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Hedge Funds and Counterparties: Report by GAO

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

I found this section reprinted below to be especially informative on the issues involved when hedge funds utilize credit.  The section provides a history on hedge funds and counterparty risk management and has concluded that the counterparty risk management procedures have tightened from the late 1990’s when we saw the crash of Long Term Capital Management.  It is likely that in this current environment that even stricter risk management procedures will become common and that due diligence by counterparties (banks and brokerage firms) will also increase.

If a manager has any questions on receiving credit or leverage, the manager should talk with the fund’s broker and/or banker well before any credit or leverage is needed – as always, managers are urged to give themselves plenty of time when negotiating credit and leverage terms.  Please feel free to contact us if you would like to discuss anything discussed herein.


Creditors and Counterparties Can Impose Some Market Discipline on Hedge Fund Advisers as Part of Credit Extension, but the Complexity of Counterparty Credit Risk Management Poses Ongoing Challenges for Financial Institutions:

By evaluating hedge fund management, the fund’s business activities, and its internal and risk management controls, creditors and counterparties exert discipline on hedge fund advisers. According to market participants, entering into contracts with hedge funds as creditors or counterparties is the primary mechanism by which financial institutions’ credit exposures to hedge funds arise, and exercising counterparty risk management is the primary mechanism by which financial institutions impose market discipline on hedge funds. According to the staff of the member agencies of the PWG [the President’s Working Group on Financial Markets, please see this article for more information], the credit risk exposures between hedge funds and their creditors and counterparties arise primarily from trading and lending relationships, including various types of derivatives and securities transactions.[1] As part of the credit extension process, creditors and counterparties typically require hedge funds to post collateral that can be sold in the event of default. According to market participants we interviewed, collateral most often takes the form of cash or high-quality, highly liquid securities (e.g., government securities), but it can also include lower-rated securities (e.g., BBB rated bonds) and less liquid assets (e.g., CDOs). They told us they take steps to ensure that they have clear control over collateral that is pledged, which according to some creditors and counterparties we interviewed, that was not the case with LTCM. Creditors and counterparties generally require hedge funds to post collateral to cover current credit exposures (this generally occurs daily) and, with some exceptions, require additional collateral, or initial margin, to cover potential exposures that could arise if markets moved sharply.[2] Creditors to hedge funds said that they measure a fund’s current and potential risk exposure on a daily basis to evaluate counterparty positions and collateral.

To control their risk exposures, creditors and counterparties to generally large hedge funds told us that, unlike in the late 1990s, they now conduct more extensive due diligence and ongoing monitoring of a hedge fund client. According to OCC, banks also conduct “abbreviated” underwriting procedures for small hedge funds in which they do not conduct much due diligence. OCC officials also told us that losses due to the extension of credit to hedge funds were rare. Creditors and counterparties of large hedge funds use their own internal rating and credit or counterparty risk management process and may require additional collateral from hedge funds as a buffer against increased risk exposure. They said that as part of their due diligence, they typically request information that includes hedge fund managers’ background and track record; risk measures; periodic net asset valuation calculations; side pockets and side letters; fees and redemption policy; liquidity, valuations, capital measures, and net changes to capital; and annual audited statements. According to industry and regulatory officials familiar with the LTCM episode, this was not necessarily the case in the 1990s. At that time, creditors and counterparties had not asked enough questions about the risks that were being taken to generate the high returns. Creditors and counterparties told us they currently establish credit terms partly based on the scope and depth of information that hedge funds are willing to provide, the willingness of the fund managers to answer questions during on-site visits, and the assessment of the hedge fund’s risk exposure and capacity to manage risk. If approved, the hedge fund receives a credit rating and a line of credit. Several prime brokers told us that losses from hedge fund clients were extremely rare due to the asset-based lending they provided such funds. Also, one prime broker noted that during the course of its monitoring the risk profile of a hedge fund client, it noticed that the hedge fund manager was taking what the broker considered to be excessive risk, and requested additional information on the fund’s activity. The client did not comply with the prime broker’s request for additional information, and the prime broker terminated the relationship with the client.

