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Transcript of M Lynch_Multi PB
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The Multi-PrimeBroker Environment
Ovrcong h Chang
an Rang h Bn
June 2008
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For or nforaon, a conac:
AmeRiCAs
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euROpe, middle eAst, & AFRiCA
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Merrill Lynch Global Markets Financing & Services
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The Multi-Prime Broker Environment —Overcoming the Challenges and Reaping the Benets
Historically, it has been common or a hedge und to utilize multiple executing
brokers and a single prime broker. oday, many hedge unds have discovered the
benets o working with multiple prime brokers, as well. Given the value that
investment banks place on nancing ees, prime broker balances play a signicant
role in determining access to the scarce resources that investment banks oer hedgeunds: alpha-generating trade ideas, deal origination, research, calendar access,
capital introduction, etc. By spreading balances across multiple prime brokers,
a hedge und can eectively leverage its access to these valuable resources rom
multiple providers.
ransitioning to a multi-prime operating environment does have its challenges;
a signicant one being the need to aggregate position, cash balance and risk data
into consolidated reports. However, these operational challenges are usually not
insurmountable. Additionally, the process o going multi-prime can oen be a catalyst
or reducing the dependence on outside service providers, giving the und greater
control over its operations. Tis may assist in growing the und, especially given theincreasingly global trend o institutional investors demanding “best-practices” back-
and middle-oce environment beore investing.
Te research indicates that the majority o large unds are using multiple prime
brokers. A 2006 study conducted by Greenwich Associates indicates that three
quarters o hedge unds with more than $1 billion in AUM utilize at least two prime
brokers, and more than 35% o those unds use our or more. Many o the smaller
unds surveyed utilized multiple prime brokers as well.
Figure 1: Number of Prime Brokerage Relationships by Fund Size1
1 Greenwich Associates study commissioned on behalf of Merrill Lynch, 2006
Funds with less than $100 million in AUM
Funds with $100 million to $1 billion AUM
Funds with more than $1 billion in AUM
Prime brokerage is a
currency which can be
used to obtain scarce
resources from theinvestment banks.
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Why are most hedge funds using multipleprime brokers today?
Hedge unds typically launch under the auspices o a single prime broker. Such
relationships are very symbiotic in that the hedge und oen receives a great deal
o high-touch services during its start-up period and the prime broker garners 100
percent o the und’s asset balances. Tese relationships are also very sticky or the
initial prime broker, since the new und’s operating procedures oen evolve aroundthe trading, risk and reporting tools provided by the prime broker. But in spite o this
stickiness, most growing hedge unds nd working with multiple prime brokers oers
several strategic benets that outweigh the cost o making the operational changes.
Tere are many reasons why hedge unds utilize multiple prime brokers, but the recent
turmoil in the nancial markets and the collapse o a bulge bracket prime broker
have driven diversication o counterparty risk to the oreront o those reasons.
Having multiple prime broker relationships may help acilitate the rapid transer o
assets i one broker shows signs o imminent ailure. Additionally, there is anecdotal
evidence that institutional investors are increasingly encouraging the und managers
they invest with to consider utilizing multiple prime brokers as well.
For hedge unds that are dependent on securities lending, multiple prime brokers
means additional sources o borrow and better pricing. Each prime brokerage rm has
a dierent inventory o lendable securities, and some are deeper than others. Some
rms specialize in hard-to-borrow and non-equity securities. Plus, adding prime
brokers encourages a more proactive search or dividend enhancement opportunities.
A signicant strategic benet o using a prime broker is the ability the prime broker
has to make available alpha-generating ideas and strategies. Consider the investment
bank that utilizes its resources to research and help with customized tax-ecient
trades or the hedge und. I the investment bank only has a trading relationship with
Benets of Adding a Second Prime Broker
• Mitigation of risk: counterparty, nancing, liquidity and operational
• An additional source of alpha-generating trade ideas, capital
introductions, etc.
