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.
THE “NEW” MATH
Absolute revenue, or wallet, is still important for gaining access to resources at the banks. In terms of allocating your wallet, hedge funds need to first decide what services are important to them and what it will cost to gain access to them. There is no reason to overpay for services. Hedge funds also need to understand what part of their commission wallet is included in the numerator of the Prime Brokerage ROA calculation. I recently asked one of the major prime brokers about this and was told that only equity trading commissions are included in their Prime Brokerage ROA calculation e.g., derivatives and fixed income commissions are excluded. Once the hedge fund knows what commission revenues are included they must then coordinate their financing and trading groups to more efficiently manage financing and commission revenue across their providers i.e., the numerator. Once the hedge fund has determined how to efficiently allocate their wallet then managing prime brokerage ROA is the next priority.
Revenue is the numerator, now we move to the denominator – balance sheet usage. The efficiency of the hedge fund’s portfolio drives balance sheet usage and ROA. Prime brokers may say they want their clients to consolidate their providers and allocate more of their financing revenues to them but if the hedge fund has a directional book the primes will not be that interested in the incremental financing revenue. Citigroup’s 2014 white paper provides a very comprehensive explanation of how to calculate and manage ROA (see my 10/8/14 post).
Now that the hedge fund has efficiently allocated its wallet and given their prime a relatively balance sheet efficient financing book (and confirmed this with the prime broker) then they should be able to stay above the return thresholds. From that point on they are off the ROA radar. Now hedge funds can turn to adjusting their prime broker lineup to create a multi-prime model that mitigates counterparty risk in the Basel III world.
THE NEW MULTI-PRIME MODEL
To restate my view: Hedge funds will need more prime brokers in the future, not less. There are a couple of reasons for this view, one relating to daily operations and the other to the next crisis.
First the overall impact of Basel III has been the shrinking of bank balance sheets, which will reduce the aggregate availability of financing. Therefore it is a real possibility that some hedge funds may find themselves stopped out for financing at their prime brokers. For example if a hedge fund can only get 90% of the financing it needs from its current stable of primes then they will need to consider adding prime brokers to bridge the financing gap.
Second, when the next crisis hits it won’t be as easy as just calling up your other prime brokers and getting the Risk group to approve taking your positions from your ailing provider. The impact of your financing book on the prime brokerage balance sheet usage will be the critical factor in the decision to accept the hedge fund’s positions. (This added layer of decision-making will also slow down the process for transferring assets at a time when it is essential to move quickly.) Basel III has changed the multi-prime game. It’s not enough to have multiple prime brokers a hedge fund needs counterparties that will commit to taking some or all of their book from a foundering counterparty. The other flavor of this Basel III risk is if the prime broker asks the hedge fund to leave (e.g., for not being profitable from an ROA perspective). Again the hedge fund will need to identify other active primes that will take their positions.
There also needs to be some reconsideration about the minimum number of prime brokers. Today that number is two but it may need to increase to three or four. Think about this example: The hedge fund has two prime brokers and one of them (or the hedge fund) gets into trouble and their other PB won’t take all (or any) of their book. Now what? A hedge fund with three or four primes has options. It is also important to diversify PB correlation e.g. regions and countries. For smaller hedge funds getting to three or four primes will mean engaging mid-tier and introducing (mini) primes. Bulge bracket primes won’t be interested in splitting a small book three or four ways.
So in summary there are two things a hedge fund needs to do in this new Basel III world: actively manage their ROA at each of their prime brokers and have a group of primes they can turn to in a crisis. It’s a numbers game now.