Synthetic prime brokerage and the fallout from a $10 billion non-event
In a dynamic market, investors make misjudgements. When the market moves against them, their mistakes are laid bare. This does not mean that the entire system is at risk. As Alan Greenspan said in 1998, when giving testimony on behalf of the Fed to the House Committee on Banking and Financial Services, “consequences are generally felt mostly by the perpetrators and, thus, rarely cumulate to pose significant problems for the financial system as a whole.” Archegos is one such case. The material losses for certain dealers did not ultimately lead to systemic or financial stability consequences.
From that perspective, it was a non-event. For a non-event, however, it has certainly attracted a lot of regulatory attention on both sides of the Atlantic. Making no distinction between desks with different functions and their raisons d'être, prudential regulators have equity finance, cash and synthetic prime brokerage and banks with large derivatives portfolios trading with investment funds, all firmly on their watch-lists.
On December 10, 2021, in what was clearly a coordinated effort, the Bank of England in its capacity as the Prudential Regulation Authority and the FCA on one side, and the Federal Reserve Board on the other, published letters expressing their concerns with certain market practices. They encouraged risk measurement and management processes to be tightened up.
No one doubts that prevention is better than cure. Far better for a prudential regulator to steer the market away from the cliff edge than for the government to need to pick up the pieces after the fact. If the implicit assumption is that the government otherwise provides a safety net, it creates moral hazard, thereby increasing risk in the market. On the other hand, choosing the bad decisions of one family office as the basis for encouraging banks to re-think risk measurement and management processes applied to the entire hedge fund market, may have unintended consequences.
The President’s Working Group on Financial Markets (PWG), which reported to the US Senate after the near collapse in 1998 of the hedge fund run by Long Term Capital Management (LTCM), observed that, “In the immediate aftermath of LTCM's near collapse, credit risk management practices vis-à-vis highly leveraged institutions were tightened. But market history indicates that even painful lessons recede from memory with time.” It comes as no surprise, then, that current “concerns” about the risk to financial stability posed by highly levered investment vehicles are strikingly similar to those in the past. Memories have indeed faded.
The difference between then and now is one of timing. LTCM wasn’t quite an after-the-fact case, but it was as close as it could possibly have been. The medicine was dispensed at the eleventh hour. The Fed facilitated private-sector refinancing of the hedge fund; it did not step in with its own funds. Now, the Fed and the UK regulators want to ensure that preventative measures are implemented well before the clock approaches midnight.
It is worthwhile comparing what was said then to what is being said now to gauge how the regulatory approach may have developed. On the subject of leverage, in 1999 the PWG advocated “the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume.”
The Fed is now warning of the need for: “margin practices [to] remain appropriate to the fund’s risk profile as it evolves, avoiding inflexible and risk-insensitive margin terms.” The UK regulators make a similar point, stating the need for firms to have the ability to change margin terms mid-trade. What was therefore once a naked call for de-leveraging has now become a call for risk-adjusted leverage.
This nuance is likely to be lost in the politics of compliance that inevitably surrounds any regulatory focus. The need to demonstrate to regulators that the risk management dial has been turned up could mean a lurch towards orthodoxy, across the board. That is not what the regulators have said they want to see - they want a client-specific approach.
Nevertheless, there is a risk that the shared responsibility of the sell-side to do their part in managing financial stability will manifest itself in a way that constitutes collective punishment for the buy-side. The prime broker that withstands the temptation to make change for change’s sake or impose one-size-fits-all margin increases, will be rewarded with balances. Buy-side confidence in prime brokers will rest on a measured response to these letters based on a thorough qualitative assessment and sophisticated understanding of the client portfolio and its strategy, not an inflexible documentation negotiation manual.
For most hedge funds, fixed or locked-up margin terms are not about squeezing as much leverage out of the system as possible. The motivation is the need to achieve a high degree of certainty so they can properly manage their liquidity. The idea that margin can change in an unpredictable fashion overnight based not on objective considerations but because of fear, whether irrational or otherwise, is disconcerting at the best of times.
Hedge fund managers, literally incentivised to measure and manage risk on their books, would then be forced to find liquidity and/or prematurely realise P&L. Where the margin adjustment has an arbitrary or capricious basis not matching the expectation of the person best placed to understand the positions - the portfolio manager - the risk to the fund is unacceptable.
Another striking similarity involves the regulatory perspective on transparency. The PWG explained regulatory supervision of banks as examining “whether banks have established mitigating controls when the transparency of the hedge fund is inadequate… [including] requiring collateral or negotiating more conservative covenants (especially contractual provisions that become more stringent as credit quality deteriorates) into credit agreements.”
The Fed is now saying much the same thing. Firms should “set sufficiently conservative terms for the relationship if the client does not meet appropriate levels of transparency.” The UK regulators are entirely consistent: “risk limits and margin requirements, should formally take into account the level of disclosures provided by individual accounts.”
This all makes sense of course. But it is important to remember that transparency is a two-way street. The provision of position-level information represents the acquisition of valuable knowledge by a firm. Information barriers within firms are the favoured technique for managing the conflicts of interest which arise. While these exist to fence off prime brokerage, these are necessarily different to the public/private Chinese Wall that separates the investment bankers from the rest of the firm.
Independent credit risk management groups, analysts best placed to understand convexity effects and risk in a complex portfolio, and “equities franchise distribution capabilities” (as traders staffed with managing a potential unwind are described by the UK regulators), all sit outside of prime brokerage.
As the UK regulators say, “Firms should ensure that exposures are scaled and calibrated to their own capabilities to exit risk positions upon default of a counterparty.” That implies a regular information flow within the firm, not just in a default scenario. If it is understood that a firm's own interest on one side of an information barrier potentially conflicts with the interests of a customer of the prime brokerage group on the other side of the barrier, then it must also be understood that appropriate contractual assurances are needed. After all, this is highly sensitive proprietary information.
The psychology behind close-outs and fire sales represents another potential conflict. Close-outs are generally uncoordinated across dealers. Each decision is self-serving, designed to enable an individual firm to manage its own exposure and disengage from risky assets in an effort to reach relative safety and liquidity. The possibility that prices achieved do not reflect longer-run potential are often an acceptable cost for getting out.
Close-out may trigger a fire sale elsewhere. Multiple fire sales triggered by cross-default clauses risk drying up market liquidity. As Alan Greenspan said in 1998, “a fire sale may be sufficiently intense and widespread that it seriously distorts markets and elevates uncertainty enough to impair the overall functioning of the economy.”
The stays now afforded to banks in trouble buy them the time to refinance or effect resolutions. These protections do not extend to hedge funds. The opportunity for a refinancing or orderly unwind is then not available, in the absence of coordination across dealers. The Fed makes the point that contractual terms that prevent a firm from closing out positions quickly if a fund misses margin calls may be inconsistent with safe and sound practices. The other side of the coin is the unforeseen knock-on effects to the wider market of a quick-off-the-mark close-out by an individual firm.
Nine months on, the fallout from Archegos is only now about to be felt in the wider market.