Since he left Deutsche Bank in the spring of last year, Chris Caruso has turned everything he learned as a prime broker into a valuable service to hedge fund CFOs and COOs: he shows them how to manage their counterparty credit risks more intelligently and effectively.

When Chris Caruso left Deutsche Bank in the spring of 2012 he knew two things for certain. One was that, after 15 years in prime brokerage with Morgan Stanley and another decade in the same business at Deutsche Bank, he did not want to work in the banking industry any more. The other was that he wanted to work in a smaller organisation. The question was how to parlay 25 years of experience of prime brokerage into a line of work that met that twin criteria. As it happens, Chris Caruso did not have to look far or for long

There was one field in which he had acquired extensive knowledge and experience, and fund managers had developed a considerable demand for both: the management of counter-party risk. In the five years that followed the acute phase of the financial crisis in 2007-08, Caruso had found himself dealing on behalf of Deutsche Bank with an intensifying as well as lengthening list of inquiries from clients about counter-party credit risk and asset protection.

On leaving Deutsche in April 2012, he set up Pangaea Business Solutions to provide hedge fund managers with advice and training, with a particular emphasis on how to better manage their counterparties. After 25 years on the other side of the table, the game-keeper was ready to turn poacher. "Managers wanted to know how they could guard against Lehman risk, so to speak," he explains. "I saw a need and an opportunity to help. The core product at Pangaea is advisory and training around counterparty risk." In fact, the core product is a two hour training course covering counter-party risk, under the broad headings of assessment, mitigation and management.

The assessment module explores the meaning of counterparty credit risk and the economics of prime brokerage. It helps managers understand what type of client they are, and how valuable they are to a prime broker. The mitigation and management sections then explore what the manager can do to mitigate current risks, and manage them better in future. The risk mitigation and management modules include a review of asset safety options offered by prime brokers and custodian banks, from bankruptcy remote vehicles to tri-party structures.“You cannot eliminate counterparty risk, but you need tools to manage it,” says Caruso. He says the course is proving popular with senior staff at hedge funds, as well as operational heads and junior employees, and not only because those who attend can collect continuing professional development (CPD) points," says Caruso.

. “Hedge funds want to raise the level of competence about counterparty risk in every part of their organisation, because being well-informed is the first line of defence around this whole issue of counterparty risk management. Sometimes we do stand-alone sessions with the senior managers to look at how they are handling the issue at present, or to help them develop a plan to do so.”

He offers a simple but illuminating piece of advice: worries about the credit quality of a counterparty need to be placed in the context of what the counter-party is doing for the fund “How many counterparties do you need?” he asks. “That is an interesting question, and a complete answer has to be based on a full understanding of what services the manager is trying to obtain from the counterparty - whether they are trading or banking or research relationships, as well as what view the manager has of the counterparty from an asset protection perspective.” Caruso accepts that many investors, let alone managers, dislike uncertainty and want simple rules by which to operate. As a result, they appoint the highest quality counter parties (“Lots of times, the thinking is front-loaded”) and shift business as soon as the CDS spread passes a trigger point, even if the assets earn less elsewhere. “There ought to be a reason why you are giving business to a particular counterparty,” insists Caruso. “Relationship management is a big part of counterparty credit risk management.”

"HEDGE FUNDS WANT TO RAISE THE LEVEL OF COMPETENCE ABOUT COUNTERPARTY RISK IN EVERY PART OF THEIR ORGANISATION, BECAUSE BEING WELL-INFORMED IS THE FIRST LINE OF DEFENCE AROUND THIS WHOLE ISSUE OF COUNTERPARTY RISK MANAGEMENT."

A meaningful plan has to be based on a thorough understanding of the size, strategy and trading locations of a fund, and of its positions, financing methods and appetite for leverage, and of course of the service providers used. To achieve that degree of understanding, Caruso signs a non-disclosure agreement that gives him access to all the ISDA and prime brokerage agreements of a fund, and to reports sent by counter-parties.

That inside knowledge makes it possible to assess how well the financing structures and counterparties chosen match the investment and financing goals set by the manager. It also makes it easier to identify weaknesses and recommend economies, especially through cross-margining. “You need to understand the story before you start making any judgement calls,” says Caruso. “These are all sophisticated firms, and they have done things for a reason, but there is always something they have not thought about.”

