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Rebuilding Confidence

As the industry recovers from the collapse of family office Archegos Capital Management, both prime brokers and hedge funds will have to rebuild confidence in their resiliency and risk management practices, according to Cowen’s global co-heads of prime brokerage and outsourced trading, Mike Rosen and Jack Seibald.

Reprinted with permission from Global Custodian

Global Custodian: What are prime brokers taking away from the collapse of Archegos in March?

Mike Rosen: We realised that while firms can have all types of systems and procedures in place to manage risk and margin, acting upon them and having the necessary conversations with clients in an unemotional manner is not consistently applied. The systems in place were able to warn bankers of what was going on, but bad decision making over how to manage the exposure and risk ultimately led to the fund’s collapse and extraordinary losses on the Street. Generally, our guiding principle is to err on the side of conservative which forces us to make decisions that may mean we need to sacrifice potential revenues and profits and in extreme cases client relationships for the greater good of our Firm.

Jack Seibald: On a global basis, the debacle showed us that calculating the exposure to clients is not just about knowing what they are doing with you, but discerning what else they are doing with other counterparties. That is not easily accomplished in situations where there is no full disclosure.

GC: Do you see the events of March changing how prime brokers conduct business with hedge funds?

MR: It’s likely that margin requirements and financing costs will be increased; in particular when it comes to swaps. What happened in the Viacom situation was that after initial margin was posted under the swap agreement, and the stock went up, excess variation margin developed permitting Archegos to remove cash and reduce the collateral that was posted. This experience could affect the way the swaps business is managed, and swaps positions will likely be margined in a more dynamic manner than they been historically.

JS: What is likely to change is the level of regulatory oversight. Archegos, being a family office, was able to gain massive exposure in a select number of names with multiple counterparties. It was not required to disclose this because family offices aren’t required to abide by the same rules as registered funds. It may not necessarily had prevented this incident from occurring, but the magnitude of the losses has gained the attention of regulators, and the likely outcome is greater oversight and tighter regulation.

GC: Do you see the events of March changing how prime brokers conduct business with hedge funds?

MR: It’s likely that margin requirements and financing costs will be increased; in particular when it comes to swaps. What happened in the Viacom situation was that after initial margin was posted under the swap agreement, and the stock went up, excess variation margin developed permitting Archegos to remove cash and reduce the collateral that was posted. This experience could affect the way the swaps business is managed, and swaps positions will likely be margined in a more dynamic manner than they been historically.

JS: What is likely to change is the level of regulatory oversight. Archegos, being a family office, was able to gain massive exposure in a select number of names with multiple counterparties.  It was not required to disclose this because family offices aren’t required to abide by the same rules as registered funds. It may not necessarily had prevented this incident from occurring, but the magnitude of the losses has gained the attention of regulators, and the likely outcome is greater oversight and tighter regulation.

GC: Will PBs and their clients have a new outlook on the industry?

JS: From a fund manager’s perspective, it raises the concern of counterparty risk and the specific banks you are dealing with. Post-financial crisis, there was a broad move toward diversification of counterparty risk with funds taking on second or third prime brokers to spread their exposure. As firms assess their counterparties, we may end up witnessing a period during which balances move towards those banks that were less affected by Archegos, or not at all. As we are not a bulge bracket bank, we don’t use balance sheet to extend clients excessive credit, but rather provide margining that tends to be more thoughtful and closer to the norm. We have seen some increased level of inquiry from fund managers that had one of the impacted primes as a counterpart and are looking for alternate solutions.

MR: From what we have seen in the public domain, the level of margin requirements and the cost of financing to this client was very thin and at levels that are hard to justify. As clients get bigger, and the levels of business they do with you continues to increase, its typical to make pricing concessions along the way. An event like this could result in a recalibration in the prime brokerage industry and create an opportunity for primes to improve their pricing and margin requirements.

GC: How strong is the prime brokerage industry?

JS: We think of last year as a lengthy and severe stress test for the prime brokerage business, and many industry participants had their best performance in some time. This year has brought its own set of stress tests, including the meme stock phenomenon and the related short squeeze efforts in January and February, Archegos in March, and more recently the China stock implosion which wiped away $1 trillion of market capitalisation. Any one of those events individually could have shaken the foundations of the prime brokerage industry, but you’ve had all three in the span of seven months, and yet here we still are with no rise in overall volatility and the vast majority of firms intact. From a resiliency perspective, 2021 is proving that the system is well capitalised and functioning well enough to withstand global events and still delivering service to clients.

MR: Financial institutions have much more robust capital bases after ’08, and while the industry continues to make some of the same mistakes it has made in the past, all in all the industry navigated the two years extremely well with little to no stress in the system. On the flip side, we are seeing investment managers doing a better job of managing their risk, as they don’t want to be forced out of their positions at the most inopportune times. We had very few clients that got themselves in real trouble over the past couple of years and only had a handful of forced liquidation that took place.

GC: As certain banks look to resize, de-risk, and even pull out of certain services, what opportunities does this bring?

JS: As some banks downsize their books, or some decide to leave the market regionally or altogether, thatpresents opportunities for firms like ours because we have continuously made the investments to evolve the business. Our presence in Europe is notably different today than 24 months ago, largely because we were able to assume the business of GPP, and because we’ve been able to hire a good number of talented people across client support, operations and trading to accommodate new business. We also developed a footprint in Asia, which gives us that global coverage that we can articulate to clients. Where we can differentiate is by offering services that bulge bracket banks won’t – such as outsourced trading, which has become a much more broadly accepted solution by hedge funds and long-only investment managers. We also report on assets that are held away from us and provide a set of shadow book of records. Such services enable us to touch larger clients, and as conditions change in the marketplace, we continue to see opportunities to pitch prime brokerage, outsourced trading, or a combination of both.

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