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Do hedge funds need to be mindful of the credit risk of their prime broker?
Penney: For the most part, hedge funds are net borrowers of money. We are the creditors, theyÆre the debtors. If you have a mortgage on your house, you donÆt worry too much about the quality of the institution which lent you the money.
That said, cash management does take place at a prime broker and the loans that we make are haircuts taken on the actual collateral deposited with us. So there is operational risk in the sense of being obliged to return that cash and securities in our custody in a timely way. Any risk of loss beyond that would imply some sort of lawbreaking or malfeasance.
Does operations get the right level of respect in prime brokerages? How can it be done better?
Operations people have never gotten the appropriate level of respect.
A well functioning middle and back office makes the difference between a situation that is orderly and one that can lead to default.
In the last two years, operations have won a lot more respect than it once had. Prime brokers have also evolved from what was seen once as a back office function holding less respect than the investment banking part of the firm, to now being viewed as a significant risk and profit centre.
WeÆre in a liquidity crunch. IsnÆt it both logical and safe for a prime broker to raise haircuts? Yet in general, prime brokers seem reluctant to say that they are taking what seems like a prudent step.
The two reasons why the margin might change are, one if you panic and donÆt want to lend money anymore
The other is a consequence of the loan-to-value ratio of the instrument you are margining. We havenÆt changed our rules and policies around collateralized margin lending, but those policies are a function of the volatility of assets, so if a change were needed, we would try to make changes in big steps, so clients donÆt have to put up with continuous fluctuations.
If a portfolio changed in terms of volatility or liquidity, that means the price could change more over a liquidation period, so in that case, haircuts should be adjusted. For liquid assets where volatility isnÆt so much of an issue, haircuts shouldnÆt change at all.
The credit crunch might lead people not to want to extend unsecured credit, but that doesnÆt follow through to secured collateralised financing.
How does your treasury charge you for your funds? If there are increases, do you pass them on?
We have reduced the amount that relies on our corporate treasury. We re-hypothecate assets and that brings in cash. It is in our interest to use our corporate treasury as little as possible. So weÆre self-funding as much as possible. There are always some items, for example OTC convertible bonds, or pieces in odd lots that sit there and we have to fund, but thatÆs blended into our overall cost of doing business.
Is there a difference between a prime broker that is a commercial bank and one that is a securities firm?
Absolutely. WeÆve had to hire sales people as weÆve grown the prime broking business in the last couple of years. They have to understand the capital markets and how funding works û and not just go off to the treasury department - they have to know how repos and total return swaps work. We havenÆt found a salesperson from a commercial bank who met that standard of knowledge. ThereÆs a big distinction in how the respective prime brokers function.
Should hedge funds feel safer though with a commercial bank as prime broker?
The psychology is interesting. If you go back to the Amaranth liquidation they had a spread of different prime brokers. The securities firms were doing secured lending and the collateral and hence valuations never changed. The commercial banks extended lending lines, and when the credit of Amaranth changed, they rescinded those at the worst possible time and their reputations suffered as a result.
The psychology of that reversed in recent months with some feeling that they needed to go to a bank and not a securities firm. I personally think that leaves them on a soft footing.
How do you think the prime broking playing field will change as a result of Bear Stearns?
There is a consolidation afoot. On the hedge fund side, they are becoming larger and more multi-strategy oriented so they need something to reflect that with their prime broker. That leads to industry consolidation. That will continue with some firms taken over by others or some giving up.
Merrill Lynch has positioned itself as the number three prime broker, in terms of revenue and balances. We attracted several billion in balances in just three days last week. People who can achieve a global footprint can make a go of it. Those that cannot, will probably find themselves marginalized.
It may encourage growth in multi-prime broking relationships for hedge funds that just find themselves sitting on one prime broker and relying on that firm exclusively.
How can a prime broker differentiate an offering from other prime brokers, beyond just having good service or handling multi-assets?
Not with things like clearing trades, because matters like that are commoditized across all of us. For Merrill Lynch in particular, IÆd say it was securities lending, we have a massive footprint there and a captive supply through our private clients business and supply from global lenders.
WeÆve moved forward with illiquids in a controlled way, so now weÆre not having to jerk around with it. We donÆt just do liquid portfolios, we do whateverÆs in the portfolio. I welcome illiquids in the context of a broader portfolio as they help provide diversification and protect the tail risk of your lending activities to give you something of value. For clients who have an illiquids part of their strategy, weÆre more than happy to accommodate that. Where it gets more difficult is stand alone illiquid strategies. It is really no more than unsecured lending if you canÆt do anything with the collateral.
With capital introductions, every prime broker has the same list, so what is the difference between a successful cap intros function and one that isnÆt?
It comes down to the people. ItÆs a networking business. I see it as an extension of the sales team. I expect them to know the consultants, funds of funds, asset holders. To be good at it, they have to be able to network as well as the best salespeople you can imagine.
Have you changed your selectivity process for hedge fund clients?
We have a lot of resources, so we want to work with clients, frankly, who can afford them. Clients have to be IT savvy and that makes them more scalable. Clients with good risk and operational control make good clients.
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