At many managers, counterparty risk has not progressed much beyond diversification. One result is over-diversification, with some managers sporting as many as nine prime brokers. “Sooner or later, diversification adds risk,” explains Caruso. “Not all counterparties are created equal in terms of counterparty credit risk. There may be a good explanation of why a manager has eight or nine." That said, Caruso is clear that returns, service and relationship considerations should never override concerns about counterparty credit risk. “No, they should not,” says Caruso. “The ultimate counterparty risk is getting your assets trapped in Lehman or MF Global situation. A lot of hedge funds acknowledge that they should reduce their exposure as much as they can to their higher risk counterparties. If they feel a counterparty is in imminent risk of failure, that overrides everything.”

The challenge, of course, is to obtain information about a failing counterparty in sufficient time to escape. “If you do get out in good time, you are bound to be early, or appear to be early, and that is a hard decision to make,” says Caruso. This is why he includes in his training programme a section entitled “active intelligence gathering.” It emphasises the importance of monitoring data sources which experience shows are best adapted to deliver early warning signs.Paradoxically, the appetite for more sophisticated risk monitoring techniques of that kind reflects the greater knowledge and awareness of the post- 2008 generation of CFOs and COOs. “Everybody came up the curve - hedge funds, investors, prime brokers - on the importance of understanding who you are dealing with, where your assets are at any given time, and which jurisdictions you are dealing with,” says Caruso. “It is a much better informed marketplace today.”

This is most obvious in the evolution of attitudes towards the re-hypothecation of assets, where virtually every manager now insists on full reporting of re-hypothecated assets, where they have not actually banned the practice altogether, despite the implications for financing costs. “Pre-2008, that was not done,” say Caruso. “The larger firms, which have the infrastructure and the treasury capability and financing function, are spending a lot more time on truly understanding legal regimes, jurisdictions and so on.”

They are also spending more time on prime broker reviews, where Caruso is also asked to help, turning what he learned as a prime broker into valuable tips for hedge funds. "I help them understand what questions to ask, who to ask them of, and what are the hardest questions for a prime broker to answer," he explains. "I offer them a repeatable template for conducting that kind of review, through which they can get more and better information. My involvement levels the playing field for a lot of hedge funds, because a broker review is a time-consuming exercise."

Because he brings to the exercise an understanding of all of the exposures of a client, Caruso reckons he also obtains a perspective denied to the prime broker undergoing the review. "Because I am independent, hedge funds have an opportunity to do something with Pangaea that they are not normally able to do, which is to show not only their approach but their entire book of counterparty exposures to someone who has experience in the industry," he says. "Normally, the people with the experience are at a particular prime broker so they are only going to show them one dimension of what they are doing. They can show me the whole book and we can see how the pieces fit together."

This is a different prism from the one through he viewed the industry during his time at Deutsche Bank. “I used to spend a lot more time seeing a piece of the picture,” says Caruso. “Now I see the whole picture. So, if it is liberating for them, it is enlightening for me because, during all those years in the bank, I did wonder what it looked like from the other side, in terms of how they approached counterparty risk. At the bank, we always took a very segmented view of risk: secured risk, unsecured risk and general creditor risk. Hedge funds say, ‘That is all well and good but we know that at the end of the day it is all going to get mixed together, so we figure that if there is any unsecured risk it is all unsecured risk.

Managers can look forward to a 20 page, 150- plus question guide to prime broker reviews which Caruso intends to publish this year. More ambitiously, he is considering the development of a counterparty risk metrics benchmarking product. “Hedge funds have embraced outsourcing for a lot of services already,” he says. He will distribute it to clients on a quarterly basis, especially if he believes it will have some impact on counterparty credit risk. Adding a regular benchmarking component is only an extrapolation of this service.

"AT THE BANK, WE ALWAYS TOOK A VERY SEGMENTED VIEW OF RISK: SECURED RISK, UNSECURED RISK AND GENERAL CREDITOR RISK. HEDGE FUNDS SAY, ‘THAT IS ALL WELL AND GOOD BUT WE KNOW THAT AT THE END OF THE DAY IT IS ALL GOING TO GET MIXED TOGETHER, SO WE FIGURE THAT IF THERE IS ANY UNSECURED RISK IT IS ALL UNSECURED RISK."

