rehypothecate it as they saw fit in return for financing and stock loan – is no longer viable.
The advent of third party custody and multi-priming has seriously impacted prime brokers’ profit margins. Furthermore, hedge fund leverage is down, which again has hurt the business.
One way prime brokers can restore a little gilt is by performing collateral upgrade trades. To meet CCPs’ margin requirements, hedge funds via their prime broker will be required to put up high-grade collateral such as G7 government bonds or cash – products they tend not to have on their books. Prime brokers will in effect accept ineligible hedge fund assets and through a collateral upgrade turn these assets into eligible collateral to be posted at the CCP.
However, one of the core attractions of mandatory OTC clearing to prime brokers was that they originally thought they could be gross to the market and net to the clearing house in a collateral sense. Now, the CFTC has nixed that and the ability to rehypothecate excess collateral has shrivelled up. Some have questioned whether the risk-reward ration makes sense now for the prime brokers.