Prime Brokerage Business

Prime Brokerage Business | Wikipedia

Quick Link: Hedge Fund Prime Brokers

Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a leveraged basis and achieve an absolute return. The business advantage to a hedge fund of using a Prime Broker is that the Prime Broker provides a centralized securities clearing facility for the hedge fund, and the hedge fund’s collateral requirements are netted across all deals handled by the Prime Broker. The Prime Broker benefits by earning fees (“spreads”) on financing the client’s long and short cash and security positions, and by charging, in some cases, fees for clearing and/or other services. It also earns money by hypothecating the portfolios of the hedge funds it services and charging a fee to those borrowing securities and other investments.

The following services are typically bundled into the Prime Brokerage package:

• global custody (including clearing, custody, and asset servicing)
• Securities lending
• Financing (to facilitate leverage of client assets)
• Customized Technology (provide hedge fund managers with portfolio reporting needed to effectively manage money)
• Operational Support (prime brokers act as a hedge fund’s primary operations contact with all other broker dealers)

In addition, certain prime brokers provide additional “value-added” services, which may include some or all of the following:

• Capital Introduction – A process whereby the prime broker attempts to introduce its hedge fund clients to qualified hedge fund investors who have an interest in exploring new opportunities to make hedge fund investments.
• Office Space Leasing and Servicing – Certain prime brokers lease commercial real estate, and then sublease blocks of space to hedge fund tenants. These prime brokers typically provide a suite of on-site services for clients who utilize their space.
• Risk Management Advisory Services – The provision of risk analytic technology, sometimes supplemented by consulting by senior risk professionals.
• Consulting Services – A range of consulting / advisory services, typically provided to “start-up” hedge funds, and focused on issues associated with regulatory establishment requirements in the jurisdiction where the hedge fund manager will be resident, as well as in the jurisdiction(s) where the fund itself will be domiciled.

History

The basic services offered by a prime broker give a money manager the ability to trade with multiple brokerage houses while maintaining, in a centralized master account at their prime broker, all of the hedge fund’s cash and securities. Additionally, the prime broker offers stock loan services, portfolio reporting, consolidated cash management and other services. Fundamentally, the advent of the Prime Broker freed the money manager from the more time consuming and expensive aspects of running a fund. These services worked because they also allowed the money manager to maintain relationships with multiple brokerage houses for IPO allocations, research, best execution, conference access and other products.

The concept and term “prime brokerage” is generally attributed to the U.S. broker-dealer Furman Selz in the late 1970s. However, the first hedge fund operation is attributed to Alfred Winslow Jones in 1949. In the pre-prime brokerage marketplace, portfolio management was a significant challenge; money managers had to keep track of all of their own trades, consolidate their positions and calculate their performance regardless of which brokerage firms executed those trades or maintained those positions. The concept was immediately seen to be successful, and was quickly copied by the dominant bulge bracket brokerage firms such as Morgan Stanley, Bear Stearns, Merrill Lynch, Lehman Brothers, and Goldman Sachs. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domestic long-short equities funds. The first non-U.S. prime brokerage business was created by Merrill Lynch’s London office in the late 1980s.

Through the 1980s and 1990s, prime brokerage was largely an equities-based product, although various prime brokers did supplement their core equities capabilities with basic bond clearing and custody. In addition, prime brokers supplemented their operational function by providing portfolio reporting; initially by messenger, then by fax and today over the web. Over the years, prime brokers have expanded their product and service offerings to include some or all of the full range of fixed income and derivative products, as well as foreign exchange and futures products.

As hedge funds have proliferated globally through the 1990s and the current decade, prime brokerage has become an increasingly competitive field and an important contributor to the overall profitability of the investment banking business. As of 2006, the most successful investment banks each report over two billion dollars in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).

Fees

Prime brokers do not charge a fee for the bundled package of services they provide to hedge funds. Rather, revenues are typically derived from three sources: spreads on financing (including stock loan), trading commissions and fees for the settlement of transactions done away from the prime broker. The financing and lending spreads, which are charged in basis points on the value of client loans (debit balances), client deposits (credit balances), client short sales (short balances), and synthetic financing products such as swaps and CFDs (Contract for difference), make up the vast majority of prime brokerage revenue. Therefore, clients who undertake substantial short-selling or leverage represent more lucrative opportunity than clients who do relatively less short selling and/or utilize minimal leverage. Clients whose market activities are principally fixed income oriented will generally produce less prime brokerage revenue, but may still present significant economic opportunity in the repo, foreign exchange (fx), futures, and flow business areas of the investment bank.

Risks

Prime Brokers facilitate hedge fund leverage, primarily through loans secured by the long positions of their clients. In this regard, the Prime Broker is exposed to the risk of loss in the event that the value of collateral held as security declines below the loan value, and the client is unable to repay the deficit. In practice, such conditions arise only in the case of extraordinary volatility or unexpected correlation reversions and are exceedingly rare. Other forms of risk inherent in Prime Brokerage include operational risk and reputational risk.

Large prime brokerage firms today typically monitor the risk within client portfolios by either Value at Risk (VaR) or “Rules Based” stress testing. Stress testing entails running a series of what-if scenarios that identify the potential gains or losses for each position due to adverse market events.

