Like any useful product or service, the use of multiple prime brokers by hedge funds has evolved over the last fifteen years. We are now entering our third major iteration of the multi-prime model. Before we look at version 3.0 let’s take a brief tour of the earlier versions of the multi-prime model.
Pangaea has just developed a new training course: Basel III: The Impact on Prime Brokers and Hedge Funds. There has been much discussion, and confusion, about the effect of the Basel III rules on the banking industry and the subsequent impact on the banks’ clients.
“There are known knowns… there are known unknowns… and there are unknown unknowns…” Donald Rumsfeld
In this age of uncertainty over the regulatory impact on the banking industry we turn to former Secretary of Defense, Don Rumsfeld for some guidance on how to think about managing counterparty risk. Let’s break down this quote and see where it leads us.
How will the next crisis look? We’re not talking about cause but effect. No one knows what will tip the balance, where that vulnerable inflection point lies. Examining some possible scenarios can help us to prepare and protect ourselves during the next financial crisis.
Senator Elizabeth Warren was back in the news recently spinning her one issue platform (perhaps presidential) calling for the breaking up of Citigroup. In her reference to the breakup of Citigroup she said, “ We should have broken you up into little pieces when we had the chance.” What those pieces would be one can only wonder because Senator Warren hasn’t let us in on the specifics of her plan. Though she does seem sure that their sheer size is the problem of the major US banks. She went on to say, “Can someone pass something, anything to reign in these banks?” she pleaded in her news conference.” Uh, Dodd Frank? Basel III? The new capital, leverage and liquidity rules are doing more to shrink the size of the major banks than Warren wants to admit or realizes.
What is the right number of prime brokers in the Basel III new world order? This month’s essay addresses another unintended consequence of financial regulation: its impact on the risk reducing effects of the multi-prime model. Basel III and the new US bank regulations have prime brokers fixated on balance sheet usage and client ROA. The conventional wisdom being put forth by the prime brokers is that hedge funds should consolidate their financing balances across fewer primes to boost their returns (ROA). Besides being a self-serving argument it misses the point. I feel hedge funds should do exactly the opposite. First, let’s review the new math of Basel III.
Continuing on the theme of the unintended consequences from the new bank regulations we come to the recent, and increasing, exodus of senior players from the industry. It started with Mike Cavanaugh, the heir apparent to Jamie Dimon, (who is now recovering from throat cancer) leaving for a job in private equity. His reason? He couldn’t see his future in such a regulated industry. This was quickly followed by a large group of the senior ex-Lehman Barclays executives leaving. Same reasons. Now hardly a week goes by without another announcement of a senior banking executive leaving for a hedge fund, private equity or striking out to set up their own boutique investment advisory firm.
“The war is over. They won”. 
The impact of Basel III and Dodd-Frank on the banking industry is becoming clearer and it appears the government is getting what it wanted: a smaller, less risky and less leveraged banking system. Capital ratios, leverage and liquidity rules are all combining to constrain the size of the major banks. Throw in the Volker rule so banks can’t risk their own capital through prop trading and the picture is complete. However in the world of unintended consequences, to paraphrase the Rolling Stones, you can’t always get just what you want.
Citigroup’s Prime Services Consulting group’s white paper that came out in the early summer (Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization) is the best paper yet on the impact of the new regulations on prime broker profitability and hedge fund return on assets (ROA). These new regulations, especially those affecting, liquidity and leverage, are having a significant impact on the profitability of the prime brokerage business. The initial response by the prime brokers has been to raise prices for their services and consider off boarding less profitable clients.
Pangaea Business Solutions announces the release of CP Accelerator. It is important that every hedge fund have a framework for managing counterparty risk. It must also be sized to your organization and your capacity. CP Acclerator is a quick, cost-effective way for a hedge fund to develop this initial framework for their counterparty risk management process. This product includes the following: