There are indications that prime brokers added to systemic risk in the financial crisis by hoarding liquid securities, says the European financial regulator.
The European Securities and Markets Authority (Esma) has just completed a working paper into the financial intermediation chain between hedge funds and prime brokers and says substance is added to research by others that has already pointed towards hoarding.
Esma, which based its research on a dataset covering the 306 largest global hedge funds and their prime brokers between July 2001 and December 2011, says the hoarding occurred in the financial crisis when the volatility of prime broker excess returns became exceptionally high, along with hedge fund illiquidity.
Under these conditions, the prime brokers’ financing activity and securities holdings increased, but their lending did not.
A key part of prime broker activity is lending money to hedge funds in return for collateral, typically securities. Prime brokers may then re-use these securities in the repo market, which helps them keep borrowing costs down for clients.
This means that hedge funds are important for the workings of the repo market, which was one of the markets hit by the drying up of securitised funding in the financial crisis.
The Esma report says that the discrepancy between increased securities holdings at prime brokers on one hand, and a lack of lending on the other, indicates that prime brokers hoarded liquid assets and Esma believes this was in order to prevent a run on assets by clients.
“But by following this incentive they impaired the flow of collateral assets to the repo market. Thus, it turns out that this particular behaviour of prime brokers adds to systemic risk in securities markets, since, in times of crisis, they have an incentive to withdraw liquidity from an already weakened market,” says Esma’s report.
The report also notes that some of the policy measures implemented by central banks helped to alleviate the disruptions in the financial intermediation chain between hedge funds and prime brokers. In particular, in March 2008 the Federal Reserve Bank of New York created a new facility, the Primary Dealer Credit Facility, which allowed prime brokers in times of market distress a discount-window like access to central bank liquidity.
The Esma working paper is called The systemic dimension of hedge fund illiquidity and prime brokerage.
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