High Line Advisors LLC

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Posts Tagged ‘risk management

Out of the Shadows: Central Clearing of Repo

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High Line Advisors has published a white paper entitled Out of the Shadows: Central Clearing of Repo – A Transparent Market Structure for Cash Borrowers and Lenders.

“Although personally I am quite content with existing explosives, I feel we must not stand in the path of improvement.” — Winston Churchill

Article at a Glance

Repurchase agreements (repo) are the largest part of the “shadow” banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic. Just as depositors can make a “run” on a bank, repo lenders can take their money out of the market, thereby denying the lifeblood of cash to broker-dealers (stand-alone or those owned by banks or bank holding companies), which rely on leverage to operate.

The entire shadow banking system has been demonized as a place where loans are hidden within derivatives among nonbank counterparties rather than displayed on the balance sheets of traditional, regulated banks. In reality, the shadow banking system is a legitimate market for secured financing, in which cash is lent in exchange for collateral. Repo in particular has many positive attributes, including disclosure on the balance sheet; nevertheless, the financial crisis exposed several flaws in the secured financing markets in general and repo in specific, and the Federal Reserve System ultimately interceded with liquidity to prevent the further collapse of banks and broker-dealers.

While not categorized as a “derivative,” repo is an over-the-counter (OTC) contract that shares many key characteristics with derivatives, including a reliance on its counterparts to meet obligations over time. The inability of regulators to measure activity in OTC derivatives resulted in the passage of the Dodd-Frank legislation, which requires that certain instruments be moved to a central counterparty clearing house (CCP). As the nexus of all trades, a CCP provides visibility to regulators and credit intermediation for all market participants.

The benefits of central clearing are directly applicable to the repo market and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike. Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.

Central clearing of repo can also provide capital efficiency and more stable funding for banks and broker-dealers. Ultimately, a CCP for repo can evolve into a hub of funding activity for many forms of liquid collateral, thereby bringing the majority of the shadow banking system into full view.

Download a PDF of the article here.

Streamlining Equities

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High Line Advisors has published an article entitled Streamlining Equities: Ten Operating Strategies for Competing in Today’s Markets. A PDF of the article is available here.

“Whosoever desires constant success must change his conduct with the times.” — Niccolo Machiavelli

Article at a Glance

Equity sales and trading (“Equities”) is a core business for many banks and broker-dealers, on its own merits and because of its synergies with corporate banking and wealth management. Like all capital markets businesses, Equities under increasing pressure from electronic trading, reduced leverage, increased capital requirements, regulation of over-the-counter derivatives, and limitations on proprietary trading.

New operating conditions call for a leaner operating model to protect revenue and maintain growth, starting with a reevaluation of the product silos that require so many specialists. Profitability also depends on the firm’s ability to deliver resources to clients and capture trades with greater efficiency. Success requires re-thinking the entire legacy organization, looking at new ways to combine or expand roles, and reevaluating the skills that are needed on the team.

These ten initiatives in sales, trading, and operations, can help management streamline the Equities organization for greater top line revenue and increased operating leverage:

  1. Recast “Research Sales” for delivery of all products and firm resources
  2. Create “Execution Sales” to maximize trade capture across products
  3. Rebalance Coverage Assignments to foster team selling for client wallet capture
  4. Fortify Multi-Product Marketing to maximize product penetration and client wallet share
  5. Deploy Sector Specialists to generate alpha and raise internal market intelligence
  6. Implement a Central Risk Desk to consolidate position management and client coverage
  7. Merge Secured Funding Activity to manage collateral funding and risk
  8. Centralize Structured Products to eliminate redundancy and internal conflict
  9. Reengineer Client Integration for speed and control of non-market risks 
  10. Normalize Client Service to eliminate duplicate processes and improve client experience

Collateral Management: Best Practices for Broker-Dealers

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High Line Advisors has published an article entitled Collateral Management: Best Practices for Broker-Dealers. A PDF of the article is available here.

col•lat•er•al (noun)
something pledged as security for repayment of a loan, to be forfeited in the event of a default.

col•lat•er•al dam•age (noun)
used euphemistically to refer to inadvertent casualties among civilians and destruction in civilian areas in the course of military operations. — Oxford American Dictionary

Article at a Glance

Stand-alone broker-dealers, as well as those operating within banks and bank holding companies, face increasing pressure to minimize costs and balance sheet footprint. Collateral management is a set of processes that optimize the use and funding of securities on the balance sheet. For a broker-dealer, sources of collateral include securities purchased outright, as risk positions or derivatives hedges, and securities borrowed. Additional securities are obtained through rehypothecation of customer assets pledged in principal transactions such as repurchase agreements (repo), margin loans, and over-the-counter (OTC) derivatives. This pool of securities is deployed throughout the trading day. At the close of trading, the remaining securities become collateral in a new set of transactions used to raise the cash needed to carry the positions. Poor collateral management leads to excessive operating costs, and, in the extreme, insolvency.