• Ensure optimal nancing through competitive pricing of
margin lending and stock loan
• Gain access to competitive or innovative cross-margining
policies of the competing prime broker
• Leverage across the relative strengths of service providers
in synthetic nancing, swap trading or market access
• Catalyst for reduced dependency on outside service
providers, giving greater direct operational control
Many growing hedge
funds nd working with
multiple prime brokers
offers several strategic benets that outweigh
the cost of making the
operational changes.
A signicant strategic benet of using a prime
broker is the access to
alpha-generating ideas.
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the und (and not a prime broker relationship), the investment bank is compensated or
its eorts through the commission on executing trades. However, a ull service prime
broker arrangement may be more nancially enduring and rewarding than only trading
commissions. Since the resources to research such customized trades are limited, the
investment bank may share its alpha generating with the clients that generate higher
revenues. By using prime brokers, the hedge und may benet rom multiple rms with
distinct resources working to help identiy alpha-generating trade ideas.
Another key benet may be the ability or the CFO or COO to ensure that the und is
optimally nanced through competitive pricing. Prime brokers with sole mandates,
particularly the top-tier prime brokers, may charge a premium or their services
(margin nancing, security lending, etc.). A und may assert pricing pressure on its
initial prime by introducing additional prime brokers.
Additionally, the types o services and their relative strength vary across prime brokers.
Not all rms have the same capabilities with regard to synthetic nancing, swap trading,
local market access or direct market access trading tools. Cross-margin policies and
the manner in which o-setting positions can reduce collateral requirements also vary
among dierent prime brokers. Capital utilization may be optimized by custodying a
group o securities with whichever prime broker oers the best margin or collateralrelie or any given position.
Utilizing multiple prime brokers may allow a hedge und to mitigate several types o risk.
Counterparty risk diversication, as mentioned previously, comes rom having multiple
custodians. Funding liquidity risk can be reduced by having nancing relationships
with multiple brokers, which is especially critical at times o market distress. On the
operational side, multiple prime brokers may act as a “check-and-balance” or corporate
action processing, minimizing the likelihood that a corporate action will be missed i a
given security is held at multiple primes. Also, by not relying on a single prime broker,
the hedge und has more options in the event one o its prime brokers experiences a
business interruption scenario. Lastly, splitting a und’s balances across multiple primebrokers ensures no single investment bank can view a hedge und’s entire portolio,
which may give the und manager an additional level o reassurance when working
with a prime broker rm that also conducts proprietary trading.
Implementing a Multi-Prime Broker Environment
Introducing additional prime brokers into a hedge und’s operating environment is
not without its challenges. Te degree o diculty is directly correlated to the level
o reliance on the initial prime broker or tools, such as intra-day P&L, position and
risk reporting, investor reporting, etc. Te more systems that are either maintained
in-house or by a neutral third-party provider, the easier it is to add a prime broker.
Data Aggregation
ransitioning to a multi-prime environment requires a number o decisions to be made
by the und manager. One signicant decision is the process or daily data aggregation.
When a hedge und uses only one prime broker, that prime broker has visibility to the
entire hedge und’s book. With all trade and position data maintained in one place, it is
Utilizing multiple prime
brokers allows a hedge
fund to mitigate several
types of risk.
Investment strategy
can drive the need for
multiple prime brokersand dictate the
solutions required.
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easy or the sole prime broker to provide position, cash balance and risk reports or the
entire portolio. Once additional prime brokers are introduced, it becomes necessary
to aggregate data rom the multiple primes in order to generate consolidated reports,
including whole-portolio risk, portolio accounting and perormance metrics. I
managing multiple unds, simply assigning a dierent prime broker to each und
may minimize the need or large amounts o data aggregation. However, i this is not
practical and multiple prime brokers will be servicing a given und, three options or
data aggregation are:
Use the hearsay reporting capabilities o the frst prime broker – In some cases,the prime broker with the bulk o the hedge und assets (usually the initial prime
broker) will oer to receive a eed o trades and positions rom the second prime,
and aggregate them into their established reports and statements. Tis is requently
the easiest and least disruptive option or the hedge und in that the managers will
continue to receive the same consolidated reports rom the initial prime broker they
are accustomed to. However, the use o hearsay reporting negates one o the risk
diversication benets o a multi-prime environment — preventing any one prime
broker rom having ull knowledge o the und’s portolio. Also, the reliance on
hearsay reporting is generally not a scalable solution. As more primes are added,
more balances are shied away rom the initial prime, who will thereore be less
willing to provide hearsay reporting. Lastly, hearsay reporting can be operationally challenging or the initial prime, making one dependant on the quality o the people
servicing the account. For these reasons, hearsay reporting can be a “rst step” in the
process o creating a multi-prime environment, but is usually replaced by one o the
other two options described below.
