Well it looks like the day may have finally come. After years of more and more regulations being heaped on the U.S. banks the Treasury announced in June plans to ease, or a least revisit, a number of the Dodd Frank rules. Most of the proposed changes will not require the approval of Congress, which makes it even more likely that many of these changes will happen (unlike the Financial Choice Act which will likely not get passed by the Senate). The upshot is that the Treasury is putting the brakes on any new regulation and is taking a significant look at what needs to be changed in the existing regulations.
Now that Fed Governor Daniel Turrullo is gone and bank-friendly folks are at the reins in the Treasury department the road has been cleared for this kind of action. Many have been calling for a time-out to evaluate the effects of the now seven year old Dodd Frank regulations. It only makes sense to take some time to do a review to see what is and what is not working. This type of discussion has been difficult with the extreme partisanship in Washington and lingering populist anger with Wall Street. That said, there have been many unintended consequences from the financial regulations and some recalibration needs to be considered. The Treasury proposal should be encouraging for the major banks. It gives them some hope that they won’t have to deal with any new regulations and what they already have to deal with may get dialed back.
What does all this mean for prime brokers and hedge funds?
The Treasury proposal contains changes to two regulations that will be a positive for prime brokers: the Supplementary Leverage Ratio (SLR) and High Quality Liquid Assets (HQLA). Specifically the proposal addresses some of the inefficiencies of the SLR and broadens the definition of HQLA to more closely align with that of the foreign banks.
The change to the SLR would provide the prime brokers with more balance sheet capacity. The U.S. banks are already well above the leverage thresholds and these changes will only increase this buffer. The SLR changes and their impact on prime broker balance sheets may also lessen the balance sheet scarcity especially in a crisis. The change to the HQLA definition won’t directly impact the primes but it may reduce the internal liquidity charges allocated to their business.
That said, in the end these changes are incremental and it will take a while for whatever changes are made to flow through the hedge fund financing food chain. Therefore status quo will probably be maintained for the foreseeable future. The primes and the hedge funds have reached a steady state in terms of managing the balance sheet and client returns. In the end the current counterparty risks brought on by regulation probably won’t be eased much for two reasons. First as mentioned earlier, these changes will take time. Second, the banks will be slow to make any big changes to their capital and liquidity management process knowing that a change in the political winds could reverse what the treasury is proposing to roll back.
In the end I will paraphrase the legendary Barton Biggs who once said in reference to tough times “…the news doesn’t have to be good it just needs to be less bad.” The Treasury proposal news is less bad for the banks.
The kerfuffle last fall around the fortunes of Deutsche Bank resurrected the question among hedge funds about how to react to increased insolvency risk at one of their counterparties. Call it Lehman Brothers redux. The potential $14B mortgage settlement with the DOJ created panic among the bank’s clients (the flames being ably fanned by the media coverage). The Deutsche Bank situation forced their hedge fund clients consider whether to reduce exposure and by how much. One would think with what hedge funds learned in 2008 that they would move decisively in this type of situation. I would suggest that in 2017, more than eight years after the fall of Lehman, that this is still a difficult decision. Counterparty risk management remains both science and art.
Since the populist fervor swept Donald Trump into the presidency last week financials have been rallying based on the feeling that his dovish views on financial regulation will lesson the constraints on the banks. In particular Trump has talked about repealing or significantly rolling back parts of Dodd-Frank the landmark banking regulation that was put in place after the financial crisis. The House Republicans have also recently passed the Financial Choice Act that is aimed at paving the way for changes to Dodd-Frank.
“If it keeps on raining the levee’s going to break”
In our case the levee is the prime broker industry and the rain is government regulation of the banking industry. The levee’s not looking too good these days. Recent news from some of the major foreign banks show we have moved, and are accelerating, into the next phase of re-structuring the prime brokerage business. The script is playing out with the major prime brokers “focusing on our core client base” which is code for “we’re re-pricing or throwing everyone over the side that makes sub-optimal use of our balance sheet”.
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.
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.
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 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.