A disciplined trading operation aims to be “self-funding” by borrowing the cash needed to run the business in the secured funding markets rather than relying on corporate treasury and expensive, unsecured sources such as commercial paper and long-term debt. The funding transaction may be with other customers, dealers, or money market funds via tripartite repo. Careful management of the settlement cycle for various transactions allows a broker-dealer to finance the purchase of a security by simultaneously entering into a repo, loan, or swap on the same security or other collateral.

Many aspects of secured funding and collateral management are common to all trading desks. A centralized and coordinated collateral management function supports the implementation of several best practices and provides transparency for control groups and regulators. Regulation and increased dealings with central counterparty clearing arrangements will soon increase capital and cash requirements imposed on broker-dealers. Even in advance of such changes, customers are placing restrictions on the disposition of their assets and limitations on the access granted to broker-dealers. This trend makes it more critical for dealers to optimize their remaining sources of funding.

Note that the prime brokerage area of a bank or broker-dealer is in the best position to manage the collateral pool as a utility on behalf of the entire global markets trading operation. For more detail, see “The Future of Prime Brokerage,” High Line Advisors LLC, 2010. Figure 1 from the article is provided below. A print-quality PDF may be downloaded from our website here.

Collateral Management for Broker-Dealers

Finding New Revenue Opportunities

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[part of a series on hedge fund sales coverage]

Existing client revenues may be sustained or even increased in a bull market, but a firm stands a better chance of achieving growth even in bear markets if planning is deliberate and focused on specific opportunities. Fortunately, new revenue opportunities may be found through direct client feedback and some basic marketing.

Sales managers need a minimum amount of useful data that can be acted upon for maximum impact on revenue. A practical client plan must be succinct, easily prepared and easily understood. The planning must be done by the salespeople who know the client best, but supported by data and standards for comparison. Many client planning processes either have too little data or become frustrated in their attempts to collect too much detail. At one extreme, plans based on salesperson intuition are not robust and may be clouded by incentives. At the other extreme, it is impossible to collect precise data from clients who are unwilling to disclose the details of their product utilization or spending to the broker community as a whole. Industry-wide surveys and fee pools may be directionally useful but are not specific enough to optimize the unique relationship between an individual broker and client.

Developing Client Plans

In our experience, a basic but useful client plan consist of three items: an organization chart of the client at the fund level, a budget showing revenue expectation at the product level), and one or more action items required to achieve the budget.

At a minimum, an organization chart for an institutional investor should indicate:

  1. assets under management (using size as a rough proxy for revenue potential)
  2. allocation of assets among various investment strategies (using strategy as an indicator of product and resource needs)
  3. decision makers for each strategy (to identify whom to target for relationship building)

It is best to ask the client directly rather than to rely on assumptions that may be incorrect or incomplete. A map of the client organization can expose any misconceptions regarding their investment activity and lead to the discovery of new revenue opportunities. For example, a convertible bond salesperson may not register that the client also has a distressed equity fund until the salesperson is asked to map the entire client organization. The investment strategies used by the client immediately suggest product utilization, which can be confirmed in subsequent discussions with the client. Existing relationships can provide the introductions needed to open up new trading lines. Simply “connecting the dots” in this way does not require elaborate planning and can yield immediate results.

The next step is to identify potential for revenue improvement. We suggest that detailed knowledge of a client’s wallet are not necessary to manage a successful sales effort. Instead, only a few key pieces of information are needed, and these may be readily extracted from the clients themselves:

  1. What is the firm’s rank with the client? For each product the client trades (i.e., single stock cash), where does the client currently rank the firm? #1? Top 3? Top 5? First tier? Second tier? Allow the client to define the way they rank their brokers.
  2. Is it possible for the firm to do better? (i.e., move up in the client’s ranking).
  3. If so, what would be required? Ask the client what actions it will take for the firm to move up. This can be anything from senior management attention, more outgoing calls from analysts, changing sales coverage, or raising capital. These become the action items.
  4. What would it be worth to the firm? Ask the client to estimate the incremental revenue opportunity to the firm in each product if the the actions are taken. The sum of historical revenues plus these incremental amounts becomes the client budget.

The questions may be posed by sales people or independent persons or who are not conflicted over critical feedback. It is in the interest of the client to answer these questions, as they seek honest feedback and express a willingness to improve. Once the feedback is provided, an implicit contract is created between the client and the firm that if requirements are met, revenues will follow. It is equally important to find out if the client intends to reduce product trading, or if there is no way for the firm to do better.

When combined with historical revenues, the answers to these questions comprise a business plan for the client: prior revenues (reflected in the initial segmentation) may be adjusted by the amounts indicated by the client as potential increases or expected decreases. The plan must also document the actions or resources needed to achieve the budget. Clients with greater potential for increased revenues may receive higher tiering in the next iteration of client segmentation than suggested by their historical revenues alone.

