Prime Brokers Finishing With OTC

Hedge funds of varying sizes report being given notice by prime brokers that OTC derivative give up arrangements will end quickly, according to GlobeOp, an independent financial technology firm which provides integrated middle and back-office services.

Funds ranging in size from $25 million to $2.5 billion are being told new derivative trades "done away" will no longer be accepted near the end of the first quarter and that give up relationships will end completely in April.

Give up arrangements - in which the executing broker writes trade tickets on behalf of both counterparties - provided hedge funds with three advantages: easier post-trade operations, cross margining and credit intermediation.

Hans Hufschmid, CEO of GlobeOp Financial Services, comments: "Challenged by investors to provide increasing levels of transparency, independent validation and reporting frequency, funds would also have to find the operational bandwidth and capability to efficiently manage the complexities of OTC trade processing involving multiple instruments, high volumes and multiple counterparties. And the February 28 deadline after which major dealers will not accept novation consents by email looms."

GlobeOp noted that during the Lehman Brothers crisis in September 2008, hedge funds began diversifying counterparty risk by abandoning the practice 

of single prime broker give ups and converting to multiple direct counterparty relationships. Their three-fold objective was: to avoid the risk of assets being trapped by investment bank insolvency, locking the fund out of the market; to have greater strategic control of collateral management; to ensure that no one single bank had too much control over the fund's credit extensions, balance sheet, leverage terms or exposures.

Hufschmid observes: "Intense revenue pressure on banks and on credit risk overall is forcing banks with prime broking activities to take a very tough approach to profitability. Give ups were, for many, never a core business, used to support the profitable business of lending securities to hedge funds. As risk tolerances and the lending business have become less attractive, the reasons for providing low or non- profitable support services like give ups are falling away."

If the initial signals become a trend as financial markets and the hedge fund sector restructure, outsourcing will increase in appeal as hedge funds simultaneously face: increased investor demand for independent administration and robust infrastructure; declining fund performance and management fees to fund or ramp up the required technology and people resources; continued attractive opportunities for strategies involving OTC derivatives.