Beware the fragile relationship between prime brokers and hedge funds

Buttonwood

Prime movers

Aug 9th 2007
From The Economist print edition

THERE is a paradox at the heart of the financial markets. And that paradox is playing a key role in the continuing tumult. It is commonly assumed that the growth of hedge funds has dispersed market risk. In particular, credit risk has been packaged up and resold. When bad debts occur, the pain is spread far and wide instead of focused on the high-street banks, which hold the deposits of ordinary consumers. The result should be a more robust financial system.

At the same time, however, financial regulators have been looking for ways to keep tabs on the fast-growing hedge-fund industry. They are naturally keen to avoid a repeat of 1998, when the collapse of Long-Term Capital Management (LTCM) prompted a liquidity crisis. Many regulators have decided they can keep in touch with hedge funds by monitoring the activities of the prime brokers that serve them.

This makes sense. After all, prime brokers provide the finance that allows hedge funds to gear up their returns and lend them the stocks so they can sell individual shares short (ie, gamble that their prices will fall). And monitoring is made all the easier because three investment banks—Goldman Sachs, Morgan Stanley and Bear Stearns—dominate prime brokerage. The trio act as brokers for about 60% of hedge-fund assets.

But this is where the paradox appears. Hedge funds are supposed to be dispersing risk. But if their chief financiers are just three Wall Street banks, is this dispersion more apparent than real? Could banks have shown risk out of the front door by selling loans, only to let it return through the back door of prime broking? Take credit insurance. Banks that own corporate bonds may use the swaps market to hedge against a company defaulting. But if the other side of the swap is taken by a hedge fund whose finances are dependent on loans from that same bank, has risk really been transferred?

The prime-brokerage arms of investment banks also face a number of potential conflicts of interest. The trading desks of those banks will be operating in the same markets as the hedge funds and often taking the same positions.

This is hardly surprising; many hedge-fund managers have previously worked on trading desks and will be using systems developed at their old employers. But it creates the opportunity for banks to trade against their clients' interests. As became clear in the fallout from 1998, banks that were aware of LTCM's loss-making positions had a real advantage.

Of course, prime brokers say they go to great lengths to keep themselves separate from their trading desks. Still, most hedge funds are sufficiently suspicious to maintain links with several brokers, so that no single firm is aware of all their positions.

In some ways prime brokers may also act against the interests of their own parent banks. At the moment, brokers are trying to rein back the funding they provide to the smaller and weaker hedge funds. This is quite natural, given the recent problems in credit markets. The brokers may have been pledged collateral against their hedge-fund loans but, as Merrill Lynch recently discovered in its dealings with two Bear Stearns hedge funds, it may not be possible to sell that collateral for anything like the current market price.

However, taking away credit from hedge funds means they have to sell assets. And that may hurt the trading desks of the investment banks as prices fall. It may also hurt the syndication departments and bond-sales desks—the divisions that peddle the debt the banks have underwritten. Without hedge funds to buy the bonds or loans, the risk may end up back on the banks' balance sheets.

The fundamental problem is the nature of market liquidity. When hedge funds are doing well, prime brokers are happy to lend them money; in turn, the use of geared money by hedge funds drives up asset prices. (Although some funds will take short positions, the industry normally has a net long position.)

But when prime brokers turn off the funding tap, this virtuous circle may turn vicious. Hedge funds may be forced to sell their most liquid holdings since more complex positions may be impossible to offload. So a problem in one part of the financial system, such as American subprime mortgages, can quickly become a global issue. As Richard Bookstaber wrote in his recent book, “A Demon of Our Own Design”: “Trying to control the risk ends up creating the liquidity crisis.”

The financial system will probably survive this sell-off: the global economy looks resilient enough. But the market turmoil may be a dress rehearsal for the real crisis that will emerge when the economy is in poorer shape.