Risk-Wary Primes Pass OTC Processing Burden to Funds
Hedge funds will face new costs as prime brokers cut back on give-ups
March 30, 2009
Hedge funds could find it more difficult to process over-the-counter derivative trades as their prime brokers grow increasingly reluctant to provide give-ups, where they act as counterparty to their clients' dealers.
Market participants say the trend does not extend beyond OTC derivatives, but it could present new challenges and expenses for funds that trade fixed-income products and use derivatives to hedge them. Those transactions will have to be processed through multiple counterparties rather than just their prime broker, and credit risk will grow proportionally.
The reluctant primes tend to be units of large international banks such as Goldman Sachs and Barclays. Those firms deal in fixed-income-related instruments like credit default swaps (CDS), repos and currency swaps and have the operations to process and clear them. Goldman, for one, has been "deemphasizing credit intermediation of OTC trades in anticipation of the more centralized clearing venues," explained a spokesperson for the firm.
IntercontinentalExchange's ICE US Trust subsidiary recently began clearing CDS index trades, and NYSE Euronext and CME Group are in the process of launching credit derivatives clearing initiatives. For now, however, prime brokers that provide give-ups are the focus of clearing and settlement risk for their hedge fund clients.
Primes Pare Back
According to the manager of a global macro fund with tens of millions of dollars in assets under management, prime brokers are recommending their customers enter direct relationships with counterparties, which helps the primes reduce operational expenses and credit risk. Such efforts are part of a broader movement among Wall Street firms to deleverage their balance sheets and make their businesses more efficient.
The large primes' efforts to pare down their offerings has created opportunities for smaller brokers such as Merlin Securities, Grace Financial Group and Lek Securities Corp. But those firms tend to focus on exchange-traded securities. The head of a midsized prime brokerage in New York said counterparty risk had prompted the relatively few large prime brokers offering give-ups to back away. "We do not intend to get involved in that activity," he said.
Hedging counterparty risk became imperative after the September bankruptcy of Lehman Brothers, a major OTC derivatives dealer. In fact, many hedge fund customers of Lehman's U.K. office reportedly found themselves without a counterparty and their assets frozen in bankruptcy proceedings.
Since last fall, purchasing CDS and other hedging instruments has become far more expensive. Because gives-ups typically have been provided by prime brokers as a value-added service, the higher hedging costs make it less than practical for any but the largest and most profitable customers. And the OTC derivatives market is far less automated than listed securities, which makes it more expensive to process transactions.
"Profit margins are a lot less for those types of transactions, so if you're not getting adequate margin it doesn't make sense to support give-ups," said Chris Zingo, SVP for the Americas at SuperDerivatives, which provides prime brokers with valuations and software that confirms OTC trades and transmits data for clearance and settlement.
Even if the emerging central counterparties reduce counterparty risk, hedge funds that are unable to get give-ups will need to process and manage the transactions or pay a third party to do it. OTC derivatives are "very complex trades with a life cycle management aspect to them," noted Aite Group senior analyst Denise Valentine. They require payments over the life of the transaction, and predefined events can trigger payouts.
