| The role of prime brokers in hedge funds |
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| Paul Farrell explains the function of prime brokers. |
Market volatility in 2002 led to a continued increase in demand for alternative investment strategies and a consequent rapid growth in the hedge fund industry. Having evolved into a global business in the ‘90s, the growth of the hedge fund industry has continued with assets under management in June 2002 approaching $600 billion.
A common feature of hedge funds that tends to distinguish them from more traditional investment funds is their appointment of prime brokers and the regulatory and technical implications that arise from such an appointment.
A prime broker’s core functions include providing clearance, settlement and custody facilities to a hedge fund, margin financing and stock lending to support a hedge fund’s short positions, reporting facilities and technology and credit to facilitate foreign exchange payments and securities transactions.
One of the defining features of the relationship of a prime broker with a hedge fund is the provision of financing to the hedge fund by the prime broker in return for which it can take an unfettered title over all or part of the hedge fund’s assets. This enables the prime broker to lend on the assets and to use those assets to satisfy other obligations it may have. The result is that the prime broker is able to source assets to satisfy its obligations in an easier and more cost efficient manner. In return the prime broker will provide finance to the hedge fund at lower rates than usually available to the hedge fund.
This process often entails the assets of the hedge fund not being segregated from the assets of the prime broker and in the event of default, insolvency etc. on the part of prime broker a hedge fund would rank no higher than an unsecured creditor. As any restriction on the ability of a prime broker to lend on the assets can have an impact on the rate of financing provided to the hedge fund there is therefore a trade off between safety and the rate of interest paid.
In the case of Irish domiciled hedge funds, this obviously raises Irish Financial Services Regulatory Authority (formerly the Central Bank of Ireland) (IFSRA) concerns in relation to the ability of the prime broker, in the context of taking collateral against the provision of shorting/financing facilities, to utilise those assets as if they were its own, rehypothecating and/or pledging those assets to third parties. The concern being that effectively the hedge fund’s assets would end up, in part or entirely, outside of the custody network and the control of the Irish hedge fund’s custodian.
Ireland
In the late ‘90s, IFSRA recognised that there were opportunities for Ireland in this area that could be achieved while protecting Ireland’s reputation for probity and regulation. Following submissions from the Irish funds industry and firms like Matheson Ormsby Prentice, the Irish Central Bank introduced rules which facilitated the appointment of prime brokers by IFSRA regulated funds.
The response to these rules was immediate with leading providers of prime broker services targeting Ireland and Irish based funds for development. This trend has continued and the assets under management in Irish regulated hedge funds in the year-end to June 2002 increased by an impressive 248 per cent.
A draft Guidance Note was issued by IFSRA with the intention to reflect its position on the appointment of prime brokers by collective investment schemes. The following is a summary of the IFSRA’s current position as set out in that draft Guidance Note: (a) the value of assets passed to the prime broker must not exceed the level of the hedge fund’s indebtedness to the prime broker; (b) the arrangement must incorporate a procedure to mark positions to market daily in order to monitor the value of assets passed to the prime broker on an ongoing basis; (c) the prime broker must agree to return the same or equivalent assets to the hedge fund; and (d) the arrangement must incorporate a legally enforceable right of set off for the hedge fund.
Where the prime broker holds assets greater than the level of the hedge fund’s indebtedness, it must be appointed as a sub-custodian by the hedge fund’s custodian.
The prime broker, or its parent company, must have a minimum credit rating of A1/P1 and must be regulated as a broker by a recognised regulatory authority and it, or its parent company, must have shareholders’ funds in excess of e200 million (or its equivalent in another currency).
There must be clear disclosure in the hedge fund’s documentation of its proposed relationship with the prime broker.
Revision
The general view of the Irish funds industry is that the indebtedness limit is too restrictive and needs to be extended to permit prime brokers to hold and use excess collateral other than in the custody account. Debate currently centres on whether any, and if so, what limit should be applied to the amount of the excess collateral which could be held or used in this way.
A recent proposal by the Dublin Funds Industry Association (DFIA) is to provide for a 30 per cent excess exposure limit calculated on the basis of the indebtedness test.
The DFIA has sought this test over an asset value based test for a number of reasons including the fact that as the prime broker does not necessarily have access to the asset value of the hedge fund, a test other than the indebtedness test would create an additional layer of reporting, and prevent the prime broker from expeditiously calculating its ability to rehypothecate or otherwise utilise the assets of the hedge fund
The limit on indebtedness is not the only area proposed for amendment. In its continued efforts to provide more flexibility in the Irish regulated hedge fund industry, a number of other amendments have been proposed by the Irish funds industry as a whole. These include amendments to the counterparty qualifications for a prime broker and changes to IFSRA’s approval process for promoters and prime brokerage agreements. The Irish funds industry is optimistic that IFSRA will be amenable to these proposals.
It is interesting to note that it is largely in response to Ireland’s success in the regulated hedge fund industry that Luxembourg has finally introduced its own rules applicable to hedge funds and funds of hedge funds. This onus is now back on IFSRA to maintain Ireland’s lead over Luxembourg in the industry.
The Cayman Islands has long been the leading jurisdiction for hedge funds, having a very quick legal process and like Ireland, local service providers that have a high level of experience and expertise.
Although hedge funds in the Cayman Islands are subject to a degree of regulation, this regulation is generally non-intrusive, with no restrictions on investment objective, investment policies, rates of return, identity or location of service providers. As a result it is normal for a promoter of a hedge fund seeking regulation to choose Ireland as the domicile of choice for its hedge fund rather than the Cayman Islands.
Hedge funds and the use of alternative investment strategies are today rightly viewed as a critical component of portfolio diversification. With the continuing initiatives and developments being proposed by IFSRA and the Irish fund industry itself, there is no reason to believe that further growth cannot be achieved in Ireland with an increased number of hedge funds with prime brokers being established here. The indications are that Ireland is determined to remain at the forefront of the regulated hedge fund industry. |
Paul Farrell is a partner in Matheson Ormbsy Prentice.
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| Article appeared in the May 2003 issue.
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