Managing Hedge Fund Risk and Financing: Adapting to a New Era

The Quick and the Dead

Prime brokers provided much of the leverage exploited by hedge funds to generate high returns before the crisis. Essentially, prime brokers, through their margin requirements, determine how much cash a hedge fund needs to post to invest in a security. The prime brokers provide the difference between the price of the security and the margin requirement as financing (essentially a loan) to the hedge fund to finance the purchase of the security. The prime broker holds the security as collateral against the loan. As the security's value rapidly falls, the fund needs to post more cash with the prime broker in order to remain invested in the position.

In the crisis, not only were security values falling (resulting in hedge funds having to post additional cash to remain invested), but several prime brokers were also increasing their percentage of a security's value a hedge fund had to post to own the security. Sometimes this was a specific response to a decline in a particular hedge fund's creditworthiness and sometimes this margin change was applied across all funds holding a certain type of risky asset. Regardless of cause, having to post greater margin further reduced hedge funds' liquidity and available cash to meet redemptions.

Prime brokers, hedge fund managers and their investors faced a prisoner's dilemma³ where, if the demands for cash were balanced, they could all increase the probability they would collectively emerge from the crisis while the first one ...