Through continuous monitoring of counterparty credit exposure to hedge funds, creditors and counterparties can further impose market discipline on hedge fund advisers. Some creditors and counterparties also told us that they measure counterparty credit exposure on an ongoing basis through a credit system that is updated each day to determine current and potential exposures. Credit officers at one bank said that they receive monthly investor summaries from many of their hedge fund clients. The summaries provide information for monitoring the activities and performance of hedge funds. Officials at another bank told us that they generally monitor their hedge fund clients on a quarterly basis and may alter credit terms or terminate a relationship if it is determined that the fund is not dealing with risk adequately or if it does not disclose requested information.

Some creditors also said that they may provide better credit terms to hedge funds that consolidate all trade executions and settlements at their firm than to hedge funds that use several prime brokers because they would know more about the fund’s exposure. However, large hedge funds may limit the information they provide to banks and prime brokers for various reasons. Unlike small hedge funds that generally depend on a single prime broker for a large number of services ranging from capital introductions to the generation of customized accounting reports, many large hedge funds are less dependent on the services of any single prime broker and, according to several market participants, use multiple prime brokers as a means to protect proprietary trading positions and strategies, and to diversify their credit and operational risks.

Despite improvements in disclosure and counterparty credit risk management, regulators noted that the effectiveness of market discipline may be limited or market discipline may not be exercised properly for several reasons. First, because large hedge funds use several prime brokers as creditors and counterparties, no single prime broker may be able to assess the total amount of leverage used by a large hedge fund client. The stress tests and other tools that prime brokers use to monitor a given counterparty’s risk profile can incorporate only those positions known to a trading partner. Second, the increasing complexity of structured financial instruments has raised concerns that counterparties lack the capacity (in terms of risk models and resources) to keep pace with and assess actual risk, illustrating a possible failure to exercise market discipline properly. More specifically, despite improvements in risk modeling and risk management, the Federal Reserve believes that further progress is needed in the procedures global banks use to manage exposures to highly leveraged counterparties such as hedge funds, in part because of the increasing complexity of products such as structured credit products and CDOs in which hedge funds are active participants. The complexity of structured credit products can add to the already complex task of measuring and managing counterparty credit risk. For example, another Federal Reserve official has noted that the measurement of counterparty credit risk requires complex computer simulations and that “the management of counterparty risk is also complicated further by hedge funds’ complicated organizational structures, legal rights, collateral arrangements, and frequent trading. It is important that banks develop the systems capability to regularly gather and analyze data across diverse internal systems to manage their counterparty credit risk to hedge funds.” One regulatory official further noted the challenges faced by institutions in finding, developing and retaining individuals with the expertise required to analyze the adequacy of these increasingly complex models. The lack of talented staff can affect counterparty credit risk monitoring and the ability to impose market discipline on hedge fund risk taking activities. Third, some regulators have expressed concerns that some creditors and counterparties may have relaxed their counterparty credit risk management practices for hedge funds, which could weaken the effectiveness of market discipline as a tool to limit the exposure of hedge fund managers. They noted that competition for hedge fund clients may have led some to reduce the initial margin in collateral agreements, reducing the amount of collateral to cover potential credit exposure.

[1] A derivative is a financial instrument, such as an option or futures contract, the value of which depends on the performance of an underlying security or asset. Securities financing transactions include repurchase agreements, securities lending transactions, and other types of borrowing transactions that, in economic substance, utilize securities as collateral for the extension of credit. A repurchase agreement is a financial transaction in which a dealer borrows money by selling securities and simultaneously agreeing to buy them back at a later date.

[2] According to the literature, (1) current exposure represents the current replacement cost of financial instrument transactions, i.e., their current market value; (2) potential exposure is an estimate of the future replacement cost of financial instrument transactions; and (3) an initial margin is the good-faith deposit that protects the counterparty against a loss from adverse market movements in the interval between periodic marking-to-market.

Other related HFLB articles:

Hedge Fund Service Providers Expanding During Market Turmoil

If you read a lot of the stories which have been coming out in the last couple of weeks, you would think that the hedge fund industry was about to go the way of the dinosaur.  (See NYT Deal Book Article)  Personally, I think the exact opposite – that the hedge fund industry, after a bit of a cooling off period, will see assets come back to the table in greater force than before.  I also believe that hedge funds will become more institutionalized products with more robust due diligence procedures as a standard practice and that hedge funds will (eventually) emerge as retail products.  Whether any of the above happens quickly or slowly remains to be seen, but there were four separate press releases we published last week that shows hedge fund service providers are especially bullish on the industry.