Examples of stress test scenarios include:

* Flight to Quality
* 1% up or down parallel movement in 10 year treasury yield curve

Retrieved from Wikipedia

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Benefits of Hedge Funds

List of 4 Hedge Fund Benefits

In the midst of 200 articles on the Bernard Madoff fraud case which you can read about here, I spotted an article by Alphaville spelling out the top 9 ways in which hedge funds add value to the investment industry. Here is a short version of the list:

1. Providing liquidity
2. Bursting bubbles
3. Restore confidence during risky investment periods
4. Survival of the fittest models

Here is the full article.

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Hedge Fund Tracker Updates

Hedge Fund Tracker Notes | Updates

Our team has recently updated the Hedge Fund Tracker Notes on these hedge funds:

• Arcanum Capital Management
• Fortis Investments Hedge Fund
• Ramius Capital Group LLC
• RAB Capital Plc
• Bridgewater Capital
• Veritas Asset Management

Read through profiles on over 1,000 hedge fund managers within our Hedge Fund Tracker Tool.

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Video on Hedge Funds

What to Know About Hedge Funds

Here is a short video on hedge funds, the attention they are getting in the media and on short selling. What is nice about this movie is that in plain English it explains why most of what is going on is not new and how short selling is not evil. To view this video via my daily hedge fund newsletter please click here, otherwise please see below.

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Hedge Fund Statistics

Video Interview on Closures & Redemptions

Here is a short video interview with a Yale professor who is an expert on hedge funds. He estimates that the industry will shrink by another 25% next year due to poor markets, volatility and low liquidity across many asset classes. He also discusses hedge fund redemption rates and how many institutions need to raise cash and many have lost some faith in hedge funds. This means that many hedge funds have had to restrict the securities which they own so they can meet redemption requests. The reporter also discusses how many hedge funds have been slashing fees to attract more investors.

If you are viewing this article via our daily hedge fund newsletter please click here to view the video now.

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Below is a short piece on a recent family office merger. I believe these will increase in frequency as highly profitable leaders within this industry look to re-invest cash in smaller family offices. In many cases smaller family offices could use best practice processes, centralized due diligence and manager selection services of the larger family offices. Here is the article excerpt:

Multi-family office Stonehage Group has announced the merger of TriAlpha, its asset management arm, with ACP Partners to create a combined business owned 50:50 by the two groups that will be known initially as ACP TriAlpha and has some USD2.5bn in assets under management.

Founded in 1997, TriAlpha is an asset management house with an absolute return bias that manages a range of multi-manager hedge funds, multi-asset class funds and direct securities products for clients including institutions and high net worth families.

London-based ACP was founded in 2001 by Joseph Sassoon, former founder and head of Goldman Sachs’ European private wealth management business, and Alok Oberoi, who was head of Goldman’s Asian private wealth management business and subsequently chief operating officer of global private wealth management in New York. Brett Lankester, the former head of private wealth management for Goldman in the UK, joined ACP in 2007. source

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The Truth

The Truth About Hede Funds

“All Truth passes through Three Stages: First, it is Ridiculed…
Second, it is Violently Opposed…
Third, it is Accepted as being Self-Evident.”

- Arthur Schopenhauer (1778-1860)

I believe by 2012-2015 that the value of hedge funds will be self-evident. We are living through the ridicule and violent opposition but in the end there is a place for hedge funds and there will always be investors in hedge funds.

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Hedge Fund Maguire

Hedge Fund Maguire | Letter to Hedge Funds

(http://HedgeFundBlogger.com) Below is a short excerpt from the NY Post and their comments on a letter which Sandra Manzke sent out earlier this week regarding the recent actions of many desperate hedge fund managers. If anyone has the full version of this letter please shoot it over or post it below. For now here is an excerpt of the review article:

Fed up with misbehavior in the hedge-fund industry, respected hedge fund investor Sandra Manzke is fighting back.

A pioneer in hedge-fund investing and best known for founding Tremont Capital Management, Manzke sent an angry missive to hundreds of her peers earlier this week, calling on them to join together to push for reform in the $1.5 trillion industry.

“I am appalled and disgusted by the activities of a number of hedge-fund managers,” said the letter, which raises a fist against what Manzke sees as a general degradation of ethics in the industry.

The letter, reminiscent of the way in which Tom Cruise’s Hollywood agent character penned a manifesto blasting his cutthroat industry in the hit movie “Jerry Maguire,” comes amid a historic shakeout of this once-lucrative business. Hedge funds are battling the double blows of poor performance – down an average of 20 percent so far this year – and billions in investor withdrawals, known as redemptions. Read more…

Here is the actual letter:

MAXAM Capital Management LLC
RE: AN IMPORTANT LETTER TO HEDGE FUND INVESTORS
Dear Sir/Madam:

I was one of the earliest investors in hedge funds. I made my first investment in 1985 when the industry was exclusive to the United States and there were only 68 funds in existence. As such, I have watched the industry grow from a small private investment club to its current state managing in excess of a trillion dollars with more than 10,000 funds. I was an early proponent of the fund of funds business which enabled smaller investors the ability to access the talent pool, and gain diversification with lower minimum investment. I once was proud of the industry, now I am concerned.

