12/05/2010 Author: Zaki Abushal

Multi-prime's first test

The market's reaction to the Greek debt crisis and concerns about the exposure of some European banks to the contagion will be seen by many as the first real trial of the revised prime broker relationships established by hedge funds in the wake of the Lehman collapse. Did the new system pass the test?

It was a correction waiting to happen. The 15 minutes of madness on the afternoon of 6 May was spectacular. Shares tumbled, heavyweights like Procter & Gamble were reduced to little more than penny shares. The speed of the descent took everybody by surprise. That it happened was less of a shock, in fact for many it was seen as a relief from months of tension and uncertainty in the markets.

With a €750bn ($960bn) bailout announced last weekend, the Eurozone powers have acted to reassure markets and seemingly secured the region’s own fragile currency union. The union between hedge funds and prime brokers has also been tested – with the spectre of fragile banks, and their prime brokerage units, presenting the first post-Lehman trial of the veracity of the oft-heralded multi-prime model.

“Valuable lessons appear to have been learned,” believes Chris Keen, founder of UK fund of hedge funds (FoHF) Culross Global Management, “the funds we deal with have made responsible decisions and made the successful jump to multi-prime pre- and post-Lehman.” Christopher Miller, CEO at hedge fund consultancy business, Investment Quotient, agrees, saying that this time the threat has moved on from counterparty risk to more basic trading worries.
And, at a trading level, the downturn was largely expected by the hedge fund industry. Despite the rumour mill’s claims that large hedge funds had gone under, the truth wasn’t as sensational – losses are expected but the industry at large adopted a fairly balanced view, sceptical of the rally and wary of investor ire when the correction inevitably arrived.

In the days preceding the drop, media chatter was directed toward the spike in Goldman’s credit default swaps (CDS) to levels above that of Citigroup. Off the mainstream business pages, but perhaps no less concerning, was the inverted credit curve on Goldman CDSs on Wednesday 5 May. On 10 May, Goldman’s CDS was quoted at 192bps by Markit, 25bps tighter than the day before, but 100bps wider than the day before the SEC announcements against the bank.

But Goldman definitely wasn’t the only prominent bank with an inverted curve and isn’t the only bank with wider CDSs. The last time this happened, hedge funds reacted en masse; first, to escape any exposure they may have with Lehman  and then to worry about the potential of other big banks going the same way. To put it into context, Morgan Stanley’s CDSs went out to more than 1,000 immediately after Lehman’s collapse, prompting an exodus of hedge funds from its prime brokerage, only to return when market fear subsided.

The reaction of the market was to establish a host of prime broker relationships. Today, the market is relatively comfortable with the idea of the multi-prime model, it offers hedge funds the get-out they need when it comes to counterparty risk issues and ameliorates the effects of risk hitting individual banks and causing isolated panic.
More importantly, investors have bought into the ideal of multi-prime and the notion that counterparty risk is spread. One hedge fund seeding business, known to be particularly hawkish on standards of due diligence, believes the situation has moved on considerably from the post-Lehman rush for the PB exits.

“We are living in different world,” he says. “For investors and hedge funds, probably the most important aspect of the multi-prime arrangement is now knowing that their capital is secured by a custody bank, and that if the bank should go under, 80% of its capital is safe,” he says.

In a perfect world, this custodial safety belt holds true in most instances, but perhaps for some of the smaller managers the truth is not so straightforward.  At the time of Lehman’s collapse, demand for multi-prime was so high, driven hard by investors, that hedge funds scampered to sign agreements to set up accounts with prime brokers.
 
That much is well understood, but for investors, the bigger question isn’t whether the hedge fund has more than one prime broker but whether the ‘other’ prime broker has actually been tested and can deliver if it comes to the crunch. The worry for some investors is that hedge funds have papered over the cracks by paying lip service to the multi-prime model, enabling them to tick the requisite box on the due diligence questionnaire.

This is a minority that shouldn’t detract from the strength of the multi-prime model. The strains of the past few weeks were a test that multi-prime passed with flying colours.