Key Takeaways
- • Citi's FX prime brokerage business reportedly lost $180 million in December 2018, prompting a fresh debate over whether prime brokers price financing for speculative hedge fund positions correctly.
- • Citi published a white paper urging banks and executing brokers to share the costs of managing risky derivatives trades, citing the incoming uncleared margin rules (UMR).
- • The white paper estimated that a non-cleared NDF trade with a $10 billion notional value would cost 31 times prevailing rates once funding costs and regulatory capital are covered.
- • Prime brokers are tightening due diligence on hedge funds, scrutinizing counterparty quality, volatility, redemption cycles, collateral types and market liquidity before taking on portfolios.
- • Industry executives at Wells Fargo, Nomura, BNY Mellon's Pershing and Societe Generale say pricing has not kept pace with risk, with some well-established funds still extracting favorable terms.
Summary
Hedge fund performance in 2018 is pushing prime brokers to reassess the credit and counterparty risk embedded in their financing arrangements, according to The TRADE. The central catalyst was a reported $180 million loss in Citi's FX prime brokerage business in December 2018, which has reopened debate over whether prime brokers charge a fair price for financing hedge funds that take speculative positions.
The article notes that as prime brokers competed to win hedge fund market share and lift returns, pricing power over balance sheet usage shifted substantially toward clients. Eamon McCooey, head of prime services at Wells Fargo, said some rates in the market "don't make sense" and questioned whether counterparties fully understand liquidity and other financing risks. Risk parameters in pricing include the identity of the counterparty, the volatility of the traded product, redemption cycles, collateral types, and whether trading takes place in frontier or less liquid markets.
In response, prime brokers are conducting more forensic due diligence before onboarding funds. Dougal Brech, global head of prime finance at Nomura, said the bank examines each asset in a portfolio, how it can be used and financed, who the fund executes with, and its turnover.
After the reported Citi loss, the bank circulated a white paper among clients calling on other banks and executing brokers to share the costs of managing risky derivatives trades. The paper argued that the incoming uncleared margin rules will materially affect FX prime brokers, which must hold initial margin for clients trading FX forwards and also post it to the executing broker. As an example, it estimated that a non-cleared NDF trade with a $10 billion notional value would cost 31 times prevailing rates once funding costs and regulatory capital requirements are covered.
Equity prime finance and synthetic prime brokerage could also be affected, as brokers may have to absorb the cost of holding collateral and greater counterparty exposure through certain equity derivatives. Mark Aldoroty, head of prime services and collateral funding and trading at BNY Mellon's Pershing, warned that added collateral and operational drag under UMR could push rates higher, adding that there must be a point beyond which a prime broker is no longer fairly compensated.
Clients nonetheless retain negotiating leverage. John O'Hara, Americas head of prime brokerage and clearing at Societe Generale, said large and small clients recognize that prime brokers must be profitable to be sustainable, but the lack of pricing consensus lets some well-established funds command terms that do not make economic sense for providers. O'Hara said SG prefers to forgo opportunities rather than misprice credit or assume outsized risk.
The article notes that as prime brokers competed to win hedge fund market share and lift returns, pricing power over balance sheet usage shifted substantially toward clients. Eamon McCooey, head of prime services at Wells Fargo, said some rates in the market "don't make sense" and questioned whether counterparties fully understand liquidity and other financing risks. Risk parameters in pricing include the identity of the counterparty, the volatility of the traded product, redemption cycles, collateral types, and whether trading takes place in frontier or less liquid markets.
In response, prime brokers are conducting more forensic due diligence before onboarding funds. Dougal Brech, global head of prime finance at Nomura, said the bank examines each asset in a portfolio, how it can be used and financed, who the fund executes with, and its turnover.
After the reported Citi loss, the bank circulated a white paper among clients calling on other banks and executing brokers to share the costs of managing risky derivatives trades. The paper argued that the incoming uncleared margin rules will materially affect FX prime brokers, which must hold initial margin for clients trading FX forwards and also post it to the executing broker. As an example, it estimated that a non-cleared NDF trade with a $10 billion notional value would cost 31 times prevailing rates once funding costs and regulatory capital requirements are covered.
Equity prime finance and synthetic prime brokerage could also be affected, as brokers may have to absorb the cost of holding collateral and greater counterparty exposure through certain equity derivatives. Mark Aldoroty, head of prime services and collateral funding and trading at BNY Mellon's Pershing, warned that added collateral and operational drag under UMR could push rates higher, adding that there must be a point beyond which a prime broker is no longer fairly compensated.
Clients nonetheless retain negotiating leverage. John O'Hara, Americas head of prime brokerage and clearing at Societe Generale, said large and small clients recognize that prime brokers must be profitable to be sustainable, but the lack of pricing consensus lets some well-established funds command terms that do not make economic sense for providers. O'Hara said SG prefers to forgo opportunities rather than misprice credit or assume outsized risk.
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