Utilize a und administrator – From an operations perspective, und administrators
are engineered to consolidate a und’s data rom multiple sources in order to perorm
their primary unction o independently valuing a hedge und’s entire portolio.
Key Operational Changes to Consider
• Aggregation of trade and position data from multiple
prime brokers to generate consolidated reports:
risk, portfolio, accounting and performance
• Decide on an allocation methodology for attributing
trades to each prime broker
• Signing of new documentation, reecting:
– Corporate or management changes since inception
– Changes in signing authority
– Changes in the regulatory environment
– ISDA agreements with credit terms appropriate to the fund
– Inclusion of ERISA / pension money invested in the fund
The reliance on hearsay
reporting is generally
not a scalable solution.
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Tereore, they requently provide consolidated versions o the common reports
prime brokers generate (position, cash balance, risk reports, etc.). As a solution to
the data aggregation problem, use o a und administrator does not suer the same
scalability issue that hearsay reporting does. It also has the advantage o ensuring
that each prime broker can only view their portion o the hedge und’s portolio.
Some und administrators also oer outsourced middle oce services. In addition to
data aggregation, these services may include much o the daily processing necessary
to support a und (P&L calculation, reconciliation, collateral management, etc.).
Tere are some challenges with this approach, most notably the need or hedge und
sta to manage the process. Fund administration and/or middle oce outsourcing
is an additional expense that will have to be borne by the und, as many domestic
unds do not use a und administrator or their onshore entities. Further, not all und
administrators have the ability to service the complex asset classes that are now being
employed by many und managers.
Build in-house capabilities – Te most fexible (and generally most costly) solution
may be to implement internal systems that will consolidate the data across all prime
brokers and generate all the necessary reports internally. Such implementations
requently start out with a vendor-supplied order management system to controlthe allocation o trades across multiple primes (see below). Requirements or control
over in-house data aggregation requirements, internal and investor reporting
requirements, and accounting control, lead to the use o a third-party accounting
solution. Tese systems usually require customized integration with the other existing
soware packages and data present within the und. While this approach does entail
signicant cost, both in terms o the vendor soware and the I services/personnel
required to implement and maintain the system, the benet is sel-suciency and
Consolidated Reporting Options
O P T I O N S P R O S C O N S
Haray by
pr Brokr
wh Bk of
A
• Easiest implementation
• Least expensive option
• Already familiar with reportformats
• Not scalable – hard to add athird or fourth Prime Broker
• “Prime” Prime Broker can still view entire portfolio
• Dependency on “Prime” PrimeBroker’s release schedule, willingnessto accommodate hearsay, etc.
Fn
Anraor
• Scalable up to any numberof Prime Brokers
• Each Prime Broker only views
its portion of the portfolio• Usually more cost eective
than doing all aggregation
and reporting in-house
• Additional expense (to the fund)
• Some have diculty withexotic products
• Must get familiar with new report formats
B in-Ho
Caab
• Most exible
• Each Prime Broker only viewsits portion of the portfolio
• All data remains in house
• Most costly in both time
and expense (usually borne bythe management company)
An in-house solution
ensures that there is
no dependency on any outside providers or
vendors for custom
reporting, data
extracts, etc.
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complete control over the und’s data. Te importance o this can’t be overstated. A
common complaint rom unds in the multi-asset class arena is the inability to access
“our data” rom external vendors and service providers. An in-house solution may
remove the hedge und’s dependency on any outside providers or vendors or custom
reporting, data extracts, etc. Additionally, each prime broker will continue to have
access to only their portion o the portolio.