While we all recognize the difficulties of the current market environment, I am appalled and disgusted by the activities of a number of hedge fund managers. The increased use of gating, side pocketing, suspension of redemptions, failure to post an NAV, fund liquidations that favor management are just a few of activities that are giving this industry a bad name. Worse, there are managers who are attempting to get their money out ahead of investors, attempts to eliminate high water marks, asking investors to increase fees to pay for fund expenses, receiving fees on liquidating funds, receiving fees on illiquid securities, and mispricing their books.

We have seen funds which claimed to have no leverage, in fact, facing margin calls that wipe out capital. And managers who have received millions of dollars in incentive fees, walking away and leaving investors with nothing. Further, management fees have crept up to outrageous levels and hedge fund organizations are paying employees lucrative wages, while investors are bearing these costs, unjustified by mounting losses.

I was in favor of SEC registration and oversight and 2008 is certainly a poster child for the need for better regulation. Now, I feel that investors need to form an organization to protect against the egregious hedge fund manager. Hedge fund managers do not disclose their investors and we are each operating in a vacuum. We should be able to unite to change how this industry operates. I am proposing that we form the “Hedge Fund Investors United Forum” to propose reform in the industry that would protect our clients’ and our own interests.

Carl Icahn has started his shareholders group to change the behavior of corporate America. I urge everyone to go to his blog and join, because corporate America has lost its way. Corporate management needs to get back to running companies to make money for shareholders, not for personal gain. We need to get hedge fund managers to work for their investors and not for their personal gain.

As a group we can influence the future of the industry. We can start to define neutrally beneficial terms, not punitive investor terms. If we want to survive, we have to restore confidence and reshape the industry. I am not saying everyone out there is a bad apple, but there are too many bad apples for my taste and it only takes a few to bring the industry to its knees.

If you are interested in joining with me to bring reform to this industry, please email me and together we can start the process.

With great concern,
Sandra L. Manzke
Chief Executive Officer

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Hedge Fund Connection

The Hedge Fund Connection | Why They Work

Mark Cuban recently published a post on what is currently wrong with how hedge funds operate. In short he believes that hedge funds are not setup to benefit investors because they are paid on an annual basis where as investors are looking for long term 3, 5 and 7 year returns. to read his full post please click here.

Here is a quote from the article: “Those who give money to hedge funds rarely if ever have a 1 year investment term. In fact, the contracts for investment do everything possible to lock up your money for as long as possible. vs. Hedge Fund Managers pay themselves on an annual basis.

That is a huge disconnect and there in lies the rub. While it is true that the managers are paid on a performance basis (plus their 2pct of assets) and some even have clawback provisions, that is not enough. If a fund can get big enough, all they have to do is max out in a single year and the managers are set for life. They put hundreds of millions of dollars EACH in their pocket.”

I disagree with his assessment on many levels. Here is why:

Hedge Funds align their interests with investors more closely than mutual funds and corporations. Hedge funds earn their large profits by taking a percentage of the profits generated for their investors. Why aren’t CEOs, mutual fund managers and ETF managers compensated in this way? Why don’t corporate CEOs have high water marks written into their compensation plans? I think that hedge funds are the answer to the broad misalignment of interests in the marketplace, not the problem.

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Hedge Fund Assets

Hedge Fund Assets Drop by Estimated $100B

(http://HedgeFundBlogger.com) Here is an article on the drop of assets within the hedge fund industry. While all of these reports are simply guesses based on limited information I agree with Kusano below that redemptions will probably continue for 6 months. What will be more interesting though is how much of those assets will jump right back into different hedge funds once the market levels out or turns. There is little evidence that hedge funds will not simply regain all of these assets plus more within the next 3-4 years. Here is the article exceprt:

The global hedge-fund industry lost $100 billion of assets in October, according to an estimate from Eurekahedge Pte, as firms including Sparx Group Co. were hammered by investor withdrawals.

Clients took about $60 billion out of funds, Singapore-based Eurekahedge said in a statement. Funds fell 3.3 percent on average, based on preliminary figures from the Singapore-based data provider, as measured by the Eurekahedge Hedge Fund Index, which tracks the performance of more than 2,000 funds that invest globally. That compares with a 19 percent slide in the MSCI World Index last month.

The biggest market losses since the Great Depression and investor withdrawals hurt the $1.7 trillion hedge-fund industry that manages largely unregulated pools of capital. The index of global funds has lost 11 percent this year, set for the worst performance since 2000 when Eurekahedge began tracking the data.

“This wave of redemptions in the hedge-fund industry is going to last for at least another six months,” said Toyomi Kusano, president of Kusano Global Frontier, a hedge-fund research firm in Tokyo. “There are some funds that halted withdrawals, but those funds would eventually have to defreeze, and that means another wave of redemptions.” Source

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Financial Crisis of 2008

Financial Crisis & Hedge Fund Performance

(http://HedgeFundBlogger.coM) Interesting article below looking at recent hedge fund performance vs. the S & P 500. Many hedge funds may have been dragged down farther than they would ever have liked, but I still believe when the market does correct hedge funds will be in place to outperform everyone else in the market once again. The biggest worry I have heard lately is that it may take 4-6 years for the market to to turn again.

Hedge funds as measured by both the Greenwich Global Hedge Fund Index (“GGHFI”) and the Greenwich Composite Investable Index (“GI2″) declined marginally when compared with global equity returns during the month of October.