The four press releases deal with (1) expanding hedge fund due diligence; (2) increased investment from single family offices; (3) prime brokers continuing expansion based on industry changes and (4) a hedge fund administrator moving into the prime brokerage arena.  I’ve highlighted the takeaways from the press releases below.

1.  Hedge Fund Due Diligence Firm Expands. (Link to release)  The press release below provides details on a hedge fund due diligence firm which is expanding its operations.  In the coming months and years hedge fund due diligence is poised to become a central part of the hedge fund investing process. Specifically, the press release quotes the new hire as saying… “in the current markets, hedge fund investors face multiple challenges that, more than ever, involve operational risk. Investors must understand many new issues, including counterparty risks, the impact of FAS 157 and how to deal with funds which impose gates, suspend redemptions or restructure. Castle Hall helps investors enhance their due diligence program and better respond to these new challenges.”  I completely agree.  For more information on due diligence, please see the following HFLB articles:

2.  Single family offices to increase hedge fund investing in the next year. (Link to release) Rothstein Kass, a well known hedge fund audit and administration firm, released a study which indicates that Single Family Offices will continue to invest in hedge funds.  This press release states two interesting items from the report:

Good Performance and Additional Investment – family offices are generally happy with the performance of hedge funds and will commit more money to funds within the next twelve months.

Transparency – the release states that more than 70% of single family offices said that a lack of transparency in their hedge fund investments is concerning.  Additionally, a director of Rothstein Kass is quoted as saying  “while high-net-worth individuals generally recognize advantages of hedge fund investing, they are frequently confounded by the growing roster of products and services available.”  This really comes as no surprise and signals that hedge fund due diligence will become a major focus from here on out.  Transparency is achieved not only through the hedge fund manager, but also through hedge fund service providers who have developed technology solutions to offer to hedge fund managers.  On a going forward basis hedge funds are going to need to be more transparent.  For more information, please also see:

3.  Prime Broker continues to expand during industry changes. (Link to release) The prime brokerage industry is going through a lot of changes currently as the biggest prime brokerage firms, Goldman and Merrill have changed into bank holding companies.  Additionally, with the collapse of Lehman, the conventional wisdom is for larger hedge funds to prime with multiple brokers.  As this trend continues to develop I expect that more firms will jump into the prime brokerage business and that prime brokers will begin to offer more back office and administration services to hedge funds.  New and surviving hedge funds should benefit as prices decrease and quality of services increase.

4.  Hedge fund administration and back office firm, announced that it is expanding into hedge fund prime brokerage. (Link to release) This press release highlights two specific interesting trends in the hedge fund industry.  The first is the move from segregated service providers to shows which provide a whole suite of services including back office, admin and prime brokerage.  The second trend is the move from one main prime broker to housing assets at many prime brokerage firms.  We saw with the collapse at Lehman and the corresponding freeze of some hedge fund assets, that small and large funds alike want to diversify across brokers and custodians.  I believe Conifer is the first in a wave of admin/ back office firms which will put a shingle out as a mini-prime or introducing prime broker.


While none of these individually provide conclusive evidence that the industry will remain strong in the coming months, it does show that people in the industry are investing in the infrastructure which will allow the industry to expand in the coming years. Please feel free to contact us if you have questions or comments on any of the above.

Hedge Fund Administrator Tests Prime Brokerage Waters

There was a previous press release about a hedge fund prime broker expanding its services.  We can see from the press release below that hedge fund adminsitrators are also expanding their service offerings.  I believe the reason for the expansion in the service offerings of these firms indicates a belief that the hedge fund space will continue to grow.  It also indicates that hedge fund service providers are looking to be more diversified – these service providers are looking to become one stop shops for hedge fund managers.

Conifer Securities Launches Prime Brokerage Through J.P. Morgan Chase

NEW YORK, Oct 15, 2008 /PRNewswire via COMTEX/ — Move Comes as Hedge Funds Look for New Financing and Prime Brokerage Options

Conifer Securities, a leading provider of business and operations solutions to asset managers and institutional investors, today announced that it has entered the prime brokerage business. Working with J.P. Morgan’s Broker Dealer business services, Conifer is now building upon its Fund Administration and Outsourced Trade Execution services by offering hedge funds a full-suite of prime brokerage services including financing, securities lending, asset custody and daily account reporting. J.P. Morgan’s capital position, extensive capabilities and innovative approach stand out during the current market volatility.

