Hedge fund managers can greatly reduce their credit exposure to counterparties by negotiating contracts that anticipate the potential default of a prime broker. In negotiating such contracts, appreciation of the implications of the governing legal and regulatory regime is essential. In addition, limiting the extent to which a broker may rehypothecate a hedge fund's collateral, negotiating netting, set-off and collateral provisions in ISDAs and Credit Support Annexes, setting minimum transfer amounts, and negotiating bankruptcy remote custodial arrangements which ensure that excess assets and/or collateral posted is held in accounts maintained by a third party can significantly reduce counterparty exposure to the prime broker. As negotiated contracts with high quality counterparties cannot limit counterparty risk, diversification of counterparties can further reduce the likelihood of a loss. While these actions can significantly reduce a hedge fund's counterparty risk, they can be directly and indirectly costly. Operational and financial costs incurred by the fund should be balanced against the potential losses avoided through these actions.
1. In the case of LBIE, the safe and timely return of client assets was hindered because U.S. prime brokerage clients lost their proprietary interests in the assets, and consequently lost money and asset protections under the U.K. Financial Services Authority's Client Assets Sourcebook (CASS).
2. A CSA requires that when ...