The GGHFI and GI2 posted declines of -5.06% and -8.53% on the month compared to global equity returns in the S&P 500 Total Return (-16.79%), MSCI World Equity (-19.05%), and FTSE 100 (-10.71%) equity indices. Year-to-date, the GGHFI and the GI2 have shed -14.29% and -16.60%, while the S&P 500 Total Return, MSCI World Equity, and FTSE 100 Indices have lost -32.84%, -39.75%, and -32.21%, correspondingly. 36% of constituent funds in the GGHFI ended the month with gains.

“October’s returns are the result of similar market conditions that impacted hedge funds in September. Although long/short equity funds were notably lower, other event driven and arbitrage funds that trade in more illiquid securities were also negatively affected due to redemptions and forced selling. ” notes Margaret Gilbert, Managing Director.
Long/Short Equity managers experienced roughly half the losses of global equity markets during October, losing -7.88% on average. Source

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Improvement

HedgeFundBlogger.com Improvement

If you have a minute I would like to collect additional feedback from visitors of HedgeFundBlogger.com to understand:

1. Why you visit HedgeFundBlogger.com
2. What do you wish was here or somewhere online which you can never find?

Please leave your answers below within the comment form. Thank you in advance for the feedback.

DJ Hedge Fund Indexes

Dow Jones Hedge Fund Indexes

(http://HedgeFundBlogger.com) I thought this article on how Dow Jones was suspending the publication of over 1/3rd of their hedge fund strategy index benchmarks was interesting. I have never heard of this occurring before and I’m not sure this helps build faith in their product going forward. Here is the article excerpt:

Dow Jones Hedge Fund Indexes Inc. said Monday [Nov. 3] that it had temporarily halted daily publication of one-third of its hedge fund strategy benchmarks as the investment manager of the managed account platform worked to “reduce the risk profile of some of its underlying hedge fund managers.”

Effective Oct. 31, daily publication of the long/short equity and equity market neutral strategy benchmarks was suspended. Publication of the Dow Jones Hedge Fund Balanced Portfolio Indexes was also suspended, according to the company.

Dow Jones Hedge Fund Indexes referred questions about the investment manager’s action to the manager, which it did not name. The manager did not immediately respond to an inquiry passed along by Dow Jones Indexes/STOXX press office.

The long/short equity and equity market neutral indexes are among six strategy benchmarks tracked by Dow Jones Hedge Fund Indexes. The other strategies are convertible arbitrage, distressed securities , event driven and merger arbitrage. Daily publication of those strategy benchmarks will continue, according to Dow Jones Indexes. Read more…

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UK banks, led the FTSE100 higher but ended mixed (FTSE350 banks down 1.3%, which is really just camera shake, even HSBC down 2%, but Barclays down 13% is serious! It may be because of its intention to tap Government funds though moderated by offering existing investors the chance to take preference shares or other instruments beforehand. HBOS led the FTSE100 risers again by a long way, up 31% to reach the Lloyd TSB offer price, while RBS added 5.8% and Lloyds TSB up 1%.

The drop in the FTSE’s afternoon session coincided with the expiration of a U.S. SEC’s ban on short selling in more than 950 financial stocks.It seems to me the ban should have been extended. LIBOR rates fell with the base rate cut. There is a possibility that the Fed will do more to force banks to start lending to one another across the Atlantic. This was not the best result for the UK so-called bail-out plan. One bit of good news is that oil is now 40% below its July peak!
The newspaper posters and banners are screaming “Darling’s £260bn Bail-out!”, “£500bn World’s Biggest Gamble Ever!”, “New World Order!” and the revolutionary Economist magazine’s September cover, “OH FUCK!”. The FT today has calculated the figure to be £400bn with headlines, “Banks thrown £400bn lifeline!”, “The great British bail-out” and “There can be no return to business as usual!” At a face the press yesterday, our Scottish First Minister, Alex Salmon, began by saying not many people know that the Chinese “May you live in interesting times!” is actually a curse! We got that one.

The New World Order is a gathering recognition that the boot is on Asia’s foot. Martin Wolf titles his full page essay on the subject “Asia’s revenge” seeing that the credit crunch infects one half of the world economy but not the other half. Actually, both halves are interdependent and complicit in this problem. For years economists like Wynne Godley, Francis Cripps and Alex Izurieta have accurately predicted the current crisis seeing its origins in the extreme imbalance that grew in world trade (+ FDI flows) whereby credit boom high deficit economies had to package and sell financial assets to the trade surplus countries in order to maintain their GDP growth. This was not without massive benefits for credit boom economies (high employment and low inflation) and for emerging economies (double-digit growth despite high inflation). So what is this New World Order apart from cynical and deriseful loss of confidence in banks and in neo-liberal “small government is beautiful” ideology?

Already, we see a massive 180-degree turnabout in the world trade trends. China and Japan have no external growth impulse from exports (exports have stopped growing) while the USA is now increasingly reliant on export-growth while imports slump. So far so good, except all economies are now slowing down and Japan, USA, UK, Ireland, Italy, others are either officially in recession or probably in recession or close to it (at least two quarters of negative growth in profits and earned income and/or measured as falling general spending.) But is this ‘new’? The world’s stock markets have all been falling this week on recession fears more than fears for the banking sectors’ problems. That we’ve come through recessions before is not a salve to those fearing this time will be deeper and longer than any time since the 1930s and maybe even worse than that!

