The Treasury Department has announced the formation of two advisory groups to determine “Best Practices” for hedge funds. The new advisory groups were formed under the auspices of the President’s Working Group of Financial Markets. One group is comprised of hedge fund investors, the other Asset Managers, and they are tasked with deriving some recommendations by year’s end.
Their main focus should be to look at Portfolio Financing. I’m not so concerned with how Hedge Funds trade or their strategies, but I am interested in what they come up with around Hedge Fund Operations wrt Prime Brokers. Specifically, Prime Broker risk management within their Portfolio Financing/Lending Operations.
Three or 4 Prime Brokers control the majority of the business – it is very concentrated. While a hedge fund might broker trades through literally everyone on the street, it is uncommon for a large hedge fund to have more than 2 Prime Brokers. Trading strategies are less of a concern to me than how they are financed.
Prime Brokers provide hedge funds with enough credit so that a fund may be trading 2 to 10 times nominal capital. How are the loans priced? Computer models are used to evaluate a manager’s strategy and calculate event risk to said strategy in the fund. Financing decisions are made off computer models. IMHO, these models most likely underestimate the chance of an outlier event.
Given that there are only a handful of Prime Brokers controlling a large percentage of the Prime business, the models and the eventual lending are not diversified enough to withstand a cataclysmic shock to the financial system should there be such a Black Swan event. We saw what happened to the markets during the subprime fallout and loans that were priced to models, not the markets. We need to know more about how the Prime Brokers diversify their books. On the outside, it looks like one big trade to me.
A second area with Prime Brokerage to look at is the lack of transparency around Equity Loans.
The Working Group was created in March 1988 by President Reagan in response to the events that led to Black Monday. The Working Group is comprised of The Secretary of the Treasury, and the Chairs of the Fed, the SEC, and the CFTC.