Leading prime brokerages are preparing to hit clients with across-the-board increases in the cost of trading, which could dry up liquidity and cause niche global markets to shut down.
The brokerages – which execute trades and provide financing for the $2tn hedge fund industry – are facing new liquidity and capital requirements as a result of Basel III banking regulations. These are being brought in between now and 2018, with the first batch of rules to be enforced by the end of this year.
The Financial Times has spoken to top brokers including Goldman Sachs, Morgan Stanley, JPMorgan and Deutsche Bank, all of which confirmed they were preparing to price in increases to the cost of funding and pass them on to hedge fund clients in the coming months.
“We are having regular in-depth meetings with clients and the common theme is the impact of the new regulatory regime on financing and on trading,” said Louis Lebedin, global co-head of prime brokerage at JPMorgan. “The Basel III rules recognise the importance of balance sheets, capital and funding and are forcing all firms to meet the same requirements.”
Even for relatively simple “plain vanilla” hedge fund strategies, such as trading equities, the new rules are likely to result in higher costs.
For more esoteric programmes, or those that use leverage, the impact could be far greater.
“Things that qualify as tier III [hard to value] assets or that can’t be re-lent in the secured market are likely to become more expensive to finance across the market,” said Barry Bausano, head of equities for the Americas at Deutsche Bank.
According to the global head of one top-five prime brokerage, the new rules may “kill” some markets altogether.
Trading in mortgage-backed securities, for example, will become much more difficult for hedge funds to engage in, causing concern for some that liquidity in the market, which is only just beginning to recover and is seen as crucial for a recovery in property prices, could evaporate.
Even relatively mainstream hedge fund strategies, such as convertible bond arbitrage, are likely to suffer as a result of the new higher financing costs.
“Gone are the days when people weren’t held accountable for the amount of funding they draw down from their central treasury, gone are the days of free balance sheet. We have to justify the return on the balance sheet we use,” said Nick Roe, global head of prime finance at Citigroup.
“Some of the pricing that exists right now is unrealistic,” he added.
No brokerage has, as yet, wanted to be the first to increase trading costs.
“Largely this has not been passed on,” said Jack Inglis, managing director at Barclays prime services, adding that the bank was assessing its book on a “client by client” basis.
“There is no one price fits all,” he said.