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organisational issues. The firm should consider assigning leadership responsibility for each of the three key functional areas: operations and finance, risk management and technology. For small funds with single strategies such as a US$100 million equity long/short fund, a single individual such as a Chief Operating Officer (COO) with responsibility over all three areas might suffice. Larger funds with multiple complex strategies such as a global-macro fund with several billion dollars under management, should consider separate roles for each of the three functional areas: a COO, a Chief Risk Officer (CRO), and a Chief Technology Officer (CTO).

This team should report directly to the firm’s managing partners or Chief Executive Officer (CEO). The firm should consider creating an executive committee which meets regularly, providing a forum for this team to interact with the managing partners, CEO and each other on issues facing the firm. Once the leadership team and structure is in place, the team should be allocated a budget and tasked with assembling the required resources and staff for each of the functional areas. These measures create the organisational framework for a robust operating platform, and highlight the firm’s commitment to minimising operational risk.

Policies and procedures – knowing what to do, and who does whatDeveloping procedures can be viewed by some as wasteful and bureaucratic. However, it can actually be very useful in identifying issues and solutions, and clarifying roles. Creating written policies and procedures also makes it easier to communicate tasks and adjust if needed.

These should identify:1. How to consolidate trade reporting and position

tracking across prime brokers? What are the systems and reports to use?

2. What are the operational procedures for settlements, cash management, handling trade breaks and addressing failed settlements?

3. How are cash and securities reported to the firm’s custodian?

4. What are the firm’s pricing procedures? What products are marked using pricing models and what are the appropriate models?

5. How are market and credit risk and limits managed? How are these aggregated across the prime brokers and portfolios?

6. What is the month-end accounting process? How is the fund’s Net Asset Value (NAV) calculated?

risk management framework at the firm. The due diligence questionnaires of institutional investors such as funds of hedge funds, university endowments and pension plans, emphasise fund’s operations and risk management functions. Increasingly, a firm’s operating platform, in addition to performance and track record, has become a key distinguishing feature between hedge fund managers, and a crucial one for institutional investors when making asset allocation decisions. A strong operating platform is a significant advantage in competing for investment money and for increasing assets-under-management.

The challenges faced when making the transition to multiple prime brokers is a result of the responsibility of the hedge fund’s operations, pricing, risk and technology functions shifting from the single ‘full service’ prime broker to the hedge fund manager.

Often the hedge fund manager is ill equipped to manage these functions, and has to address the following issues:• Organisational issues – leadership and

responsibility• Policies and procedures – knowing what to do,

and who does what• Coordination and timing – identifying when

things get done• Information technology – creating a platform to

handle it all• Complexity and reporting – aggregation and

consolidation

Let us review them one by one.

Organisational issues – leadership and responsibilityWhen moving from a single full service prime broker, the firm should first address important

The recent events at Bear Stearns and its subsequent takeover by JP Morgan have hedge fund managers asking very difficult questions about their prime brokers. What happens if our prime broker ceases to conduct business as usual? How would we execute trades and manage daily operations? Will we have access to our cash, securities, and liquidity lines? Not surprisingly, the answers are complex and often contradictory.

One response by hedge fund managers has been to set up multiple prime brokerage relationships, which have the benefit of diversifying the risk away from a single broker. Hedge fund managers can then move trade execution, securities, and cash between prime brokers, lessening their exposure to prime brokers that may face credit or liquidity issues in the future. This allows for a great deal of flexibility in the hedge fund’s operations, and helps manage counterparty exposure and operational risk to a prime broker.Currently, several hedge fund managers, especially smaller firms, rely heavily on a single ‘full service’ prime broker for most of their needs. These funds will find it challenging to make the transition to multiple prime brokers, as they will have to ‘in-source’ key operational, risk, and technology functions, and rethink roles and responsibilities within their organisations.

While making the shift to multiple prime brokers requires a significant investment in time, effort and money, the pay off can be significant as well. Besides the obvious risk-mitigation benefit of diversification, there are several other benefits such as the ability to pick and choose between prime brokers based upon their product expertise, quality of execution, technology platform and service level.

Perhaps most importantly, successfully making the transition to multiple prime brokers results in creating a robust operating environment and

Prime Broking: Single vs Multiple?Switching to multiple brokers will result in pay-offs SANJAY BHARWANI, RISK ADVISORS & DANIEL CHAIT, LAB49

Table 1. Points to consider when shifting from single to multiple prime brokers Source: Lab49

Organisational Issues

Policies and Procedures

Coordination and Timing

Information Technology

Complexity and Reporting

• Create an executive committee

• Consider hiring Chief Risk and Technology Officers

• Clearly document roles and responsibilities

• Create a transition plan

• Reconcile reports before and after

• Allow time to hire and train staff

• Buy/build consolidated reporting, trading, and portfolio management systems

• Aggregate VAR reporting and other complexities

Consideration Key points

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Each one of these questions should be addressed by a written procedure and, if applicable, a formal policy.

