09/11/2011 Author: Tony Griffiths

The return of counterparty risk

The collapse last week of brokerage firm MF Global, following losses from Eurozone debt exposure, has put the question of counterparty risk back onto the hedge fund agenda, but what has changed since 2008?

Counterparty risk is back. Only it never went away. The collapse last week of US brokerage firm MF Global from Eurozone debt exposure may have been limited in its direct effect on hedge funds – not that clients exposed to an apparent $700m hole in the firm’s accounts will agree – but it has given managers and investors alike one more reason to question their counterparty relationships.

Combined with the deepening Eurozone crisis, the demise of MF Global has ratcheted the fear level ever closer to the 2008 benchmark. Rumour and suspicion, it seems, are back on the table – and are once again driving counterparty decisions.  

US investment banks Morgan Stanley and Jefferies have both found themselves the subject of rumours that larger-than-expected exposure to European debt had prompted an exodus of prime brokerage clients in recent weeks. Both were quick to play down such stories – a Jefferies spokesperson told CNN Money last week that there had been “insignificant” change at its prime brokerage business – but not before share prices took a tumble.

Whatever the source, there certainly appears to be increased movement of prime brokerage accounts. With tier 1 capital at a higher-than-average 13.9% and exposure to the PIIGS countries of just €75m ($102.8m), Stockholm’s SEB is one such prime to have benefitted. “We have seen business lately due to increased uncertainty regarding counterparty risk on PBs,” Atilla Olesen, head of the bank’s London-based prime brokerage operations, told HFMWeek.

Industry sources have told HFMWeek that Deutsche Bank, HSBC and Bank of New York Mellon have also seen fresh business as a result of concerns about other primes.

The prime brokerage agreement doesn’t actually offer protection in the manner some expect, said one industry source who preferred to remain anonymous. “Getting a prime to prove that they’re actually doing what they said they would – and ensuring that they tell you if and when it changes – is not a given. It’s an important part of the agreement these days – you can’t rely on it as it is.”  

One thing mangers are doing is starting to include a lot of “amber” provisions, they add. For example, if a broker’s CDS spread rises above a certain level, a fund’s unencumbered assets are moved to a separate account.

“The so-called custody model with full segregation of clients assets is definitely getting a lot of attention again,” says Olesen. “We have been operating with this business model since we launched our prime brokerage service more than 15 years ago and received a lot of interest after Lehman. We are seeing this happening again.”

“The issue has come more to the fore in the past few weeks for managers,” the unnamed source continues. “But, it’s remained a central issue for investors since 2008 – it’s not let off. Investors have long been looking at the detail of all these new prime brokerage models. It’s the managers that don’t seem to understand the differences and resultant risk.”  

He’s not the only one that sees room for improvement. Matthew Reinhard, a partner at international law firm Miller & Chevalier, has been working with managers on the US Foreign Corrupt Practices Act and UK Bribery Act. He believes hedge funds still  have “a bit of a blind spot” when it comes to due diligence on business partners and agents.  

According to Phil Chapple, director at London-based investment consultants KB Associates, investors are looking through the prime brokers and into where the assets are actually held. “They want to see not only who is the custodian but also the sub-custodian,” he says. “Investors are interested in whose name the assets are held in at each stage and in what type of account.”

With a week between the announcement of MF Global’s shock losses and the firm filing for bankruptcy, as well as a widening of CDS spreads, “there’s a general feeling that if you got caught in there then shame on you,” said one source. In terms of the wider hedge fund industry then, the demise of MF Global is most significant as a reminder, if not a warning.

“The change in the custody-prime models has been driven by investors,” Chapple notes. “The investor mantra these days is ‘the risk has to be in the strategy, not the infrastructure’. Such failings are now considered unforgivable.”