Prime Brokerages Make Hedge Fund Diversification Benefits Superficial

Prime brokerages have had a bit of a rough ride recently. Although they continue to make oodles of money, critics of their transparency and marketing practices have become more vocal (likely because they seem to have a license to print money).

Now the Economist is piling on. In this week’s Buttonwood column, the magazine suggests that concentration in this industry may increase systemic risk in global capital markets. The magazine acknowledges that hedge funds may indeed make for a “more robust financial system” by allowing risk-averse investors such as banks to package and sell off those risks. But it also says the diversification benefits of dispersing these risks are only superficial if all of the investors who buy them use the same prime brokerages (for example, Goldman Sachs (GS), Morgan Stanley (MS), and Bear Stearns (BSC), who are prime brokers for 60% of all hedge fund assets).

The article uses the following example to illustrate why this could be a problem:

Could banks have shown risk out of the front door by selling loans, only to let it return through the back door of prime broking? Take credit insurance. Banks that own corporate bonds may use the swaps market to hedge against a company defaulting. But if the other side of the swap is taken by a hedge fund whose finances are dependent on loans from that same bank, has risk really been transferred?

This argument has some merit, but Buttonwood seems to contradict him/herself by then suggesting that hedge funds often use multiple prime brokerages because they are suspicious of the Chinese walls between prime brokerages and their related asset managers. Industry concentration aside for a moment, it seems this practice would actually reduce the dependency that a hedge fund has on “loans from that same bank“.

The article also explores the complex indirect relationship between related prime brokerages and asset managers (e.g. When a PB demands that a fund deleverage, is the resulting fire sale bound to also hurt the broker’s own trading desk?). In the end, Buttonwood seems to have more of a problem with loose credit, not industry concentration per se.

But when prime brokers turn off the funding tap, this virtuous circle may turn vicious. Hedge funds may be forced to sell their most liquid holdings since more complex positions may be impossible to offload. So a problem in one part of the financial system, such as American subprime mortgages, can quickly become a global issue. As Richard Bookstaber wrote in his recent book, “A Demon of Our Own Design”: “Trying to control the risk ends up creating the liquidity crisis.

But before we hear calls for greater regulation (which, in fairness, we do not here in this piece), take note something else Bookstaber says in his book:

…trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crises rather than extinguishing them because the safeguards add even more complexity, which in turn feeds more failure.