Marketing From a Product Perspective

While the interview process seeks to uncover opportunities from a client perspective, a product-driven process can yield additional results. Each product area should have its own view of the client base that covers existing clients as well as prospects, and the priorities of the product areas can be represented in the segmentation discussion. A two-pronged analysis that covers the market from both client and product perspectives leads to a more thorough capture of opportunities. The matrix approach also improves governance.

The “product walk-across” report is very powerful for highlighting new revenue opportunities arising from introducing a client to additional products. Some opportunities are suggested by gaps in expected trading patterns: for example, hedge funds that trade ETFs may be candidates to trade index swaps; clients who trade cash and options in the U.S. but cash only in Europe are candidates to trade European options; clients who trade cash electronically may also be candidates to trade options the same way; macro investors who trade futures may be candidates to trade ETFs. Products that are similar or interchangeable may be new to the client or simply traded with another broker.

Product marketing is a process of identifying target clients and managing a concerted effort or “campaign” to introduce the targets to the product. Product marketers can identify candidates from gaps in the multi-product revenue report, and also draw from anecdotal market information and industry surveys that highlight clients who are known to trade in specific products with other brokers.

Clients are more likely to try a new product if it solves a problem for them. The product on its own merits may be undifferentiated, but the broker may be able to add value by identifying an application for the product in the client’s portfolio. Solutions-based marketing creates “demand-pull” which can superior to “product-push” in stimulating or accelerating product utilization. Clients are also more likely to take a meeting on portfolio themes than product presentations. Common thematic campaigns include risk management and hedging, emerging markets access, and tax efficiency.

The opportunities uncovered though product marketing may be cross-referenced and added to the client plans. The product-driven effort may reinforce findings from client interviews, but should also find potential opportunities that the client itself may not have recognized, as well as identifying clients who are not otherwise covered by existing relationships.

Rules of Prime Brokerage Risk Management

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We’ve assembled a list of guiding principals for managing risk in a prime brokerage business, covering the areas where prime brokers are most likely to get into trouble. We encourage the community to contribute to or debate this list. Anonymous contributions may be emailed to feedback@highlineadvisors.com.

  1. Margin Lending: Don’t finance what you don’t trade. If you don’t have price discovery or can’t orchestrate a liquidation of the collateral, don’t make the loan.
  2. Margin Lending: Lend against assets, not credit. The ability to value collateral should be a core competency of any prime broker or repo desk, while expertise in credit extension (unsecured lending) is not. Be aware of the boundary between secured and unsecured risk, as lower margin buffers increase credit exposure in extreme (multi-sigma) market events. If you don’t have possession (custody) of the asset, don’t finance it.
  3. Margin Lending: Finance portfolios, not positions. Diversification of collateral is a significant risk mitigator.
  4. Margin Lending: Accept everything as collateral, but don’t necessarily lend against it. Cover your tail risk with a lien on anything you can get, but don’t add to the problem by lending against less liquid positions.
  5. Margin Lending: Be aware (beware) of crowded trades. The liquidity assumptions used to determine margins may be insufficient when like-minded hedge funds simultaneously become sellers of the stock. This goes beyond positions in custody, but those held by other prime brokers as well. Ownership representations are reasonably required.
  6. Secured Funding: Eliminate arbitrage among similar products. Maintain consistent pricing and contractual terms when borrowing securities or entering into swaps, repos, margin loans, or OTC option combinations with customers.
  7. Customer Collateral: Accept only cash collateral for derivatives. If non-cash collateral is offered, convert it to cash (via repo), apply only the cash value against the requirement, and charge for the cost of the conversion. Cash debits and credits are the best way to manage margin/collateral requirements across multiple products and legal entities.
  8. Contractual Terms: Treat clients that do not permit cross-default or cross-collateralization among accounts as if they were as many distinct clients. If you can’t net or offset client obligations, don’t give margin relief for diversification.
  9. Derivatives Intermediation: Do not provide credit intermediation unless you understand credit risk (again, most prime brokers do not) and charge accordingly. When intermediating derivatives operations, do not inadvertently insulate customers from the credit of their chosen counterparties.
  10. Funding Sources: Raise cash from collateral, not corporate Treasury. Strive to be self-funding, raising cash lent to customers from securities pledged by customers. Practice “agency” lending (from cash raised from customer collateral) over “principal” lending (from unsecured sources of cash, like commercial paper).
  11. Term Funding Commitments: Don’t be the lender of last resort unless you understand what it means, want to do it, and get paid properly for it. Only the largest banks with substantial cash positions under the most dire circumstances may be in a position to offer unconditional term funding commitments. Does any broker-dealer qualify?
  12. Sponsored Access: Have robust controls for high-frequency direct market access, including gateways to enforce trading limits.
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