In September 2012 Barclays Prime Services published a special report on how investment banks source the funding they pass on to their hedge fund clients. Despite its innocuous sounding title, Evolution of the Hedge Fund Financing Model is probably the single most important piece of research into the future of the hedge fund industry to be published since the crisis. COO Connect founder Dominic Hobson talked to Ajay Nagpal, head of prime services at Barclays, about the profound implications for the industry of the changing ways in which prime brokers fund themselves.
Hobson: Regulators are focused on the “shadow banking” industry. What are the implications for prime brokers and, by extension, their hedge fund clients?
Nagpal: Since the onset of the financial crisis, central banks and regulators have focused on reducing the level of systemic risk within the financial system.The effort is still on-going, and many rules are still under development, but we are already seeing enforcement of some prescriptions related to liquidity, leverage and capital requirements that directly affect prime brokers. Specifically, prime brokers are being asked to do five things. First, better match the duration of their assets and liabilities. Secondly, shift their funding mix toward more diversified and longer-term sources of secured financing, while minimising their reliance on liquidity sources that are more susceptible to “runs” such as money market funds. Thirdly, perform stress tests and maintain appropriate liquidity buffers to mitigate contingent liquidity risks specific to prime broker activities. Fourthly, manage intra-day credit requirements just as intensely as other contingent liquidity risks, particularly when embedded in certain financing and settlement structures, such as tri-party repo. Fifthly, limit the extent of rehypothecation of client collateral across repo and security lending activities. The main implication of all five of these developments is that the average cost of funding has been going up for prime brokers. This increase in cost is likely to be passed along to hedge fund clients because banks and broker-dealers do not have the ability to absorb this increase in costs over the long term due to the pressure they are under to improve their return on assets. A related implication for hedge funds is that pricing will increasingly have a term structure. For example, six month financing will be more expensive than three month financing. This will likely force hedge funds to re-examine the extent to which they need term financing, based on the composition of their portfolios.
Hobson:The “internal funding efficiencies” to which the paper refers can be seen as a polite term for unlimited re-hypothecation, which investors now resist. What changes in behaviour have you seen so far, and what do you expect long term?.
Nagpal: Regulators - for example, the UK Financial Services Authority (FSA) through its Client Asset Sourcebook (CASS) requirements - have addressed this topic explicitly through their rules regarding haircuts and re-hypothecation of client assets. As a general rule, regulators want prime brokers to use re-hypothecation to fund their clients’ activities, and not their own. Additionally, prime brokers need to disclose to their clients the extent to which their assets are being re-hypothecated, and finally, they need to allow clients to place a cap on the extent of re-hypothecation allowed. While these requirements are fairly onerous for prime brokers, most hedge funds have already taken steps to reduce the exposure of excess cash and fully paid-for securities held by their prime brokers, by sweeping out excess cash on an overnight basis to their custodial accounts. Finally, while not yet explicitly mandated by regulators through caps – or at least caps beyond SEC rule 15c3.3 - I do feel that the extent of internal efficiencies employed by prime brokers may be reduced over time.
"We are already seeing enforcement of some prescriptions related to liquidity, leverage and capital requirements that directly affect prime brokers"
Hobson: The prime broker-hedge fund financing problem can be reduced to a mismatch of funding and lending terms – as your report notes, 50 per cent of funding is overnight but 50 per cent of assets mature in more than three months - which regulators wish to close. What do you expect to happen?
Nagpal:As I mentioned before, duration mismatch limit frameworks and stress testing have, together, already reduced that mismatch relative to what existed across the prime brokerage industry before the financial crisis. As the recent survey by the FSA found, the mismatch between the tenor of prime brokers’ assets and liabilities has come down significantly. Weighted average maturities of liabilities have risen and weighted average maturities of assets have declined. There was a considerable reduction in the overall mismatch from 2011 to 2012, and we expect this trend to continue for the foreseeable future.
Hobson: This is something of an under-arm ball, but is it your expectation that stand-alone prime brokers will be more affected by the changes you have described than prime brokers that belong to universal banking groups with more diverse funding sources?
Nagpal: I am definitely of the view that larger, better capitalised banks will have better and cheaper access to a diversified set of funding sources, both secured and unsecured, going forward. It is true that several of the banks seen to have better credit health - at least by the rating agencies, if not CDS spreads – are universal banks.
Hobson: In the new era, will some hedge fund strategies become nonviable? If so, which will be affected most?
