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

Hedge fund Exposures to Prime Brokers

Hedge funds, through their business model and operations, take counterparty exposure to their prime brokers, which can result in losses in the event that the broker fails. As hedge funds maintain cash and financed-security positions in their brokerage accounts and maintain additional fully paid-for securities in custody with their broker, a failure of the broker can result in loss of access to those assets. Historically and today, approximately 80 percent of derivative trading and collateralization by hedge funds and institutional managers occurs with less than 20 percent of the brokerage community. The risks of this type of concentrated counterparty exposure were clearly demonstrated in the failures of Bear Stearns and Lehman Brothers, which caused havoc in collateral-management departments within hedge funds as they scrambled to gather data on positions, collateral balances and contract agreements to assess their potential losses (see Chapter 2).

The defining features of the brokerage relationship (and the most important brokerage services) are: (1) clearing and settlement; (2) financing; and (3) custody. Clearing and settlement services enable transactions to be executed with multiple executing brokers, with centralized clearing and settlement through a single prime broker. Prime brokers typically provide financing through margin loans, securities loans (for example, for short sales), repurchase agreements and OTC derivatives (via intermediation ...