Smaller, self clearing brokers face hedge fund exodus in 2012

Dec 08, 2011 by Charles Gubert

Smaller, self-clearing brokers with proprietary and principal trading operations could find themselves losing a large chunk of their remaining hedge fund client base come the New Year, it has been warned.

The demise of MF Global earlier in the fall has re-awakened managers to counterparty risk. Furthermore, the increased credit default swap (CDS) spreads of other smaller, self-clearing brokers has alarmed hedge funds and raised questions about their future viability. Bulge bracket investment banks such as Goldman Sachs, Credit Suisse, Deutsche Bank and JP Morgan look set to be beneficiaries of this hedge fund exodus.

“Since MF Global, smaller brokers, which self-clear and have prop desks have been losing clients steadily since November. However, I know a lot of hedge funds are waiting until January or February next year to leave as the threat of default at these institutions is fairly low in the short-term and managers do not want to overhaul their operations immediately. However, a lot of hedge funds are going to be starting fresh with new prime brokerage relations in the new year,” said an industry expert.

Risk management policies at these brokers have faced increased scrutiny from numerous clients – not just hedge funds. Revelations that MF Global had bet $11.5 billion on European sovereign debt despite reservations from directors, senior traders and risk managers, predictably set off alarm bells in many operational due diligence departments globally. The MF Global saga is just the latest setback for mid and small tier, self-clearing brokers. Large investment banks have steadily terminated clearing agreements with these institutions due to concerns over risk.

“Institutional investors and hedge funds don’t want their assets in a broker that is a potential MF Global. They want to ensure assets are safe and sound. In this tough capital raising environment, hedge funds have little choice other than to oblige to what their investors want. The amazing thing is a lot of these smaller brokers don’t know that an exodus is going to come in 2012,” said the expert.

While some anticipate these developments could spell an end for such institutions, there is reason for optimism. “There will be short-term pain for smaller brokers but I suspect a lot of them will just reinvent themselves as standalone trading firms. This might actually help them survive over the longer-term,” added the expert.

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