Clearly these options vary greatly in cost and operational complexity. However,
deciding on the most appropriate data aggregation method can be a airly methodical
process. It begins with identiying the key reports that are utilized by the hedge
und in the single prime broker environment. Next, each report needs to be
analyzed individually to determine how best it can be generated in the multi-prime
environment. Te fow chart below depicts an analysis process that can be applied to
each key report.
Trade Allocation and Position Maintenance
In addition to thinking through the data aggregation procedures, a trade allocation
methodology needs to be determined. Te trade allocation methodology species
to which prime broker a given trade will be allocated. Examples o trade allocationmethodologies include: speciying a single prime broker or each legal entity;
speciying a single prime broker or each strategy; or utilizing a pre-dened ratio
to split allocations across prime brokers (e.g. using two prime brokers and splitting
each trade evenly between them). An order management system is particularly useul
in managing the allocation process and helping track where a particular position is
custodied when closing it out.
Existing Report
Reportprovided by initial
Prime Broker?
Will initialPrime Broker offer hearsay
reporting?
Initial PBgenerates report
Fund Administrator/Middle Office
Provider generates report
Use aFund
Administrator/Middle Office
Provider?
Can theFund
Administrator/MiddleOffice Provider
create thereport?
Get consolidated data
(position, balance,etc.) from Fund
Administrator/MiddleOffice Provider
In-house systemgenerates report
In-housereporting system
Use in-house system
(accounting,PMS, or CMS) toconsolidate data
Yes
No
No
Yes
Yes
Yes
No
No
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When choosing a trade allocation process, it is also important to consider the
impact o cross-margining. I the hedge und is trading o-setting positions that canpotentially reduce collateral requirements at a prime broker, it is critical that the o-
setting trades be allocated to the same prime broker. I the trades are sent to dierent
prime brokers, no margin relie will be realized.
Recommended Documentation Practices To Help with theMulti-Prime Broker Implementation
I it has been more than a couple o years since the initial prime broker relationship
was established, the managers o the hedge und should expect a more involved
documentation process. o ensure the documentation process or adding a prime
broker proceeds as smoothly as possible, it is important to rst review the und and
management company’s ormation documents. Any corporate or management changes
that have occurred since the inception o the und must be properly documented.
Additionally, signing authority documentation should be current. While going
through the process o adding a second prime broker, save all required constitutional
documents and other background inormation in a single place so they will be easily
accessible i any prime brokers are added aer the rst two. Lastly, once the process
has started, the und’s documentation contacts should be committed to providing all
inormation in a timely manner. I there are any questions about the process or the
documents themselves, quickly seek guidance rom the documentation specialists at
the new prime broker so as not to lose time or momentum.
When negotiating the prime broker relationship terms, the most critical initial actorsto consider are timing, cost and risk tolerance. Clear communication o the und
managers’ priorities, and views on these topics to both internal and external counsel
is essential. Tat said, the terms will vary among prime brokers as a result o their
dierent and evolving credit and risk tolerance levels, legal perspectives and business
models.
While going through
the process of adding a
second prime broker, save
all required constitutional
documents and other
background information
in a single place so they
will be easily accessible
if any prime brokers are
added after the rst two.
Methodologies For Allocating Trades
to Multiple Prime Brokers
s / sac • By Fund
• By Market
• By Strategy
Easiest to implement, but canbe dicult to adjust in order tomaintain target asset levels witheach Prime Broker
Granar / dynac • By Security
• On a pro rata basis
• Arbitrary method
More complex to implement,but can be recalibrated whentarget allocations of balancesacross prime brokers arereviewed and changed
Oornc • By borrow availability
• By executing Broker
Used in conjunction with oneof the others as a “ne-tuning”method to optimize nancingbenets
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ISDA and Master Conrm Agreements
For hedge unds transacting in over-the-counter derivative markets, ISDA docu-
mentation must be negotiated (i.e. the ISDA Master Agreement and Credit Support
Annex, collectively “an ISDA Agreement”). While a prime broker relationship is
not a prerequisite or establishing an ISDA Agreement, hedge unds trading OC
derivatives will typically have an ISDA Agreement with each o their prime brokers
at a minimum.
