HSBC Lures Hedge Fund Clients Away From Prime Brokers

Date: Thursday, April 10, 2008
Author: Bei Hu, Bloomberg.com

April 10 (Bloomberg) -- HSBC Holdings Plc, Europe's biggest bank by market value, is attracting hedge fund business because of concerns that prime brokers are under threat from the credit market collapse, said Tim Howell, the bank's global head of securities services.

HSBC is in talks with hedge funds with more than $100 billion in assets, and is aiming to provide some services offered by prime brokers to its single-strategy hedge fund clients, such as foreign exchange and treasury products, in addition to traditional administration and custody functions, Howell said.

``Over the last three months, funds moving away from prime brokerage have been the most significant source of the pipeline we have,'' said London-based Howell in an interview April 8. ``In the current economic climate, a lot of funds say they ascribe very high value to the creditworthiness of the person looking after their assets.''

Hedge funds have been moving cash and securities holdings not used for collateral away from prime brokers to custodian accounts elsewhere after banks globally chalked up more than $232 billion of asset writedowns and credit losses linked to U.S. mortgages, and Bear Stearns Cos. collapsed.

Value Partners Group Ltd., Asia's second-biggest hedge fund manager which oversees about $6.5 billion, recently transferred cash not used for collateral from its prime broker account to a custodian bank account, said Mark Dickens, its chief risk officer, without naming the bank. The Hong Kong-based firm plans to do the same with its securities holdings not pledged for borrowings, said Dickens.

Low Probability, High Impact

``It's what they call a very low-probability, high-impact risk,'' said Dickens. Should the financial turmoil continue for a long time, ``prime brokers would have to think hard about their business model and probably renegotiate the fee structure.''

U.S. and European funds with several billions of dollars under management have led the wave, said HSBC's Howell. HSBC provided administration and custody services, such as portfolio valuation, and investor and support services for $397 billion of hedge fund assets at the end of last year, he added.

Prime brokers provide a range of services to hedge funds including clearing, asset custody, securities lending, financing, and introducing investors. Morgan Stanley and Goldman Sachs Group Inc. have been the leaders in the industry, with other financial institutions, including Merrill Lynch & Co., UBS AG and Lehman Brothers Holdings Inc. trying to expand market share.

Bear Stearns

The biggest part of prime brokers' revenue comes from hedge fund client loans, deposits, lending securities for short sales, and synthetic financing products such as swaps. Cash and securities that hedge funds leave with prime brokers are used to help generate such revenue.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from speculation on whether the price of assets will rise or fall. Their assets reached $1.9 trillion at the end of last year, according to Chicago-based Hedge Fund Research Inc.

Bear Stearns, among the top three providers of prime brokerage services, was brought to the brink of bankruptcy following a run by clients and creditors last month. JPMorgan Chase & Co. agreed to buy it for a fraction of its market value.

Broker Failures

In case of broker failures, client assets pledged as security against borrowings go into a general creditors' pool. Assets not used as collateral should be registered under the fund's name by the prime broker, however that sometimes doesn't happen, said Paul Smith, chief executive officer of Hong Kong- based Triple A Partners, which provides seed capital to new hedge funds and buys stakes in their managers.

Smith said he has instructed two start-ups his firm invested in to make sure securities not used as collateral are registered in the funds' names with prime brokers. He urged the funds to invest cash in treasury bills or spread them among two or three banks, he said.

Duncan Smith, a Hong Kong-based partner at international law firm Ogier, said some funds have had their assets frozen for months after broker failures.

``In this environment, people don't want to take undue counterparty risk with their prime brokers,'' he said.

Hedge funds have also been hiring multiple prime brokers to reduce risk. Merrill Lynch boosted its hedge fund clientele by 50 percent in a year and is targeting multi-strategy funds seeking to do business with more than one prime broker, managing director Jeff Penney said in an interview last month.

The risk of prime broker collapse has abated with the U.S. Federal Reserves showing willingness to effectively guarantee such institutions, Dickens said.

To contact the reporter on this story: Bei Hu in Hong Kong at bhu5@bloomberg.net.