“Internationally no cap has been enforced, but most prime brokers are adopting the US cap as somewhat of an industry benchmark. Of course, this level may vary upwards depending on the quality of long assets held – another natural consideration in any financing business – but the industry appears to be settling at these levels. Assuming the portfolio holds liquid, developed market stocks, a 140 per cent cap would generally be applicable,” the broker executive says. Even three years ago, such a cap was not good enough for QIC, according to Troy Rieck.

“Our risk committee met and looked at some of these relationships where we had our assets being rehypothecated to ludicrous levels. That made us uncomfortable. After weighing up the risks and costs, and accepting that it would be more costly to run the underlying vehicles, we decided [a rehypothecation cap] of under 100 per cent of liabilities was a good place to be.” Some stock lending agents have used the Lehman Brothers experience to campaign against their prime broking competitors, arguing that asset owners are, through their hedge fund investments, unwittingly taking on the risk of an investment bank and not even being paid for it, in the way that they are via the fee and collateral re-investment return on a standard securities loan.

Some new Australian 130:30 funds have signed simple securities lending agreements and avoided prime brokerage altogether, with a selling point that their assets are segregated and cannot be lent without their consent [Ausbil Dexia’s late-2009 launch of a 130:30 fund is an example]. “Rehypothecation of long/short managers’ assets is a relic of 20 years ago, when Morgan Stanley and Goldman Sachs started the prime broking industry and really held the whiphand over clients, who at that time literally had nowhere else to go to source borrows,” continues the agent, who also requested anonymity, presumably on the basis he may one day want to work for the aforementioned firms. However Richard Keary, head of the Financial Risk Management hedge fund-of-funds business in Australia, said such comments should be taken in the context of the commercial agenda behind them. “Rehypothecation is not a rort.

It’s what the investment banks use to fund their balance sheets to enable the hedge funds to do what they do,” he said. “The straight 130:30 funds have no reason to use a prime broker, but five years ago you looked too unusual if you didn’t have one, you weren’t going to raise any money. That’s changed now. But the hedge funds who require leverage, and use derivative instruments beyond a simple short position, continue to require prime brokerage, and that involves accepting the prime brokers’ right to hypothecate.”