Prime Brokerage

The future of prime brokerage in the UK

Originally published in the December 2008/January 2009 issue

If the near-failure of Bear Stearns was a warning shot across the bows about prime broker credit risk, then the collapse of Lehman Brothers into insolvency was probably a direct hit to the hull. Some of the hedge funds with Lehman as prime broker have sunk under the damage and whilst others have managed to stay afloat, they have not yet been able to sail away and remain tangled in the debris left by the Lehman insolvency.

In particular, the Lehman insolvency has thrown the spotlight on prime brokerage agreements and the prime brokerage model and the crucial role that each plays in dealing with prime broker credit risk.

Prime brokerage agreements
There is no industry-standard agreement governing prime brokerage. Prime brokers usually have their own version which is traditionally designed to protect prime brokers against hedge fund insolvency, rather than protecting hedge funds against prime broker insolvency. As many of those who prime brokered their assets at Lehman have discovered, this can leave hedge funds painfully exposed upon a prime broker insolvency.

One of the central issues is the level of protection provided by segregation of assets and the speed with which assets can be returned to hedge funds. Certain prime brokerage agreement terms are critical in this respect. For instance, if the prime broker is permitted to use group entities as sub-custodians and subsequently becomes insolvent then, in the likely event of those sub-custodians also being subject to their own insolvency proceedings (in a different jurisdiction to the prime broker), it may be very difficult for the insolvent prime broker to retrieve client assets from them and, if they do retrieve client assets, it may not retrieve the full amount. Use of client omnibus accounts and the existence of security interest provisions in favour of not only the prime broker but also the prime broker’s affiliates may cause similar shortfall and delay in return issues.

Another key issue is the common market practice of rehypothecation – i.e. the right of the prime broker to ‘re-use’ clients’ assets for its own purposes. When assets are rehypothecated, hedge funds lose title to those assets and are left with a contractual right to redelivery of those assets. Upon a prime broker insolvency, hedge funds are left as general unsecured creditors in respect of those rehypothecated assets. In many cases, Lehman were not obliged to provide regular reports showing which assets had been rehypothecated. Hedge funds were, therefore, unable to monitor and manage this particular aspect of their prime broker credit risk.

Some hedge funds have already renegotiated the terms of their existing prime brokerage agreements, having reviewed them with their new, post-Lehman, spectacles. Among the terms that they are now seeking are rehypothecation limits, client money protection, two-way event of default rights, control of the close-out mechanism, as well as looking at the treatment of segregated assets (with the use of third party custodians being an obvious step) and mechanisms that will permit early release of segregated assets upon prime broker insolvency or that will manage the market risk on segregated assets that are trapped in the prime broker insolvency.

The future of the UK prime brokerage model
There is a growing perception that the US provides greater protection to prime brokerage clients than the UK. The SEC Customer Protection Rules and the SIPC Trustee regime are cited and contrasted with the UK insolvency regime, whose purpose is to protect the interest of creditors as a whole rather than the customers of the insolvent prime broker.

By way of counterargument, UK prime brokers quote the FSA Client Asset and Client Money Rules. They point out that, even where US prime brokers are used, non-US assets will generally be held by UK affiliates anyway. And finally, they contrast the US regulatory restrictions on the amount of leverage that can be extended against the absence of equivalent regulatory limits on UK prime brokers.

Whether the perception is based on solid foundations is open to a much longer debate; although it is worth noting that some hedge funds seem to be suffering as much frustration with the SIPC Trustee running the Lehman US prime broker as with the administrator of the Lehman UK prime broker. Nevertheless, there has been a concerted response from both the UK regulators and prime brokers.

In its November pre-budget report, the UK Government announced a proposed new insolvency regime for investment firms holding client assets and money. A review of the insolvency regime will be completed by June 2009 and will be followed by formal industry consultation on proposed regulatory changes.

In the more immediate term, there is a recognition amongst UK prime brokers that the landscape has changed. The balance of power has shifted slightly towards the hedge funds. This is not to say that hedge funds are getting their own way; it simply means that the issue of prime broker credit risk is now firmly on the table. As well as renegotiating prime brokerage agreements, hedge funds are taking other steps such as signing up multiple prime brokers.

UK prime brokers, too, have responded. Structural enhancements to the UK prime brokerage model, designed to meet concerns about prime broker credit risk, are in the offing and can be expected to be rolled out by some UK prime brokers in the coming months. Some third party custodians, who have seen their business increase exponentially in the immediate aftermath of the Lehman insolvency, have identified a potential role for themselves in new prime brokerage structures and are working to develop this.

These proposed regulatory changes are an encouraging sign that the regulators are able to respond to perceived weaknesses in the UK insolvency regime, whilst the expected structural changes to the UK prime brokerage model is yet another example of the innovation and responsiveness to client demandsthat is taken for granted in investment banks.

In the meantime hedge funds will continue to find their own solutions to mitigate prime broker credit risk through bilateral (re)negotiations of prime brokerage agreements.

The publicly available information about the changes on the horizon is still only high-level at this stage, so it is far too early to assess the effect that they might have. It is to be hoped that they will provide effective solutions to these concerns so that, in the future, sinking prime brokers hit by insolvency will not drag hedge fund clients down with them. In turn, this should then restore some much-needed confidence in the UK prime brokerage model and encourage the flow of assets back to UK prime brokers. But with the effectiveness of regulatory and structural changes, as with prime brokerage agreements, the devil is always in the detail.