The interconnectedness of banks and shadow banks is more complex and riskier than it appears. This is evident with prime brokerage activities, which are services that banks provide to hedge funds and other non-bank entities, including custody, clearing, securities lending, financing and reporting. Prime brokers can also provide leverage via cash financing or securities financing transactions.
The prime brokerage industry is heavily concentrated, with the top 10 prime brokers serving the largest proportion of hedge funds globally, according to a S&P Global Ratings report. In France, two prime brokers account for 82 per cent of brokers’ total gross notional exposures to non-bank entities.
Hedge funds rely mostly on a few PBs, which tend to be global systemically important banks. The largest ones each serve more than 1000 funds, the Bank for International Settlements found in a paper published in early March.
Research has studied how liquidity and funding shocks at PBs can spill over to hedge funds, but contagion can run in both directions, acknowledges the BIS. Hedge funds’ gross assets are small relative to the global assets of non-bank financial institutions, but this asset class can attract particular attention because of its ability to ramp up leverage, creating financial stability risks.
Prime brokers may not be aware of hedge funds’ linkages with other banks, creating potential contagion channels between institutions. In addition, prime brokers’ exposures are subject to wrong-way risk, which is the risk that a credit exposure could increase precisely at the time when the counterparty is most likely to default.
Prime brokerage should be a low-risk activity, but wrong-way risk (which arises when exposure to a counterparty is positively correlated to the rising risk of that counterparty’s default), the opaqueness of funds’ positions and poor risk management can create vulnerabilities for PBs. Opaqueness occurs as the PB does not have full visibility into the funds’ positions.
The resulting risk exposures often become apparent only when the fund is facing severe difficulties, as happened with hedge fund Archegos in 2021. The fund had large and concentrated positions in a small number of shares. When these stocks suddenly suffered, the fund’s financial strength plummeted and PBs’ exposure to the fund surged. Archegos’s PBs were not fully aware of the size of the fund’s positions with other banks, underestimating its overall leverage and impact on the markets in which it was active.
Supervisors across the globe have increased their scrutiny of banks’ counterparty credit risk management practices in recent years, especially following the default of Archegos, but still believe there are some deficiencies and data gaps, according to S&P Global Ratings.