“If I am consistently pulling out the same information year after year, I can also compare the data over time,” he explains. “Because you are comparing apples to apples, and asking the same questions of everybody year after year, that starts to create best practices.” But the complexities of developing a counterparty risk metrics benchmarking product are non-trivial. They include categorising the data by size and strategy, which in turn necessitates building a data collection operation of considerable scale- even though there is a finite number of issues to monitor in counterparty credit risk management.To some extent, the addition of this product coincides with a shift in the Caruso model of doing business. In the early stages of Pangaea, in his role of consultant, he was remunerated by straightforward fees charged at an hourly or daily rate, or by a fixed sum to complete a specific project. Recently, he has begun moving his model of business towards providing products and services by means of an annual retainer. Adding a broadly based, data-driven counterparty credit risk measurement product will also entail weaning managers off their favourite solution: the CDS spread.

Caruso accepts that CDS spreads appeal because they are available instantly and continuously, and users can explain that movements in them are responding daily to the real risk of dealing with a particular counterparty. “People want to have something quantitative, and there are no other metrics that are real time in quite the same way,” he says. “You can think about the capitalisation of the entities that you are facing, the earnings, the ratings, and so on, but these things come out quarterly at best, and the ratings do not change that often. With a CDS spread, on the other hand, a counterparty can be put on watch or the business moved whenthe spread passes through a certain level.”

Ease of use is another aspect of the appeal of CDS spreads. Caruso warns against investing mere facility with influence. “It does not take a lot of effort,” he says. “You get the market data, and the market data tells you what to do, and you do it. But what do CDS spreads actually tell you? They are just a point in time. There is a way of using them that understands trends over time, and discloses the story behind them, but in my view understanding counterparty risk entails more of an investment on a to day to day basis to monitor the qualitative aspects of their counterparties and manage the data they get from their counterparties in a way that yields information.”

Making that investment, as Caruso readily admits, is bound to appeal more to the larger firms which have the people and resources and especially the clout with their counterparties required to make it worthwhile. To put it plainly, large managers will make the investment because they are valuable enough to their service providers to re-negotiate all of their ISDAs and prime brokerage agreements. Smaller firms, on the other hand, find it hard to persuade their prime brokers to even discuss the idea.So what should they do? “What I offer smaller and mid-sized funds is tools and templates to enable them to decode the legal structure of their counterparties, and put together a matrix of their relationships with each counter-party,” explains Caruso. “I also advise them on what to ask for in their agreements, and in their reports. But the biggest challenge is the time this takes.”

“THEY ARE OFTEN ISOLATED FROM EACH OTHER, AND ARE THEREFORE UNUSUALLY INTERESTED IN WHAT EVERYBODY ELSE IS DOING. THEY ALWAYS ASK WHAT I HAVE SEEN, AND WHAT THEY ARE MISSING.”

Time is shorter than ever, as managers struggle to comply with the rising volume of regulation, and counterparty risk is one of the issues that is getting less attention than it deserves. As a result, many managers are opting for what is achievable rather than what is necessary, let alone ideal. But Chris Caruso says there are some obvious steps that every fund should take, irrespective of its resources. “First, take no more counterparty credit risk than is strictly necessary in terms of the number of counterparties and the type and range of financing structures you use,” says Caruso. “Secondly, make use of third party custodianship of cash and unencumbered assets, even though it costs additional fees for custody, because it reduces risk but costs the prime brokers nothing to lose custody of fully-paid assets additional to current margin requirements or even- at current rates of interest - cash.”

In terms of growing his franchise, Caruso is not in a hurry. He plans to build on the strong relationships he has built, and develop a model that continues to evolve in line with the needs of his clients. “Hedge funds talk a lot about best practices,” he says.“They are often isolated from each other, and are therefore unusually interested in what everybody else is doing. They always ask what I have seen, on the business side of hedge funds, they do not yet see any real competitive advantage in improving their counterparty risk management process.” Chris Caruso aims to put them right on that.