Hedge funds are evaluating their banking relationships after a fire sale of assets by family office Archegos Capital Management forced billions of dollars of losses on Credit Suisse and Nomura.
Executives are weighing up whether to switch lenders they use as their prime brokers — banks that offer a range of services including stock lending, leverage and trade execution.
The head of one London-based hedge fund said the firm had “initiated an internal process” to evaluate its prime broking relationships in the wake of the Archegos debacle.
The top concern was reputation, particularly whether their clients believed they were “associated with the bad people” in the sector, the person said.
Another London-based fund said that, in the wake of the scandal, it had been receiving questions from investors about which banks it was exposed to.
“I’d not be very comfortable if we had balances” at one of the banks caught up in the scandal, said the head of a large Europe-based hedge fund firm.
The situation evokes memories of the financial crisis in 2008, when the risk that a banking counterparty could run into financial difficulty led managers to pull their balances from some banks, in some cases exacerbating the problem.
“Anyone who lived through 2008 is going to be checking their prime brokerage exposure,” said Cutler Cook, managing partner at investment firm Clay Point Investors.
Unlike the financial crisis, there are no suggestions that the Archegos fallout will cause a bank to go under. But hedge funds are nevertheless jittery about the potential danger and reputational damage of having such a close-knit relationship with a bank perceived as less competent, particularly in its risk management. Many of them are baffled as to how the blow-up of a little-known family office could have led to billions of dollars of losses for lenders.
Some managers also fear that the losses could lead some banks to give funds less leeway in future in the time they allow to settle margin calls, or even lead them to scale back their prime brokerage businesses.
For the banks, the Archegos debacle raises awkward questions about how much leverage they can extend to individual funds and how they monitor that risk.
It also highlights the limited visibility that individual banks have of a fund’s overall market exposures. Archegos had built up similar positions with different banks, adding to pressure when lenders tried to offload assets at the same time to meet margin calls.
Archegos also used swaps to build positions, which gave it exemptions from disclosure requirements and further complicated banks’ visibility on its holdings.
“Prime brokerage looks a lot riskier today than two weeks ago,” said Andrew Beer, managing member at fund firm Dynamic Beta Investments, who added he expected banks to cull riskier clients.
“Every bank risk manager will be in the hot seat to prove that outstanding lines and swaps to hedge funds and family offices are prudent and sufficiently collateralised.”
While the full impact of the scandal is yet to be fully quantified, Credit Suisse faces an estimated loss of between $3bn and $4bn, while Nomura has said its estimated claim against Archegos is about $2bn, which could wipe out its second-half profits. Rating agencies have also raised questions about risk management and controls.
One senior prime broking executive described the debacle as “the wrong type of fund in the wrong product”, adding that Archegos’s purchases should have been funded by a margin loan between several banks, not through prime brokerage.
Another prime broker said total exposure was less of an issue for a bank than having the correct risk models in place. “The heads of [Credit Suisse and Nomura’s] PB divisions will be asking did we not have the right risk systems, whether they mischaracterised the securities, liquidity, volatility, etc, when they allowed these trades,” the person said.
Credit Suisse has a margin team that sends daily reports to prime brokerage clients, highlighting the bank’s exposure to the fund and how the bank values the fund’s different types of collateral, said a person familiar with the process.
Industry insiders say that the practice of keeping a fund’s collateral at a third party custody bank, which many funds do, makes it very difficult for a fund to pledge the same assets to multiple banks. That means there is less chance of a fight between banks over who has control of the assets in the event of a fund blow-up.
However, different levels of risk controls at some private banks or wealth managers, some of whom can allow a wealthy client or family office simply to show a statement of their assets, could lead to a risk of collateral being pledged multiple times.
Additional reporting by Tabby Kinder in Hong Kong