The ongoing financial turmoil and growing interest in counterparty diversification have created a strong demand for additional, experienced prime brokers to step in and service hedge funds. Many hedge fund managers today want to create relationships with multiple prime brokers who can provide alternate sources of financing as well as premium service. Given its 19-year track record as a top-tier hedge fund service provider, the agreement to clear and custody with J.P. Morgan puts Conifer in a very strong position to provide managers with alternative prime brokerage and financing sources.

Conifer’s move into the prime brokerage business is being spearheaded by Richard (Dick) Del Bello, who has more than 15 years of prime brokerage experience, including seven years as the head of prime brokerage for the Americas at UBS.

“The credit crisis and subsequent market turbulence have transformed our industry as hedge funds shift assets to the most financially stable investment and commercial banks,” said Mr. Del Bello. “At the same time, some of the large prime brokers are squeezing the tails of their client rosters, eliminating hedge fund accounts that aren’t suitable for their business–and that’s where Conifer comes in.”

Jack McDonald, Conifer’s president & CEO, added, “J.P. Morgan’s prime brokerage offering is the perfect complement to Conifer’s core middle and back office business, resulting in our emergence as a leading prime broker to hedge funds. Given our existing relationships with all of the other major prime brokers, we can also service established hedge funds requiring multiple relationships by providing them with centralized reporting and an infrastructure otherwise available only to the largest funds. Conifer has successfully expanded its business through the cyclical market extremes of the last twenty years. This in-depth experience and broad expertise will provide the stability and support our client partners need in growing their business.” McDonald concluded.

In addition to its prime brokerage services, Conifer provides comprehensive middle- and back-office services to its clients including: global fund accounting and administration, trade operations, outsourced trade execution, executive office space, compliance, corporate accounting, consulting services and business infrastructure.

Hedge Fund Prime Brokerage

Hedge fund prime brokerage is provided by a prime broker.  While the central service the prime broker provides to a hedge fund is trading services, the prime broker provides many other services to hedge funds as well.

Trading and execution

Generally a hedge fund prime broker will act as a hedge fund’s central broker and will execute most of the hedge fund’s trades.  Many prime brokers have online interfaces and/ or programs which allow a manager to automate many trades.  Additionally, the prime broker will be able to execute trades in large blocks and will also be able to execute trades in illiquid securities for the fund.

Custodial and settlement services

One of the main advantages of having a prime broker is that the broker will act as a custodian of the fund’s assets.  If the hedge fund executes trades through other brokers, the prime broker’s back office will work with the back office of the executing broker-dealer to make sure that the assets are settled and transferred over to the fund’s account at the prime broker.

There are a couple of advantages of having the assets custodialized at one institution: (i) reporting of the fund’s positions is easier when there is one custodian and (ii) the prime broker can use all of the fund’s assets for margin purposes (instead of simply part of the fund’s assets if there are multiple brokers or custodians).

Other Services

In addition to custodial and execution services, the prime broker can provide a whole host of other services including:

Leverage and margin – prime brokers can provide the fund with leverage and margin, depending on the fund’s investment program and circumstances.

Short sales – prime brokers generally have a “short box” of securities which can be borrowed to be sold short.

IPOs – prime brokers will often have access to initial public offerings.  Some hedge funds will choose a prime broker based on the broker’s ability to allocate IPOs to the fund.

Capital introduction – a prime broker may, in certain circumstances, introduce potential investors to the hedge fund.

Reporting – the prime broker can produce period reports which can be sent to the hedge fund administrator or to hedge fund investors.

Soft dollars – the prime broker may be able to provide certain research and other items to the hedge fund manager.  Under revised soft dollar guidance, soft dollars cannot be used for non-research items such as computer equipment or rent for the hedge fund’s management company.

Office space and IT support – some prime brokers (and other broker-dealers) will provide office space and IT support for hedge funds.  Such arrangements are often called by the perjorative term “hedge fund hotels.”

Stress test analysis and other portfolio monitoring

Joint Back Office (JBO) arrangements – these arrangements allow a hedge fund to receive more margin by becoming a broker-dealer.  These arrangements used to be more popular but the margin rules changed to a risk-based model which, for many hedge funds, abrogated the need for many JBO arrangements.

Deciding on a prime broker

The prime broker is definitely a major piece of the hedge fund puzzle.  You should discuss prime brokers with your hedge fund attorney; your attorney will be able to give you some recommendations based on your trading program and other factors.  Please contact us if you have any questions.