The chain of events unleashed by the Lehman Brothers bankruptcy painfully illustrated the many risks faced by various market participants, including hedge funds and others who act as swap counterparties and prime brokerage customers. Managers of hedge funds and other market participants should consider various risk mitigation practices with respect to their derivatives transactions and prime brokerage relationships.

In part one of this two-part series, we focus on the risk mitigation practices relevant to prime brokerage arrangements.

  1. Diversity of prime brokers. Diversification of prime brokerage accounts across different prime brokers and jurisdictions may reap a number of benefits.
  • The effect of a failure of any given prime broker will be less severe
  • Managers will be less susceptible to changes in margin requirements by any given prime broker
  • For managers that are dependent on securities lending, multiple prime brokers potentially means additional sources of financing and better pricing terms
  • Managers may benefit from multiple reminders about exercising their shareholder rights if the underlying securities are held at multiple prime brokers
  • Splitting securities holdings across multiple prime brokers ensures that no prime broker can view any given manager’s entire portfolio, which may give comfort when working with a prime broker firm that also conducts proprietary trading

Increasing this diversity of prime brokers, however, also increases operational risk. Managers should therefore weigh the desirability of this diversity against the increases in complexity and practical challenges of aggregating risk and position data across multiple prime brokers.

  1. Set-off rights and netting. Managers should assess whether their prime brokerage agreements allow them to set off losses against amounts owed to their counterparties and their counterparties’ respective affiliates as a result of separate transactions, keeping in mind that the enforceability of set-off rights varies by jurisdiction.
  1. Termination and default provisions. Managers should have a clear understanding of their rights around a termination of their contractual arrangements with prime brokers.

  1. Identity of counterparty and restrictions on its ability to transfer assets and cross defaults.Managers should make sure that they know the identity of the legal entity with which they have contracted, and/or which custodies their assets, keeping in mind that the regulatory protections afforded to their agreements with U.S. prime brokers do not generally apply to non-U.S. affiliates of such prime brokers or to assets held outside the U.S.

    One potential approach to consider is to seek to prohibit prime brokers from transferring or granting liens over a manager’s assets to their affiliated entities. If that is not feasible, managers should consider structuring their agreements with a prime broker and its affiliated entities so that a default by one entity for one transaction results in the termination and unwinding of all contracts between the manager and such entities.

  1. Third-party custodians. Where feasible, managers may consider using a third-party custodian or a bank custodian or bankruptcy remote vehicle affiliated with the prime broker. This arrangement, however, generally leads to higher fees and can present operational challenges, particularly with higher-volume trading strategies.
  1. Daily segregation report. If use of a third-party custodian is not feasible or desirable, managers should consider requesting that the prime broker deliver daily segregation reports, thereby ensuring that they are aware of those assets that are subject to rehypothecation.
  1. Excess SIPC coverage. Most customers of U.S. brokers holding assets in the U.S. are protected by the Securities Investor Protection Act of 1970, as amended, which established the Securities Investor Protection Corporation (SIPC). Subject to certain restrictions, SIPC covers shortfalls in brokerage failures up to $500,000 per customer. Many prime brokers also buy excess SIPC coverage through private insurers. Managers should be aware of any such excess SIPC coverage and consider allocating their assets among prime brokers accordingly.

Of course, different managers will make different determinations regarding the substance of their prime brokerage relationships depending on their appetite for the various risks involved and the nature of their particular business. Moreover, prime brokers may push back on any of these suggested risk mitigation practices and in return could significantly increase margin requirements.

Nonetheless, a manager that understands the options and implications of various negotiated provisions in his prime brokerage arrangements should be in a better position to manage these risks.