Paradigm Shift

Originally published in the March 2012 issue

Perceptions of the financial world have changed significantly since 2008. Clients and regulators have demanded a major shift in prime broker models toward security and transparency. The spectacular failure of Lehman Brothers on 15 September 2008 was unexpected and for many the consequences were unforeseeable. [1]

J.P. Morgan’s speedy acquisition of Bear Stearns provides an example of successful government intervention in the case of an illiquid and insolvent investment bank. [2] Lehman Brothers could have simply been another example of the same kind of successful government intervention had governments approved the same sort of merger and financing provided for Bear Stearns. However, it was not and the unintended consequences of Lehman Brothers’ bankruptcy created a run on the remaining independent investment banks. A structural change occurred to allow the remaining larger prime brokers to gain access to financing and so that the security of the government could stem the run on the remaining independent investment banks. Today there are renewed fears in the minds of the public and in the markets.

The very recent demise of MF Global and the more shocking revelation that client assets were either missing or not immediately locatable, reminds us that even three years after Lehman Brothers, sources of risk around transparency and asset location are not only possible, but very real for managers and investors. It is these types of structural issues that
can renew fears, create uncertainty and distrust that left unchallenged, starts bank and broker runs. However, today’s concerns are no longer simply over the liquidity and solvency of banks and brokers like MF Global, they now include the financial positions of governments. The evolution of the prime broker model is currently set against the backdrop of the European sovereign debt crisis. Investment managers, brokers and banks are facing increased scrutiny in terms of transparency as well as calls for heightened risk management in the prime finance model.

G20 and European sovereign debt crisis
The G20 is presently focused on re-drafting the international financial regulatory regime, including the OTC derivatives market, CCPs, brokerage and banking regulations. European governments, Troika, the US and other nations are attempting to resolve the European sovereign debt crisis which threatens the existence of the EU and the euro. Secretary Geithner has warned that urgent action is required to prevent “cascading default, bank runs, and catastrophic risk.” [3] The hazard of segregated monetary and fiscal policies presents challenges to and internal disagreement on the appropriate resolution to the crisis.
As Niall Ferguson put it, the EU is between “the Scylla of a currency break-up, and the Charybdis of a federal union that no one wants”. [4] The moral hazard of disconnected fiscal and monetary policies is clear, however whether to immediately restructure debt or add leverage and resources to a much larger European Financial Stability Fund or other bail-out fund, remains unresolved. Nonetheless, the sovereign distress in Europe has not stopped the G20 from pursuing increasing regulation of the financial markets.The G20 and its central banks and government regulators are discordant in their intentions to take further steps to control, regulate, and tax the financial markets. [5] We should ensure that governments are not set to “throw out the baby with the bathwater.” It is no small irony that at the same time as increased regulation is sought, the fiscal shortfalls and sovereign debt of nations are the foundational uncertainties impacting the markets. [6] So why does sovereign debt stand at the forefront of the consciousness of investment managers, banks, investors and the public?

For students of finance nothing is more fundamental than the risk-free rate (Rf). With the recent downgrades of the US, Spain, Greece, Italy and others a paradigm shift of sorts is taking place. [7] More fundamental philosophical questions have also arisen, such as what is “risk-free”? Even with the G20’s and EU’s tentative and conflicting plans, it remains unclear what the financial rules will be, what entities will exist, and what financial instruments and currencies will keep their value.

Level playing field
The G20 are set to attempt to standardize and harmonize many divergent markets as a response to the 2008 financial crisis. However, we have been through a variety of financial crises in the past,
from large frauds, the bubble, the Russian default, the Asian crisis, the S&L crisis, the Energy crisis, stagflation of the 1970s and many others.

In an interconnected, internationally competitive world, polemical domestic reactions to extreme examples often lead to over-regulation, which impairs domestic competition and has unintended negative consequences.

While such regulation tends to be effective in ensuring the same problem does not happen again, we rarely face the same problem in the same way. For example, the enactment of Sarbanes-Oxley enhanced investor protections but came with significant costs, regulatory burdens and increased liability for corporate issuers. The result was a significant hike in the cost of raising capital in the US, and played to the competitive advantage for other less costly and less onerous jurisdictions. An unintended consequence of the regulatory effort was the exodus of US entrepreneurs and corporate issuers to more hospitable, cost-effective locations for raising capital.

To radically regulate finance entrepreneurs, brokers, banks, institutions and other intermediaries in a manner that impairs their international competition is not in anyone’s interest, including governments, taxpayers or the general public. Accordingly, many financial institutions, including the largest banks, have appropriately lobbied for a “level playing field”. The new regulatory regime will undoubtedly have many unintended consequences if the models of prime finance are radically altered, and may lead to a competitive disadvantage for the G20.

