The Bank for International Settlement’s latest Quarterly Review is out, and it includes an interesting little aside on prime brokerages, the corner of investment banks that service hedge fund clients. PBs are one of the main links between traditional banks and shadow banks, offering services like custody, margin loans, derivatives, research and introduction to companies and investors. In return, they hope to get thick trading commissions.
However, the risks can also flow both ways. A stricken investment bank can yank credit lines from hedge funds and send its problems rippling through markets. Conversely, a major hedge fund collapse can cause havoc at a bank.
As the BIS says, with Alphaville’s emphasis in bold below: Prime brokerage is designed to be a low-risk activity, but wrong-way risk (WWR), the opaqueness of funds’ positions and poor risk management can create vulnerabilities for PBs. WWR refers to the risk that a PB’s credit exposure to a hedge fund counterparty increases at the same time as the likelihood of the counterparty’s default. Opaqueness is present when the PB does not have the necessary visibility into the funds’ positions, eg because they are booked in different entities, the assets are complex or the assets do not have readily verifiable market values. The resulting risk exposures often become apparent only when the fund is facing severe difficulties. If this sounds implausible — or like something from the 1990s — remember that Credit Suisse’s death spiral arguably started with the whole Archegos Capital debacle. ...
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