Te main structure o an ISDA Agreement is dened by the International Swaps and
Derivatives Association, Inc. which acts as a clearinghouse o industry standards, but
each dealer can modiy the schedules/annexes to the ISDA Agreement to refect their
particular views on legal, credit, business and other risks. One critical issue or the
und manager to consider in the ISDA Agreement (and prime broker agreements as
well) is whether the credit terms are appropriate or the und’s strategy. Also, und
managers should be aware that the presence o ERISA/pension money in the und
may lead to a more extended negotiation process.
Related to the ISDA Agreement certain products use a Master Conrmation which
sets orth and governs specic transaction terms, as opposed to the overarching
contractual relationship established in the main document. While not required or
trading, it is recommended or any und trading large volumes o OC derivatives. A
Master Conrmation which is negotiated once at the beginning o the relationship,
along with the process o negative armation minimizes the amount o documentation
that must be generated, tracked and signed with each OC transaction, and thereore
reduces the strain on legal/documentation resources and back oce operations.
Transition to the Multi-Prime Broker Environment
Logistics o Transerring Securities and Cash Between Prime Brokers
When adding an additional prime broker, a hedge und has two options regarding the
establishment o accounts at the new prime broker:
• Open accounts at the new prime broker and initially fund with cash only
• Open accounts at the new prime broker and transfer existing positions/cash
in rom the original prime broker.
Te rst option is simpler rom a logistics perspective. Cash is wired into the account
(street-wide practice is to require a $500,000 minimum). Te hedge und manager will
then establish positions in the account trough new trading activity.
I the hedge und manager wishes to transer existing positions between prime brokers,
the integration team rom the new prime broker may work with the hedge und client
and the existing prime broker to dene an orderly transition plan. For US securities, thiswill most likely be done through the Automated Customer Account ranser Service
(ACAS). ACAS is an automated system managed by the DC. Although reliable,
ACAS makes use o the standard settlement process, which means the transer can
take several days to complete. Alternatively, “ree delivery/ree receive” can sometimes
be perormed or overnight delivery, but this process is manual and may expose the
prime brokers to settlement risk. For international securities, the transer process
between prime brokers will vary, depending on the issuing country o the security being
transerred, and what correspondent banks the prime brokers use in that country.
Fund managers should
be aware that the
presence of ERISA/pension
money in the fund may
lead to a more extended
negotiation process.
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Use O Consulting Services
Te prime brokers recognize that the process o adding an additional relationship can
be taxing to a hedge und and its back oce sta. As a result, they requently oer
assistance in the orm o consulting services to help mitigate these pressures. Consulting
service oerings can include assistance with vendor and service provider selection,
project management, and process fow reengineering. Te consulting teams can also
provide guidance when making the decisions outlined above (trading methodology, data
aggregation, etc.) It is advisable to engage with the new prime broker’s consulting servicesas early as possible in order to help smooth the new prime broker integration process.
Reaping the Benets of theMulti-Prime Broker Environment
Clearly the decision to evolve to a multi-prime broker environment carries with it a
number o challenges to be aced and decisions to be made. While this decision will
have an impact on the daily operations o the hedge und, it is important to keep
in mind that the multi-prime decision is ultimately a strategic one. Just evaluating
the impact o an additional prime may highlight operational ineciencies (manual
processes, critical data residing in spreadsheets, etc.) that are present in many evolving
hedge unds. Since back-oce procedures may need to be modied to accommodate
the additional prime broker, the multi-prime transition may be an opportunity to
address those day-to-day ineciencies and move the und’s operations closer to
“institutional caliber.” Tis in turn may lead to better risk controls and may even
improve the und’s attractiveness to institutional investors. But ultimately, utilizing
the services o multiple prime brokers may allow hedge und managers to extract the
most value out o the prime brokerage community.
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