Special to AllAboutAlpha.com by: James Burron, CAIA
You’d be excused if you felt confused about recent changes to the prime brokerage, custody and fund administration business. Goldman Sachs is working with BNY Mellon; Deutsche Bank has a new platform; Merrill Lynch heralds changes to collateral management at industry conferences etc. In the post-Lehman world, has “boring” simply become hip, or is there really change afoot? To understand these changes, you have to go back in time, way back.
Our story starts with the birth of hedge funds themselves. Alfred W. Jones had the groundbreaking idea to start a fund that was long and short securities (and charging a performance fee) such that returns and risk might be optimized. However, short-selling was easier said than done. When I was a boy, I thought brokers had securities in their desk drawer to produce to investors when they wanted to buy them – just like trading cards. [Ed: when I was a boy, I didn’t know what a broker was…].
Unfortunately, the truth is much more convoluted, especially today with a myriad of custodians and administrators using both proprietary and off-the-shelf software to track the registration of millions of securities the world over. Even when Jones was plying his trade, custody was a complex business. His securities broker (before the advent of prime brokers, or “PBs”) needed to find securities to borrow and work out a system to lend them to Jones who would sell them into the market and later, he hoped, buy them back at a discounted price and return them to the broker who would re-place them in the original owner’s account.
Modern Prime Broking
Enter the PB, a jobber who would provide the specific function of finding ‘the borrow’ for hedge funds (its clients). It might source securities from its own book or, more likely, arrange the same from a custodian. The securities, following the upper arrows in the graphic below, would flow from the Owner through the Custodian and PB to the Borrower. The Borrower would post collateral to the PB but that is where things get a little muddy.
The collateral would form part of the PB’s commingled securities and the PB would then post collateral to the Custodian. (Actually, not to the Custodian, but to a segregated account beneficially owned by the Owner and overseen by the Custodian.) When it came time to reverse the transaction, the collateral and securities would flow the other way and everyone would be square.
If the Owner wanted their securities then the PB would scramble to replace the borrow with another counterparty. If the PB could not, then the Borrower would have to reverse the trade tout de suite. If the Borrower ran into financial difficulty then the collateral would flow to the Owner (assuming the security was unavailable to the Borrower, such as in the case of fraud) and the PB would be responsible for satisfaction from the Borrower (which is why they typically assess this risk very carefully). In a perfect world, there are checks and balances to keep the system functioning.
An Imperfect World
September 15, 2008 was a day that will live in bankruptcy. The scrappy “#5” US broker Lehman Brothers exited the stage it had danced on for 158 years, and its counterparties turned their attention to the boxes below, identical to those above save . Owners were not concerned; they could call collateral from the segregated account to cover their end. Borrowers, however, were in a quandary; they had sold the borrowed securities and were now required to remit them back to the estate of Lehman. But their collateral had vaporized in Lehman’s Chapter 11. It wasn’t “fair”, but it was articulated in contract and bankruptcy law.
There are two ways to mitigate losses due to PB bankruptcy. One is to diversify PB relationships to allow quick transfer of securities to sounder counterparties. And the other is to employ a “Collateral Management Agent” (see graphic below) to keep the amount at risk to a minimum (CMAs use real-time systems to siphon-off or add collateral as and when needed).
Both solutions are not truly bankruptcy remote and come with administrative and operational costs.
Another Stop-Gap Solution
Borrowers reacted to the Lehman bankruptcy by going a step further – fully segregating their collateral from the PB. It made eminent sense to them: why mix their good money with what might be a broken bench?
PBs reticently agreed, with a caveat: they would need to use their capital to post collateral with the Custodian–and this cost of capital would be passed on to borrowers. In addition, a Collateral Management Agent would need to be employed to ensure the required collateral was in the segregated account (this was done internally at the Custodian for its segregated account, but would be an added cost for PBs). Naturally, borrowers resisted paying a multiple of their original costs simply to insure against counterparty risk and this solution did not gain much traction.
Looking at the graphic above, one might ask “Why not just compress the roles of PB and Custodian and have one segregated account where both parties could oversee collateral? That is exactly what is happening right now in the PB industry.
In this new model, a single segregated account holds collateral for the trade and has lines of sight from the PB and Custodian parties. If the Borrower falls away, the Owner gets the collateral. If the PB/Custodian disappears, the relationship between the Borrower and Owner remains—and those parties could retain the transaction or execute an orderly unwind. Both Owners and Borrowers now have a measure of protection from the next perfect storm.
Many global banks and custodians use at least one of these models. Choosing the one right for a particular Borrower comes down to their level of comfort with each model and the costs involved.
After years of portfolio management advancements (chronicled superbly on these very pages), the back-office is the new frontier for innovation. Who would have thought?