Central counter party model
The failure of the over-the-counter credit default swap market was a major problem for the entire financial industry in 2008. Accordingly, one of the most important areas of reform is the OTC derivatives market. The original model allowed for diversification of risk from bilateral trading partners by purchasing CDS contracts. One of the key sources of diversification was perverted by a fundamental miscalculation of risk by an important regulated firm that set off a “daisy chain” of distress to a variety of known and unknown financial intermediaries. The lack of transparency surrounding who was holding the risk set about a cascade or “domino effect” when it was revealed that one party held the risk, and that party was unable to pay. The regulatory response has been to suggest that all risk should be borne by a central counter party (CCP). The CCP becomes theoretically responsible for the risk in some or all of these financial markets (See Fig.1 and Fig.2).RBS1

Some finance experts estimate that the collateral required for this kind of CCP model in the UK alone may exceed $1 trillion. However, the reality may be far more costly, given that the gross market value of the OTC market for the G10 exceeds $20 trillion. [8] Further, it is likely that calculations of risk will diverge markedly between inexperienced government regulators and experienced investment managers. And there are serious business questions about the fees, taxes, regulatory burden, the number of CCPs and their ultimate purpose. What if every nation has their own CCP both within and outside the G20?

For many it will be mandated by law that the CCP interface with all market participants. The result would be a consolidation of risk in these entities as each CCP would likely be considered “too big to fail”. Such a public policy response may ultimately prove to drive a significant increase in global systemic risk with the proliferation of CCPs and the consolidation of risk in the financial industry.

Given that the CCPs will need to be government-backed entities, there are questions about if and how collateral may be utilized by a government for its own rather obvious financing needs. This is particularly pressing in a crisis. At a time when the financing of sovereign nations stands paramount, a ready pool of billions ortrillions of dollars in fungible collateral would be a useful governmental tool. This may not be in the interest of the private financial community or international finance entrepreneurs.

Finance entrepreneurs or investors themselves may have other concerns about the security of collateral assets and utilization of their assets for public financing. Thus, while moving to a monopolistic or oligopolistic set of CCPs has some transparency advantages over the old OTC model, there are still a variety of other options to consider which would address transparency without creating a number of systemically important monopolies or oligopolies in the global financial markets. Given the unanswered questions about the form, use, number of CCPs, and ultimate financial support for the CCP, we should have significant concerns surrounding the adoption of reforms that are purportedly “unquestionably in the right direction.” [9]

To avoid a scenario where one financial intermediary dominates a market and in the event of a default stands unable to pay, there can be limits on certain kinds of risk taking. The firms at the epicentre of the 2008 financial crisis were regulated, and regulators had broad purview over them; regulators simply missed the opportunity to address the looming risk early. There is a spectrum of potential models for addressing the OTC derivatives markets from free private markets to total government-controlled and regulated. Mandating the CCP model is a reactionary response which would consolidate all risk in CCPs, and ultimately in governments.

However, the weaknesses of the CCP model may be operational as well as strategic. CCPs will need to be sophisticated organizations to address the needs of the international financial system. The creation of CCPs may ultimately lead to the creation of a variety of regional and national CCPs. Consider a situation where Greece, Portugal, Ireland or even Italy embraced the CCP model, and all funds, brokers, banks and other governments were required to utilize the regional CCP for their hedging of government securities? Why would we want to consolidate risk in government when the failing finances and sovereign debt of governments are the source of our greatest systemic risk? Ultimately, government intervention in the OTC derivatives market may lead to an ill-advised consolidation of risk, an increased regulatory burden, and a slippery slope towards higher fees and increasing taxes for financial transactions. [10]

The rise of multi-prime

Since 2008, custodians have become prime brokers, and prime brokers have joined with custodians to create new models of prime finance (See Fig. 3). Structural changes to the model have lead to a reduction in some of the prime broker risk. However, not all custodians and not all prime broker models are equal.

There are different sources of risk when moving to a custodian or multi-prime arrangement. The need for security and separation of assets often comes with a high price, and security over assets can be circumvented by complicated internal relationships in many-tentacled, opaque organizations. With large complex financial institutions that include custodian banks, investment banks and commercial banks additional diligence and warranties regarding asset re-hypothecation, utilization and location of assets are important considerations for investment managers.

Not surprisingly, some custodians and prime brokers are competing for new business based on the respective bankruptcy regimes in the US, UK or elsewhere. We should recall the primary concerns for investors in a crisis: location, time, certainty, and transparency. For finance entrepreneurs, having a good understanding of the regulatory regime is necessary, but not sufficient, to address investors’ concerns in a time of crisis. To some extent, it does not matter what the reality of the situation is, a run on a broker or fund is fuelled not by reason, but
by fear.