Nagpal: I would not go as far as to suggest some strategies will become non-viable. However, some strategies will be more susceptible to the pain of the rising cost of financing. At the most basic level, if and when leverage starts to become more expensive, those strategies that rely on high leverage and use less liquid assets - the financing of which is a primary target of recent regulatory actions - to generate returns will find their returns getting compressed. Another thing to keep in mind is that some hedge fund strategies may have a better ability to absorb a 50-80 basis point increase in the cost of funding, assuming they can continue to generate higher than average annualised returns consistent with their historical performance.
Hobson: Will the impact of change vary by the size of the fund, as measured by assets under management?
Nagpal: Larger funds naturally have a better ability to negotiate with their prime brokers. Additionally, bear in mind that leverage in the hedge fund industry has remained flat for several years now. If financing capacity were to ever become a constraint due to rising leverage, prime brokers might be forced to choose to make it available to larger, more profitable clients rather than smaller ones. Finally, larger hedge funds tend to be more diverse in the types of strategies they employ and assets they trade. This gives them a natural ability to cross-finance assets to an extent which, in turn, could potentially reduce their reliance on prime broker financing for their least liquid assets.
Hobson: Will the future model of hedge fund financing see an increase or a decrease in the use of synthetic financing tools? Can the prime broker of the future offer synthetic financing more or less efficiently in balance sheet terms?
Nagpal: Synthetic financing adds to the breadth of sources of liquidity for prime brokers as well as the financing arrangements that prime brokers can offer to clients. The impact of hedge funds’ potentially greater reliance on synthetic financing on prime brokers’ balance sheets will vary depending on a number of factors, including the need to access certain restricted markets where traditional repo markets have yet to develop. And, yes, synthetic financing may offer additional balance sheet synergies, but the actual impact will vary, depending on a number of factors.
Hobson: Financing has been a major earner for prime brokers. What will the changes in prospect do to the attractiveness of prime brokerage as a business overall?
Nagpal: I do not expect any of the major prime brokers to be impacted by these changes in a way that would make them reconsider whether they should be in the business. That said, if the cost of doing business is going up for everyone, some of these costs will need to be passed along to clients to maintain the fundamental viability of the prime broker business model. Prime brokerage has always been a scale business with significant entry barriers and some of these recent developments may result in marginal players exiting the business altogether.
Hobson: Has the still incomplete structural reform of the tri-party market in the United States (US) had any consequences, minor or profound, for the funding of American investment banks? If not yet, do you expect the consequences to be or to become more profound?
Nagpal: The reform efforts in the US tri-party repo market have had and will continue to have a profound effect on secured funding. In addition to enforcing change in areas such as liquidity risk management, which I alluded to earlier, there is considerable focus on operational changes to reduce the systemic risk of the tri-party platforms, such as the introduction of three-way deal matching. Probably the most important recommendation from the Tri- Party Repo Infrastructure Reform Task Force was the “practical” elimination of intra-day credit, provided historically by the two clearing banks on an unlimited, discretionary and cost-free basis. This credit was a source of considerable systemic risk, given that the US tri-party repo market is, by far, the largest, and the terms offered by the clearing banks were uncommitted. Major market participants continue to change their behaviour both operationally and in the marketplace to reduce their reliance on this daily, intra-day credit, and it seems the industry is finally making meaningful progress towards meeting this goal.Remember that one consequence of the trade-off for a reduction in systemic risk is higher costs for end-users, such as hedge funds and other borrowers. What the levels of those final costs will be is still evolving, as even current costs are not yet being passed on in full.
Hobson: Money market funds, which were a major source of funding in the repo markets of the pre-crisis era, are also being reformed. How will changes to their permissible liquidity ratios affect the funding of prime brokers?
Nagpal:Some of the changes in regulations governing money market funds have already had an impact on the extent and type of financing available to prime brokers. New portfolio maturity limits, liquidity requirements, and explicit mandates on portfolio credit quality have led to a shortening of the maturity of money market fund lending.In fact, many funds are already running well within the guidelines on several of these regulatory requirements. Some of the other regulations that have been debated in recent months, such as a floating net asset value (NAV), creation of a reserve, or the putting in place of redemption gates, are potentially more likely to impact the behaviour of lenders to money market funds, rather than borrowers like prime brokers. In my view, the goal of any further reforms should be to make the sources of liquidity such as money market funds less susceptible to potential “runs,” and the prime broker community is in principle quite supportive of that goal.