Hedge Funds Turning to Prime Brokerage Trust Affiliates for Added Protection Against Prime Broker Insolvencies
Hedge Fund Law Report
The Chapter 11 filing last September 15 of the Lehman Brothers holding entity, and the initiation of insolvency proceedings four days later with respect to the Lehman broker-dealer affiliate, woke hedge fund managers up to previously underappreciated risks – the risks that their prime broker could fail, and that such failure could limit or restrict their funds’ access to assets held at the prime broker. The near failures of Bear Stearns prior to the Lehman filings, and of Merrill Lynch after the filings (staved off at the last moment by, respectively, J.P. Morgan Chase and Bank of America), only enhanced the perception among hedge fund managers of prime broker fallibility. Recognizing the ubiquity of counterparty risk concerns among their base of clients and potential clients, and in an effort to win back as many as possible of the assets that fled in late 2008, at least one prime broker is offering a service that incorporates an independent custody concept into a single prime brokerage relationship. We offer a detailed discussion of this novel approach to prime brokerage, highlighting the specific manner in which such an arrangement can minimize counterparty risk, but also emphasizing the limits of the approach as a risk-mitigation technique, and other potential drawbacks.