Property and financial assets worth somewhere between $10 and $20 trillions (maybe one third ratio to annual global income) have evaporated. It appears to be like a spreading global epidemic, like necrotizing fasciitis caused by a financial streptococcus pyogenes (flesh-eating bacteria). Are there more such fasciitis to come?

The above graphic shows states of the USA named after those countries in the rest of the world with the same GDP values.

The present global financial crisis began modestly with property boils bursting in parts of the USA like parts of California, Florida, Nevada and Ohio, which infected banks’ mortgage-books worth a third of banking assets. Credit defaults like bacteria spores took a year to double and triple to about 6-8% in aggregate. Capital flight followed into government paper, cash deposits, equities, Europe, commodities (oil, food, gold etc.) and Emerging Markets until the last three in turn also began deflating as Europe’s finance sector crashed and global recession fears did for the rest. Somewhat hidden under residential property price falls in the US, parts of Europe and elsewhere has been the predictably faster fall in commercial property. Next, as consumer spending falters and private savings rise, will be falls in corporate profits and defaults in corporate debt that will match and then exceed defaults on household debts. Banks can roll-over some of these for fear of triggering a domino effect. Small business closures will rise by half to over 10% of all firms, employing about 2% of workforces, but new firm creation will fall dramatically and unemployment will rise by about 5% of the total workforce. Large employers may fire another 2-5% of the workforce depending on how prolonged any recession appears to be? Unemployment figures will lag the underlying reality by 6 months or so, just as actual GDP figures may take a year to catch up with ‘the actuality’.

But the sequence is a ripple effect. Recession impulses spreading out from the USA and the USA investor dominance (25% or more, usually much more) of all global markets with ebbs and flows of the tides of US dollars means that after US (Anglo-Saxon countries’) credit and economic cycles there are later peaks and troughs for Europe, then Asia and rest of the world, by which time USA et al. have recovered – and we can see early signs of recovery in the rising dollar, falling oil and large increases planned for 2009 budget deficits.

The remaining fear is that the banking sector will not be fit to resume normal service for some years. This risk was long recognised and discussed by bank regulators and a central aspect of Basel II Pillar II whereby banks should become far more cyclically aware but not (it was warned again and again) to the extent of acting severely pro-cyclically otherwise all the responsibility would rest with governments to refloat beached economies! Governments know this and were most anxious to intervene early and often to jump-start banks’ transmission mechanisms before hurricane Recession would land-fall. They failed, why? There were several institutional impossible obstacles, very broadly stated: 1. banks failing to act collectively to save themselves (continuing to jockey individually for commercial advantage); 2. political hesitancy and disbelief that missed psychological moments to restore confidence in the markets; 3. trusting belief in self-righting buoyancy of capitalist markets to automatically rediscover fundamental values and bounce back. Nothing controversial or unexpected about anyu of that, surely?

It is equally easy to describe the circumstances of boom to bust as banks and businesses sweating their assets to the maximum (a business virtue) and everyone else sweating their incomes to the maximum (and beyond) to invest in expensive assets (in a seller’s market) that should become more expensive and did so for years much faster than employment earnings rose. When the boils are lanced or bubbles burst, those most highly leveraged are the first to become technically insolvent. Cash was the joker only so long as property was King.

The only sectors that cannot become technically insolvent, indeed the only truly fundamental values (in market confidence terms) are Governments (especially OECD governments) and the top 5% of households and half of major corporations that remain solvent even when all or most major asset classes have fallen in market price. Of these, only Governments are motivated and big enough to act counter-cyclically to restore general economic growth. There was a vague hope developing for years that if prudential rulebooks are successfully imposed on all banks they could and would become partners with governments in refinancing economies out of the inevitable holes they will find themselves in periodically? This private-partnership was most apparent when banks extended mortgage lending to low-income households thereby saving government the cost of building new public housing. Indeed, in the UK alone for over 20 years, at the rate that new social housing was built or replaced by direct government spending, most social housing would have to survive as long as Stone Henge! But, as the insightful reader will have noticed this brings us full-circle: was it not mortgages for the ‘sub-prime’ poor (a policy measure that appeared practical, neo-liberal, and new socialist) that started the present sorry mess?

Guest post by Banking on Economics

HedgeFundBlogger.com

HedgeFundBlogger.com | Kaizen

First off thank you for the support from everything, the emails, story submissions, linked resources and offers of help are appreciated. We hope to continue to build out our unique hedge fund tools, tracking services, marketing resources and career tips each week over the next few years. We will publish a hedge fund horse races post sometime in the next week showing how much traffic our site gets compared to others in the industry.

We are making several changes to HedgeFundBlogger.com. Once thing that many visitors have asked for in the past are comment forms available below posts such as this. We have tried this in the past and have received too many spam submissions. We are now trying it out again with a new spam filter.

Please feel free to post comments on any of the articles you now read on the site and we will do our best to publish anything value-adding to the conversation. Your own opinion, insight and resources are all encouraged.

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Hedge Fund Fight Night

Hedge Fund Fight Night | Charity Fundraiser

(http://HedgeFundBlogger.com) I had to read this headline twice before I believed it:

At 5-foot-4 and 48 years, Nissim “The Miracle” Tse is the shortest and oldest of 34 boxers signed up for this year’s Hong Kong Hedge Fund Fight Nite.

