A new paper by the Federal Reserve Bank of New York’s Liberty Street Economics unit highlights the changing relationships between hedge funds and prime brokers – specifically that funds are spreading their business wider and that the large dealer-affiliated PBs are suffering disproportionately.
The paper, How Has Post-Crisis Banking Regulation Affected Hedge Funds and Prime Brokers? Studies how the choice of prime brokers for a given hedge fund changes over time, including the probability of new match formation and the persistence of existing matches. It focuses on Basel III and in particular, the supplementary leverage ratio (SLR) which requires that large banking organisations hold capital against their total leverage exposure – including on-balance sheet assets and off-balance sheet assets and exposures.
“Our hypothesis is that these regulations incentivise banks and their broker-dealer subsidiaries to be wary of their balance sheet size and hesitant to provide balance sheet space to hedge fund clients,” the authors state. “We expect hedge funds to adjust by splitting their business across a larger number of prime brokers. Because the regulations are more stringent for larger and more systemic institutions, we expect the effects to be stronger for prime brokers affiliated with global systemically important banks (G-SIBs).”
Using regulatory filings in the US, the research finds that the average number of prime brokers per fund has risen from around 3.6 in 2012 to almost 4 in 2019 and that the fraction of G-SIB prime brokers per fund has decreased from around 85% to around 79% across the same time horizon.
Unsurprisingly, it finds that larger funds tend to use more prime brokers, with the smallest 50% of funds having around 3.5 prime brokers per fund, while the larger 10% have approaching five PBs per fund. “Hedge funds splitting their business amongst more prime brokers post-SLR is consistent with the hypothesis that funds are under pressure from their brokers to economise on balance sheet space with larger funds under more pressure than smaller funds.,” the authors observe.
Larger funds also face the challenge of being more closely tied to the larger G-SIB providers, however, the research finds that their reliance on larger players is more pronounced than at smaller funds. This is mostly due to larger funds being more dependent on services that only a large G-SIB prime broker can provide., the paper asserts.
The paper also considers the probability of new relationships forming as well as the persistence of existing relationships. Consistent with a shift away from relying on G-SIB prime brokers, it finds that fewer new relationships are formed each year in the post-SLR period and that this effect is stronger for G-SIB prime brokers. Further, existing relationships are more persistent, suggesting a more specialised match in each broker-fund relationship, but this effect is weaker for G-SIB prime brokers and large hedge funds.
“Taken together,” the authors write. “Our results suggest a pass-through of regulation from the directly affected sector to other parts of the financial system, such as hedge funds, that rely on the regulated sector for leverage as well as funding, execution, and clearing services. This is important since it affects the ability of hedge funds to fulfill their role as arbitrageurs contributing to the functioning of the financial system.”