The head of investment operations at Colonial First State [CFS], John Paull, admitted that like most hedge fund investors, there had been a “large counterparty risk” inherent in CFS’s relationship with its prime broker, Citi Prime Finance, before the bankruptcy of Lehman Brothers in September 2008. Unlike assets held with its custodian [also Citi], the assets held with the prime broker were not allocated to individual underlying investors, but were pooled and subject to “rehypothecation” – the on-lending of stocks by the prime broker, the profits from which allow it to facilitate clients’ leverage.
Before the global financial crisis, investors had been willing to tolerate the lack of transparency and control over assets held with their prime broker, however that all changed when Lehmans went under. International hedge funds and investment managers which had received margin financing from Lehman Brothers outside the US could not withdraw their collateral when the bank declared bankruptcy, due to the lack of asset protection laws such as the US 15c3 regulations. In turn, investors who had allocated their capital to these hedge funds and investment managers also lost their rights to withdraw these assets, revealing inherent risks “that had not even been thought about by many investors”, according to Troy Rieck, the head of the Queensland Investment Corporation (QIC) Capital Markets boutique. This situation was one of the key contributors to the massive delevering witnessed in the months after the Lehman Brothers collapse.
CFS has since become an early client of what the Citi group has dubbed ‘prime custody’, a joint venture offered by Citi Prime Finance and by Citi Securities and Fund Services. “The joint venture allows clients to move assets between the two entities to ensure bankruptcy protections, physically shift assets from the broker-dealer to the custodian infrastructure for additional security and reconciles their holdings within and across each entity at will,” said Martin Carpenter, a director of Citi Securities and Fund Services. CFS’ Paull said that previously its prime broker had “carte blanche” to rehypothecate its assets, but the new arrangement sets a cap on the level of assets that can be used in this way.
This makes financing positions slightly more expensive and reduces the leverage ratio available to the underlying managers of CFS hedge fund mandates [PM Capital and Acadian included], “but not so their ability to manage money effectively is limited”, Paull said. A vice-president of one of Australia’s largest prime brokers, who spoke on condition of anonymity, said that if clients requested caps, then they should expect that where their collateral is of a lower quality, the blended cost of their financing will increase. He said the level of client assets a prime broker should be permitted to use should be tied directly to the liabilities the client’s fund is running, however in the US there was now a regulatory-imposed cap of 140 per cent of liabilities.