Calling himself “a financial warrior,” Tse likens boxing to his daytime job as a co-founder and head of trading for Hong Kong-based Pi Investment Management Ltd., a unit of London hedge fund manager RAB Capital Plc.

“It’s mental, it’s physical, it’s crazy, it’s stressful,” Tse said in an interview. “But it all happens very quickly, just like you are managing a hedge fund.”

The annual charity fight tonight, in its second year, takes place amid the most severe financial crisis since the 1930s and with the hedge fund industry bracing for its biggest annual loss since Hedge Fund Research Inc. started to keep data in 1990. The fight night aims to raise HK$1 million ($129,000) to repair children’s facial deformities and combat crime and juvenile delinquency in low-income and immigrant communities. The event beat the same target last year.

The world’s largest banks and securities firms have been saddled with more than $670 billion of losses and writedowns, with the crisis costing more than 149,000 financial industry jobs globally, according to data compiled by Bloomberg.

“This is the worst bear market I hope I will see in a lifetime,” added Tse, a 20-year hedge fund veteran who practices karate and plays golf and tennis.

All the more reason for a diversion, according to the fighters.

Graham “The Real Deal” McNeill, a 35-year-old partner at EC Harris LLP, said “therapeutic” lunchtime sessions were a release. “You completely forget about the rigors of the morning and focus on not getting your head knocked off,” he said. Read more…

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Prime Brokers & Hedge Funds

Prime Brokerage Firms Pressuring Managers

Adding to the challenges of trying to improve the performance of their funds hedge fund managers are now facing additional pressure from their prime brokers. While some funds will simply end up paying more or having to sell off some assets to meet capital requirements others will simply shop around more…further increasing the rate at which hedge funds change primary prime brokers or multi-prime with an assortment of prime brokerage firms at one time. Here is a short article on this topic:

The survival of a raft of hedge funds is being threatened by fresh pressure to stump up more collateral for trades made in a range of illiquid assets. So-called prime brokers, who provide a range of services to hedge funds, are imposing tougher conditions on their clients and charging more for financing following the collapse of Lehman Brothers in mid-September, raising fears that more funds face collapse.

The more conservative terms mean that a hedge fund would have to put up extra collateral against financing if markets fall further or sell down its holdings. The problem for many hedge funds is that they have already sold down their more liquid investments and are grappling with a wave of redemptions from their own investors. Further collateral requests or higher financing costs may push many hedge funds over the edge.

One hedge fund manager said: “Funding is being withdrawn by prime brokers and funding rates have risen sharply in the past week or two. A tough environment is just getting tougher.”

Industry managers are concerned that renewed market turmoil, leading to weaker performance and client redemptions, could lead to a vicious circle of selling by hedge funds.

One prime broker said the situation was “on a knife edge”. “Everyone needs to keep their nerve,” he added.

He also said that prime brokers were particularly targeting funds that specialised in emerging markets, both in equities and fixed income, as well as in credit and convertible bonds – instruments that can -convert into ordinary shares. Source

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Prime Brokers & Hedge Funds

Prime Brokerage Firms Pressuring Managers

Adding to the challenges of trying to improve the performance of their funds hedge fund managers are now facing additional pressure from their prime brokers. While some funds will simply end up paying more or having to sell off some assets to meet capital requirements others will simply shop around more…further increasing the rate at which hedge funds change primary prime brokers or multi-prime with an assortment of prime brokerage firms at one time.

The survival of a raft of hedge funds is being threatened by fresh pressure to stump up more collateral for trades made in a range of illiquid assets. So-called prime brokers, who provide a range of services to hedge funds, are imposing tougher conditions on their clients and charging more for financing following the collapse of Lehman Brothers in mid-September, raising fears that more funds face collapse.

The more conservative terms mean that a hedge fund would have to put up extra collateral against financing if markets fall further or sell down its holdings. The problem for many hedge funds is that they have already sold down their more liquid investments and are grappling with a wave of redemptions from their own investors. Further collateral requests or higher financing costs may push many hedge funds over the edge.

One hedge fund manager said: “Funding is being withdrawn by prime brokers and funding rates have risen sharply in the past week or two. A tough environment is just getting tougher.”

Industry managers are concerned that renewed market turmoil, leading to weaker performance and client redemptions, could lead to a vicious circle of selling by hedge funds.

One prime broker said the situation was “on a knife edge”. “Everyone needs to keep their nerve,” he added.

He also said that prime brokers were particularly targeting funds that specialised in emerging markets, both in equities and fixed income, as well as in credit and convertible bonds – instruments that can -convert into ordinary shares. Source

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Tags: Prime Brokerage Lending, Prime Brokerage Security Lending, Capital Financing by Prime Brokers, Prime Brokers in New York and Hedge Funds, Hedge Fund, hedge funds, stock market

Trading Algorithms

Colbert on Software Trading Algorithms

Quick Link: Hedge Fund Video Library

Here is a short video from Colbert on automated trading programs and their role in the recent financial crisis.

If you are viewing this post through my daily hedge fund newsletter please click here to watch the video now.

Hat tip to Barry Ritholtz for first posting this video on his site first.

