Wednesday, October 29, 2008

Where will hedge funds put their business in future?

(October 25 Economist) IN, OUT, shake it all about. The fall of Bear Stearns earlier this year persuaded many hedge funds to switch to Goldman Sachs and Morgan Stanley as their prime brokers. The two firms are the industry leaders in the (once) lucrative business of providing hedge funds with financing, lending them shares for short-selling purposes, settling trades and housing fund assets. Lots more switched again once Lehman Brothers went bankrupt in September. This time, the flow was towards the banks, as hedge funds realised that the broker-dealer model was much wobblier than they thought. JPMorgan Chase, now the owner of Bear, has seen a 25% rise in prime-brokerage assets over the past few weeks.

The question is whether hedge funds will again return to the old Wall Street fold. Now that Morgan Stanley and Goldman Sachs have received the blessing of the American government, thanks to the capital injections announced this month, worries about counterparty risk have clearly diminished. Insiders report that customers are coming back.

There is still lots of work to do. For that blame Lehman, whose failure now hangs poisonously over the relationship between hedge funds and prime brokers. In Europe many funds found that the assets they pledged as collateral in return for financing from Lehman have become trapped in the bankruptcy process as administrators strain to work out which assets genuinely belong to clients. Worse still, many assets have simply disappeared, thanks to a standard industry practice called “rehypothecation”, in which prime brokers use clients’ collateral to raise financing of their own.

[When prime brokers lend money to hedge funds, the funds are required to put up collateral (Treasury bonds and the like). Lehman then used this collateral as security for its loans, a standard industry procedure known as “rehypothecation”. But the result has been that assets belonging to some hedge funds have been ensnared by Lehman’s bankruptcy. One leading lawyer describes this as “an unmitigated disaster”. (from the October 9 Economist)]

In the long term, hedge funds are agitating for a change in the bankruptcy laws, particularly in London, to make it easier for them to retrieve their assets. There is some wistful talk of creating electronic marketplaces for lenders and borrowers of shares. In the short term, funds still have to look to their prime brokers for comfort. Funds want to ensure that assets which have not been pledged for collateral are kept in segregated client accounts. They increasingly want these accounts to act like proper custody accounts, so that prime brokers have absolutely no claim over the assets in them. And once leverage returns, many will want far more control over how their assets are rehypothecated.

Goldman and Morgan Stanley are both perfectly capable of meeting these demands. They have sophisticated systems that make it easier to document which assets belong to which funds and to sweep money cleanly between accounts. Their hope is that they can win the bulk of a fund’s assets, with another bank or two acting as back-up brokers in case of need. But confidence in the former broker-dealers has been jolted. According to Larry Tabb of TABB Group, a consultancy, the winners are likely to be banks with large custody functions, such as JPMorgan Chase and Citigroup. So don’t be surprised if Goldman and Morgan Stanley turn around and acquire custodian banks of their own.

See also: Derivatives and Rehypothecation Failure: It's 3:00 p.m., Do You Know Where Your Collateral Is?

This article begins with a discussion of over-the-counter derivative transactions and the over-the-counter derivatives industry in general, focusing in particular on transactions involving interest rate swaps. Part II discusses the practice of and describes why secured parties are so insistent on the right to rehypothecate collateral. Part III focuses primarily on the risks assumed by a pledgor with respect to its posted collateral if the secured party becomes insolvent or bankrupt after it has rehypothecated the posted collateral. Part IV argues that a participant should resist consenting to, or should at a minimum, be compensated by its counter party for assuming the risk of failure.

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