Ongoing market uncertainty and interest rate hikes mean hedge funds are taking on less leverage and looking for alternative alpha generation strategies As lenders, prime brokers face increased market competition and risk from potential hedge fund defaults. In this DerivSource commentary article, Vardaan Kohli, product specialist at Cassini Systems, discusses the need for updated prime brokerage technology solutions to monitor real-time margin movements to efficiently manage risk while providing hedge fund clients transparency and peace of mind over margin calculation processes.
Markets work in cycles, and we are currently in a period of heightened uncertainty. Recent interest rate movements have impacted the equity markets significantly. Hedge funds that take more leverage when markets are less volatile have reduced their leverage amounts, but the returns they give their client base need to be higher because of the increased interest rates. Hedge funds are, therefore, looking for new opportunities in the market or improving their operating framework in order to enhance investor returns.
Prime brokerage is an asset-based lending model, and prime brokers must be efficient risk managers in order to avoid losses from counterparty defaults. How much a prime broker wants to lend to a hedge fund client comes down to the quality of assets the fund holds and the fund’s counterparty profile. Prime brokers need to have a sophisticated model or framework to consider these criteria. They cannot rely on manual or outdated operating models. Whether the technology they use is internal or external, it needs to be robust and agile enough to adapt to the evolving needs of the hedge fund market and the broader client base they serve.
Margin Transparency is Key for Prime Brokerage Hedge Fund Clients
Hedge funds want to know how margin is calculated. Funds have put much work into understanding prime broker and exchange margin models, so they are not surprised from market movements or changes in underlying risk.
Most exchange and clearing margin models are Value-At-Risk- (VAR) based. In recent years, with the Covid pandemic, the war in Ukraine, and the resulting energy crisis, margin across all asset classes has spiked. Higher interest rates mean the collateral hedge funds need to post has become much more expensive.
Hedge funds are focused on how transparent a prime broker is regarding margining and whether they provide the tools and resources the fund needs to validate what a prime broker is doing. If a hedge fund is putting on a new exposure or rebalancing its exposures across counterparties, they need have the right level of clarity to make the decision.
For prime brokers, the market is constantly expanding, and there is always fight for market share. They want to keep their clients happy but also manage their risk effectively, whether operational, regulatory, market, or counterparty risk. They need to be able to assess changing risks in real-time and to adapt to changing market conditions. The more manual their processes, the more operational risk they take on. Prime brokers need the right level of technology resourcing to mitigate operational risks.
Managing Margin Calls with Real-Time Risk Assessment
Prime brokers have a day-to-day process for managing margin calls to their clients. They need to view whether the client has met the margin call, how that evolves throughout the day, what trading activity they are taking on, and how that impacts margin, as well as how prices are moving in the market. Prime brokers must be very proactive and have a real-time view throughout the day of what positions or portfolio levels their clients have and whether adverse moves in the market have impacted their credit quality. How high is the risk of a hedge fund defaulting and affecting the broker’s revenues?
Regulators also require prime brokers to ensure that they are not giving excessive leverage to their counterparties—the technology tools they use must provide a near real-time view of risk across their client base.
Prime brokers need a sophisticated technology solution that integrates margin calculation, trade booking, and pricing and sends reports to the right teams so they understand the downstream impact of any of these lifecycle events. Regulatory reporting is crucial, but systems and process efficiency are also critical for firms to take corrective or preventive action promptly.
“Having a technology resource that both parties can use and rely on gives hedge fund clients confidence in the prime broker’s margin models.”
The Importance of Robust Prime Brokerage Margin Models
Hedge funds are not necessarily against prime brokers charging higher margin. They want to be confident that the broker adequately manages its risk and will be around for a long time. This increases their confidence in the relationship and may encourage them to bring more business to the broker. What matters is that the prime broker’s margin model is robust enough and doesn’t change dramatically from day to day. That way, their margin remains relatively stable, and they can more confidently game out the impact of moving more business to the prime broker.
Having a technology resource that both parties can use and rely on gives hedge fund clients confidence in Prime Broker’s margin models. Prime brokers actively perform stress tests to see if the margin charged across their client base is efficient and whether there is any concentration risk across portfolios.
For example, does a move in one sector, country, individual stock, or interest rate lead to a significant spike in margin? Either in terms of what the client owes the prime broker or vice versa. Having that view of where they stand as a business is essential.
If a prime broker runs a stress test and realizes they are not efficiently margining a client, they may engage with the client to ask them to either post more collateral, adapt their portfolio, or agree to a new margin policy altogether.
Collateral is expensive in the current environment and hedge funds may or may not want to leave excess cash at a prime broker. The foresight of what could happen in a stress situation can therefore help both sides plan and optimize their collateral use.
Prime Broker Tools for Boosting Collateral Resiliency
Most prime brokers are not standalone firms but a part of a larger bank with many different departments, and certain functions are centralized. The business units within these firms may look at their risk individually, but prime brokers leverage the wider institution’s capabilities regarding liquidity analysis, stress-testing across the firm, and collateral resiliency.
However, an efficient margin tool connected to that wider platform helps them manage the margin processes and workflows, dynamically and flexibly. The margin tool can feed the results back to all the different internal systems that may use this information for collateral requirements or liquidity stress testing, for example.
On the hedge fund side, some of the bigger hedge funds do this very well with similar technological capabilities to the major banks. But the smaller hedge funds may lack the resources to look at their collateral resiliency, to phase stress test holistically across the board, and forecast their margin or even optimise their collateral to see what is left over and what they can use as excess capital for different trading activities. For those firms it makes sense to leverage a technology solution to replicate the capabilities of the larger banks, that does not require a major outlay in terms of internal capital and resource expenditure.
“Providing clarity around their margin models enables prime brokers to be transparent with their hedge fund client base and provide clients with what they need to estimate their margin requirements.”
Long-Term Advantages of Updating Margin Models and Providing Transparency
Updating their processes to more easily communicate margin models enables prime brokers to be transparent with their hedge fund client base and provide clients with what they need to be able to estimate their margin requirements. A hedge fund that is happy with its prime broker would like to maintain that wallet share and give the prime broker more business because it knows where it stands regarding its margin. It is all about strengthening that client relationship over the long term.
But the key driver is risk. The prime brokerage business relies on an asset-based lending model where hedge funds take leverage from them. Maximizing the amount they lend to a hedge fund client but doing it at a low cost is the best situation for them. The only way to do this is by having the best technology. They may have all the right policies, procedures, and governance in place, but the execution and nimbleness come from leading-edge technology.
With a real-time view of what assets they have across the board and different hedge funds’ balances, prime brokers can decide what they can lend to other clients, optimizing across that base of assets to enhance revenue. Updating their prime broker models enables them to be more efficient and improve the client relationship without lowering their risk profile.
* See other articles on collateral management here.