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Index Performance

Hedge Fund Index Performance

(http://hedgefundblogger.com) Pasted below is a recent hedge fund index performance chart showing which strategies are hurting most during this crisis:

The Credit Suisse/Tremont Hedge Fund Index was down 6.55% in September, according to Oliver Schupp, President of Credit Suisse Index Co., Inc.

Mr. Schupp said, “September was a difficult month for hedge funds across strategies, and the Credit Suisse/Tremont Hedge Fund Index will finish down 6.55% for the month.” Mr. Schupp went on to say “Convertible Arbitrage was the worst performing sector, finishing down 12.26%, while Managed Futures was down only slightly for the month, losing 0.57%. Managed Futures continues to be the best performing sector, and is currently up 6.70% year to date.”

Performance for the Credit Suisse/Tremont Hedge Fund Index and its ten sub-strategies is calculated monthly. September, August and 2008 year-to-date returns for all categories are listed below and are available at HedgeIndex.com.

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There was an article out today in the FT about low stock market trading volume. I have heard this directly from prime brokerage firms, I’ve also heard that managers are holding more cash than usual, taking more cautious trading positions than usual. The exception to this seem to be those few funds which thrive during this type of market volatility, but as the index figures which published this morning show – most funds are working within negative territory for 2008. Here is the story:

Some of the steepest sell-offs and gains witnessed in an especially volatile few weeks for Wall Street could have been exacerbated by relatively low trading volumes as frightened hedge funds sat on the sidelines.

This decoupling of volume and volatility in equity markets is just another example of the reluctance of traders to speculate against a backdrop of uncertainty over the global banking system and economy, say analysts.On October 15, for example, when the S&P 500, Wall Street’s benchmark equity index, dropped 9.9 per cent, its largest one-day drop in more than 60 years, volume was only 11.5bn shares. This was the third lowest volume day that month, with only October 1 and 2, when the ban on short-selling financials was still in effect, having lower trading levels. Indeed volume was only 58 per cent of the record reported on October 10 when the S&P 500 fell just 1.2 per cent. Source

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Low Trading Volume

Low Stock Market Trading Volume

There was an article out today in the FT about low stock market trading volume. I have heard this directly from prime brokerage firms, I’ve also heard that managers are holding more cash than usual, taking more cautious trading positions than usual. The exception to this seem to be those few funds which thrive during this type of market volatility, but as the index figures which published this morning show – most funds are working within negative territory for 2008. Here is the story:

Some of the steepest sell-offs and gains witnessed in an especially volatile few weeks for Wall Street could have been exacerbated by relatively low trading volumes as frightened hedge funds sat on the sidelines.

This decoupling of volume and volatility in equity markets is just another example of the reluctance of traders to speculate against a backdrop of uncertainty over the global banking system and economy, say analysts.On October 15, for example, when the S&P 500, Wall Street’s benchmark equity index, dropped 9.9 per cent, its largest one-day drop in more than 60 years, volume was only 11.5bn shares. This was the third lowest volume day that month, with only October 1 and 2, when the ban on short-selling financials was still in effect, having lower trading levels. Indeed volume was only 58 per cent of the record reported on October 10 when the S&P 500 fell just 1.2 per cent. Source

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Australian Short Selling

Australia Drafts Short Selling Regulation

The Australian Treasury are seeking comments on their short selling exposure draft. The current legislation around short selling is complex and unclear and the absence of reporting covered short selling has heightened uncertainty about its real impact and contributed to a 30 day temporary ban being imposed on 21 September 2008.

I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.

I am concerned that para 14 says “The Bill will replace ASIC’s interim reporting requirements for covered short sales …” If the temporary ban on short selling remains in place until the Bill becomes an Act, then the Australian financial system will be seriously impacted in the meantime.

Notwithstanding these high level comments, the draft is well balanced and shows a good understanding of the issues. I note para 16 in particular which says that “The Government is not seeking to prohibit or discourage covered short selling activity.” That’s good.

The draft distinguishes between naked and covered short sales. This distinction is relevant in relation to the current interpretation of the reporting requirement for short sales. Beyond that, a short sale is a short sale and the economic impact of being naked or covered is not relevant. This is a red herring in the argument.

Para 16 uses stock lending activity to estimate an upper limit of short selling in Australian listed securities of 4%. It notes that stock lending can be used for other purposes than short selling. However, there is no discussion of the likelihood that stock lending transactions may pass through many hands (it is a deep and liquid market) before it finally reaches a short seller. I have no evidence to support this, but typically a fund manager will ask their prime broker for stock availability. The prime broker may draw the stock from their own/their client’s inventory or go to the market to borrow the stock for the manager. To the extent this occurs, stock lending activity will further overestimate short selling.

Para 22 argues that the absence of transparency in short selling may adversely impact investor confidence and market integrity, increasing the cost of capital and reducing investment activity. I would argue that the absence of short selling brought about by the temporary ban will also have this impact.

Para 23 discusses objectives. The first two points are side benefits to investors, but are inappropriate as objectives for any legislation. Providing information that is hard earned by one set of participants freely to others is unfair and unbalanced. In the case of the first point, “to provide a signal that individual securities may be overvalued”, assumes that short sellers are better judges of share value than other investors ie those holding the investments long. This is not necessarily the case. If it is the case, then why should legislation be introduced that makes it easier for poorer judges of value?

The discussion of gross or net reporting of short sales is not relevant. Only net short selling will have an economic impact.

