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

Funding liquidity Risk management Strategies: Prime Brokers

A hedge fund's relationship with its prime broker is, in the best of times, a symbiotic partnership. The hedge fund receives leverage, which can magnify investment returns, along with a variety of valuable services; while the broker receives interest income and security collateral it can use to generate low-cost funding and additional fees. This relationship is one of trust but also of co-dependency. Consequently, the relationship breaks down when confidence in the stability of either party falters, as the failure of one can cause losses for the other. The relationship is typically governed by several documents including the Prime Brokerage Agreement (also called a “Client-Account Agreement”) and an International Swaps Dealers Association Agreement (ISDA Agreement).

These documents grant rights to both parties which can be used to insulate each from the failure of the other. The most significant rights granted to the prime broker in relation to funding liquidity risk are the right to call for additional collateral and the right to terminate the relationship, withdraw all funding, and call for the close-out amounts to be paid.

Prime Brokerage Agreements

The Prime Brokerage Agreement is a unilateral service agreement offered by the prime broker to the fund. It covers an infinite number of trades by the fund with the broker across most security types and contains credit, business, collateral, operational and legal terms. ...