In the event of another large prime broker or custodian default, it will be critical to understand the mechanics of the failure and to be able to estimate the time to return collateral as certainty over assets will allay fears. It will also be essential to have engaged prime brokers and custodians that have transparency over operations and holding structures as well as security over assets. This certainty has an important impact on good investment management businesses, as many investment funds with highly successful strategies were redeemed by investors in the 2008 financial crisis while waiting for a small amount of collateral to be returned. In a similar manner, the timing of return can be hampered by the complexity of the organization, the interrelationship of competing claims, and by complicated, inwardly dealing organizations which may have several operating business entities under one corporate umbrella. Key concerns for investors are clear understanding of asset utilisation/ location and the need for arm’s length, transparent transactions between prime brokers and custodians.

Diligence in the face of uncertainty
In 2011 there are a variety of profound uncertainties that have led many to question the fundamental assumptions of prime finance and indeed finance itself. Changes in the regulation of the equity, fixed income and derivatives markets, the development and implementation of the CCP model, and questions over sovereign risk and potential cascading defaults have presented new and larger problems for finance. There are no simple answers and the uncertainty surrounding the new models and how effective they will be continues to cast a shadow over the future.

For investment managers, additional diligence is required as structures, regulations and models change. Developing and implementing a risk management programme with experienced personnel to deal with these complex challenges is vital for all finance entrepreneurs, prime brokers and custodians. For many of the larger investment funds which have multiple prime brokers and custodians, the model need not be revolutionized. Rather, the model must evolve in terms of continuous diligence, transparency, clarity into prime brokers and custodians and certainty over location of traded assets and any commingling of assets between prime brokers, custodians or with other investment funds. In particular, managers need to receive assurances (representations and warranties) that marketmaking activities are not commingled with the manager’s activities. Similarly, investment managers need to be aware of the positions of other prime brokerage clients and should find out if positions are lumped together with other investment funds. In a liquidity or solvency crisis, such commingling may have serious negative consequences for both investment funds in the event of a cascading default and the prime broker’s needs to close out positions expeditiously in an extreme market scenario. For these investment managers, communication with prime brokers, custodians and their investors in times of crisis can be among the most important issues for an investment manager to address.

We must recognize that a paradigm shift has occurred in the foundation of risk. Concerns over specific brokers and failures like Lehman Brothers, Bear Stearns and MF Global have been overshadowed by the larger issues of mounting sovereign debt and expanding government spending shortfalls. The G20’s efforts to expand its purview will lead it to expend ever more resources and take on more liability for financial markets. This may ultimately consolidate risk in governments or quasi-governmental entities. Similarly, the new CCP models suggest that the expansion of government to consolidate, capture, tax and regulate financial markets will continue. Furthermore, if the new rules of prime finance are not harmonized, they will only serve to create two financial standards: the G20 and the rest. For good public policy and to address international competition, it is vital that a level playing field be set so that funds, brokers and banks in the G20 are not competitively disadvantaged relative to others.

For investment managers the challenge will be to continue developing innovative products and strategies while navigating the changing strategic, regulatory and operational risks of running a fund during the European sovereign debt crisis and thereafter. Central to operational risk is prime broker risk. Prime broker risk can be mitigated with heightened diligence over the new prime finance models, diversification with multi-prime platforms and allocating to multiple custodians, and ensuring corporate transparency and maintaining security over collateral assets. However, there are more structural changes to be done to address the concerns of investment managers and investors in the future. The future of prime brokerage will likely continue to focus on service, transparency, certainty over collateral assets, comprehensive post-trade and risk management solutions. The evolution of the prime brokerage model remains a much needed development for finance entrepreneurs and investors to ensure that in the future all market participants share a level playing field while avoiding the pitfalls of the past.

Gregory Wagner is Global Head, Prime Services, Equities & Structured Retail with The Royal Bank of Scotland. J.S. Aikman is the author of ‘When Prime Brokers Fail’, published by Bloomberg Press in 2010.

1. Lehman Brothers was highly rated by credit agencies on 13 September 2008, two days before it declared bankruptcy.
2. Bear Stearns was initially purchased for $2 a share (approx. $250M USD).
However, JPM received a facility from the US government of $30 billion, which was more than 125 times the purchase price to account for anticipated and unanticipated liabilities.
3. Interview, Timothy Geithner, Bloomberg, October 15, 2011.
4. Interview, Niall Ferguson, Bloomberg, 6 September 2011.
5. See the statements of President of the EU Commission, Jose Manuel Barossa, on the new Financial Transaction Tax
6. The President of the EU Commission, Jose Manuel Barroso, stated that the sovereign debt crisis and the challenges facing the European banking industry are intertwined and must be addressed together.
7. What Does Risk-Free Rate Of Return Mean?
The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. It may be appropriate now to change Rf to “risk foundation” rather than “risk-free”.
8. See
9. “Control Rights (and Wrongs)” speech by Andrew Haldane at the Wincott Annual Memorial Lecture, London, Bank of England, 24 October 2011, p.2.
10. There are a number of different suggestions for financial transaction taxes in Europe ( , the US and elsewhere which have been recently revived calls for additional taxes for transactions in equities, bonds and deriviatives. See the very recent introduction in the US financial transaction tax proposal.