The main weakness of option two (para 26) is that reporting will be made on a trade basis. This implies a significant accounting requirement to follow through the impact of the sale on existing positions and to correct for any trade failures etc. Is the position opening a new short sale, extending an existing, reducing an existing ie a purchase.

It will be more straight forward to report positions and not trades at designated points of time. This information should be published from the source of truth, which is not the trade advice received by the broker. Typically brokers do not carry a record of holdings for their clients and investors may use multiple brokers to achieve a desired position.

I believe the best source of this information is held by the investor or as is generally the case, the investor’s agent, the custodian or sub-custodian. Custodian’s that carry short positions on behalf of clients already capture, settle and report this data daily on a traded and settled basis. Positions will also include off-market transactions for which they act as custodian. There are fewer custodians, than either investors or brokers. This alternative was not mentioned at all in the exposure draft, but is likely to be the preferred route and impose lowest regulatory cost.

Also not mentioned is that Short Interest has been captured in other markets for some time. In the US, Short Interest is published by major exchanges fortnightly eg http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol=MSFT&selected=MSFT shows Microsoft’s Short Interest history. What is the process employed in these markets? Can it be applied in Australia?

Will there be areas of activity not captured by using custodians? Offshore investors will presumably use sub-custodians. Users of direct market access systems will report trades to their custodian for setlement. Broker’s principal positions? Anything else?

Para 34 discusses the problem of different trading desk activity in the same firm. Using the custodian approach, each account will be aggregated across every security. The fact that some houses will have offsetting long positions is not relevant. The fact that one group in the house has borrowed stock (or sold in advance of borrowing stock or settling) as principal or for a client is what is required to be captured, and will be captured using this approach.

Para 34 also discusses whether short sale reporting should be delayed. The concern presently is that the data should be provided frequently and quickly as it is believed to be materially important. However, international experience is that data provided fortnightly serves the market well. In fact, there is little movement from one fortnight to the next. But where there is a commercial advantage for short sellers in those markets, I believe it is sufficiently preserved with this level of periodic reporting.

In summary, the use of brokers to collect short sale trade information at the point of the trade is not the most effective way of achieving the desired outcome. Periodic position reporting by custodians, and investors that do not have custodians, is likely to provide adequate transparency of short selling in Australian securities.

Guest post by Rick Steele

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HF Quote of the Year

“Kill The Bad Funds & Regulate the Rest”

Interesting post over at the FT – discussing the regulations of hedge funds within both the UK and US. Hedge Funds are taking much of the blame for recent market activity and new regulations will probably continue to roll out over the next 18 months. My take – there will be more regulation but far more on banks than hedge funds. I believe hedge funds will come out of this crises stronger than ever as more easily defined banks are tied to ever tightening capital requirements and oversight. Here is an excerpt from the article mentioned above:

______________________

“…kill the bad Hedge Funds + heavily regulate the rest.”

That’s Dick Fuld, recounting the position of the US Treasury towards hedge funds. The phrase comes from an email between Fuld and Lehman’s general counsel, Thomas Russo, made public by congress last Monday.

It’s breathtaking not because it shows just how fixated and narrow-minded Lehman’s management were when it came to blaming all their woes on hedge funds – a fact already well known – but because it seems to show the US Treasury were thinking the same way too.

Little wonder, one supposes, when you think about it.

Paulson is as much the product of a sclerotic, class-ridden and arrogant banking fraternity as Fuld was. The US Treasury – just like Lehman – has spent months holding onto the mantra that the banks are not to blame. Fear and fear alone was causing trouble for the banks, was the parroted line. The whole wrong-headed architecture of the Tarp was prefaced on the same worldview: more liquidity and more confidence was needed, not more capital. As Felix Salmon at Market Movers writes:

“America’s banks — and the world’s, for that matter — have had de facto unlimited access to very cheap Fed liquidity for many months now. That hasn’t induced them to lend.“

It has taken Paulson two long weeks to come around to the idea that the banks need recapitalising. That’s two painful weeks to face up to the fact that actually, the banks’ problems were not mere fictions conjured by the scurrilous iconoclasts of Greenwich, CT, but were real, palpable, and destabilising.

And yet, it seems, the hedge funds are still in the target sights of regulators. Read More…

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Hedge Fund Industry

Hedge Fund Industry | US Economy

Here is a short piece reviewing what has happened to hedge funds within 2008:

They preached to the rich that they had the answers – philosophically-driven investment vehicles for the rich. Some crawled and leaped into emerging markets (high-growth but unstable developing countries), a few financed movies while others created and plied the infamous derivative trade – many packaging subprime mortgages, rating them in tranches and either holding them or selling them as high-yield instruments to institutions like Bear Stearns, AIG and Lehman Bros. A lot of billionaires were born and made in those deals.

Today, even the federal bailout has excluded investing in these funds, as hedge funds are pulling their investments out of emerging markets as fast as they can, tanking the local currencies against a rising dollar and yen. Investors are pulling their money, when they can, out of hedge funds themselves (literally dumping their investments in the already volatile marketplace), and that is a big shoe rapidly slipping off the foot ready to drop. The New York Times today: “Hedge funds lost an estimated $180 billion during the last three months and some are near collapse. Investors are demanding their money back, and Wall Street is bracing for a shake-out in the $1.7 trillion industry.” Source

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