The wave of new financial regulations that have been brought in since the end of the financial crisis have created numerous problems for financial institutions across the industry. One of the areas where these regulations have had the most impact is banks’ balance sheets where regulations have completely redefined the capital requirements for certain services.
The impact of Basel III regulations on Prime Brokerage operations is the subject of a new research booklet from JP Morgan.
Banks are in the process of redefining a finance model that provides clients access to financing, but at the same time earns an acceptable return for shareholders. Rules introduced following the financial crisis have made it necessary for banks to ration clients access to their balance sheets, and to review the businesses to which they committed capital.
Not all financing products have the same commercial characteristics for the bank in question. Before the introduction of Basel III regulations, prime services products generally had a “low” to “medium” impact on both the banks’ balance sheet and the capital requirement.
However, the introduction of regulations after the financial crisis increased the impact of prime services products on both balance sheet and capital.
Different banks are constrained by different aspects of the regulations, which makes the environment even harder to navigate for clients and the banks themselves. For some banks, national stress tests may be the limiting factor, whereas for others it could be an internal leverage ratio or risk-weighted assets to capital ratio.
Stringent regulations are making things harder for hedge fund managers who generally purchase combinations of prime brokerage products to enable them to trade the widest variety of securities and follow numerous strategies. JP Morgan outlines the most popular products:
- Equity prime brokerage, or PB, (developed and emerging markets) – Traditionally, this is the most widely offered prime brokerage service and the most attractive commercial product for prime brokers.
- Credit PB (IG, CB and HY) – Margin financing for credit funds is a smaller business line for prime brokers. Credit bonds are generally harder to finance, and the business consumes more capital than it does funding equities.
- Fixed income PB – Fixed income PB is a product offered by a relatively small number of prime brokers and is used by trading books focused on fixed income macro trading. It generally comprises a clearing and a repo financing component. For access to repo financing, it is essential that managers work with their financing counterparty to balance the book of business to maximize the opportunity to net down the positions.
- Listed derivatives – Most absolute return strategies will make use of listed derivatives. Listed futures and options are used by many funds for hedging or for “equitizing” inflows prior to investment. The balance sheet/capital treatment of listed derivatives is one aspect of the prime services business that has changed significantly, with an increased allocation of capital to the business.
- Cleared OTC derivatives – One of the policymakers’ key decisions after the financial crisis was to move as much of the derivatives activity that was previously conducted on the over-the-counter (OTC) market to clearing houses to increase transparency and reduce the contagion effects if a major market maker in OTC derivatives declared bankruptcy. This has, and will have, a significant impact on these products’ appeal to banks. 3 JPMorgan Investor Services, July 2016. This is a brief summary of the overall impact of Basel III. The ways in which the rules have changed has been covered extensively by other market commentators. 4 Risk Weighted Assets or RWA is a bank’s assets or off-balance sheet exposures weighted according to risk.
- Intermediation – Prime brokers offer “intermediation” of foreign exchange, interest rate and credit derivatives. This product is used by funds running strategies such as global macro, CTA and fixed income and consumes significant balance sheet. The revenue from intermediation has traditionally been based on ticket fees, and, therefore, generates little revenue.
The challenge for hedge fund managers and financing providers is to optimise the number of services offered, without necessarily increasing the fees they pay (for managers) or impacting balance sheet capital consumption.
There are several drivers of product and portfolio optimisation can be used to achieve the best outcome for all parties. One of the most popular is netting (portfolio skew/internalisation). As JP Morgan explains:
“Netting of long and short positions on a synthetic or cash-based portfolio will have a significant impact on the balance sheet footprint of the portfolio. This will impact equity, credit and fixed income portfolios.”
“The netting of long and short positions in equity portfolios is commonly referred to as internalization…By matching these two transactions, no financing or stock loan transaction is generated, and, therefore, the two trades do not create a balance sheet entry.”
“The netting process in fixed income is similar to that of equity… As long as the transactions meet the various requirements of the Financial Accounting Standards Board’s Fin 41 rule10, the trades can be netted down for accounting purposes, eliminating the balance sheet impact.”
“For derivatives, trade compression behaves in a similar manner, offering the benefit of reducing the notional value of derivatives to the bank counterparty.”
The bottom line
All in all, more stringent regulations are making it all the more important for managers and financing providers to work together to find the best solution that works for all parties involved. Netting is just one of the strategies that can be used by prime brokers to reduce the balance sheet impact of securities in a portfolio.