Coordination and timing – identifying when things get doneHaving created the organisation and policies, we recommend that hedge fund managers carefully plan the switch from single to multi-prime brokerage. There can be many organisational, technical and business challenges involved, which can cause problems if not handled properly.

For example, setting up adequate trading infrastructure may take many months, involving such complexities as negotiating exchange agreements, creating new software, expanding facilities and providing disaster recovery (DR) facilities. Funds may also face issues related to historical reporting and, therefore, must ensure that their numbers can be reconciled effectively across the entire time period covering before, during and after the transition. Personnel and training needs will also have to be met during this transition, including hiring and instructing staff on new procedures. We suggest that a fund assign someone to draft this transition plan and manage the process.

IT – creating a platform to handle it allWhen moving from a single prime broker to multiple prime brokers, firms are likely to require a significant upgrade in their information technology (IT). For one, the brokers are likely to provide incompatible reports, requiring funds to engineer systems to produce unified reports. This may include different formats (.CSV vs XML vs Excel, for example) as well as structures and organisations of the reporting data (for instance, different instrument identifiers, curve definitions, term structure definitions and the like).

Also, the fundamental systems involved in the trading lifecycle, such as market data subscription, analytics and order management systems (OMS), will typically need to be brought in-house and connected to broker systems. When using a single prime broker, funds can often get by with Bloomberg terminals or the equivalent. However, when a fund outgrows this stage, or when it moves to multiple prime brokers, it will need to bring in one or more market data feeds to populate their newly required pricing, risk, P&L and other systems. This can often be a difficult and complex IT challenge, involving negotiations with exchanges, physical infrastructure setup and coordination amongst various data aggregators.

Moreover, even assuming the brokers’ OMS’s use the FIX standard, they will almost certainly

differ in details such as version, custom fields and features supported. And of course, the question of which instruments to trade through which broker will have ramifications to the IT department.

Third, they will no longer be able to rely on their prime broker’s system and a handful of spreadsheets to handle all of their portfolio management. Rather, the fund will need to look at building and/or buying a variety of systems to tackle the various aspects, including position keeping, pricing and risk analysis.

Other complications include the creation and maintenance of a security master, compatible pricing models, risk calculation methodologies and accounting and back-office logistics.

Upgrading the firm’s IT, while certainly challenging, is also an opportunity to increase competitiveness through superior IT capabilities. For example, rather than trading each asset class through a given broker, a fund could build smart systems that can analyse the market and intelligently manage the order flow to optimise for lower transaction costs, faster execution times, or better prices.

Complexity and reporting – aggregation and consolidation.Finally, attention should be paid to aggregation and reporting across prime brokers and portfolios. Some exposure information and other metrics are often not additive and a simple sum across prime brokers is not sufficient. A good example is Value at Risk (VAR) reporting.

For example, assume a simple scenario where a fund trades only equities and hedges its equity exposure with index futures. It uses Prime Broker A for all of its equities and Prime Broker B for all of its index futures. In order to report VAR on the portfolio, the fund has to aggregate the portfolio across reports from Prime Broker A and Prime Broker B, but could not simply add VAR reported from Prime Broker A to VAR from Prime Broker B. Instead, after consolidating the portfolio, the fund has to factor in the correlations between the equities and the index futures, and then calculate VAR on the entire portfolio. This requires thought, planning and tools.

SummaryMoving from a single full-service prime broker to multiple prime brokers is difficult. However, it has several benefits for the hedge fund manager willing to take on the additional responsibility. Significantly, it reduces the dependence on a single broker that might unintentionally cause a business disruption at the fund (operational risk)

and reduces the firm’s counterparty exposure to that broker.

Further, it allows the fund to choose the best provider for a given service (reporting, issue resolution, and trade execution), by product (equities, FX, interest rate derivatives etc.) and not to be locked into a single prime broker. Lastly, with the increased focus by institutional investors on operational risk, it has the added benefit of creating an operating platform that would easily pass muster through the most rigorous of due diligence processes.

In sum, moving to multiple prime brokers, while challenging, results in an operating platform that allows the hedge fund manager to scale their business and address operational risk concerned with institutional investors, convince investors to increase their allocation to the fund and the result is an increase in assets under management and additional revenue for the hedge fund management company. THFJ

SANJAY BHARWANISanjay Bharwani is the founder and CEO of Risk

Advisors Inc, a consultancy that develops risk

management and pricing frameworks for hedge

funds and financial institutions.

DANIEL CHAITDaniel Chait is Founder and Managing Director of

Lab49 which specialises in low-latency and

distributed systems within capital markets.

Biography

Risk Advisors IncRisk Advisors Inc (www.riskadvisorsinc.com) is a

consultancy that assists hedge funds develop risk

management frameworks and pricing capabilities to

manage market risk, credit risk, operational risk, and

accurately mark-to-market positions. It manages and

hedges risk for complex portfolios, independent

valuation and model creation for derivatives and

other hard-to-value securities, and trading process

and systems development.

Lab49, IncLab49 is a technology consulting firm that builds

advanced solutions for the financial services

industry. Founded in 2002, Lab49 (www.lab49.com)

has offices in New York and London.

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July/August 2008