Post by meeke on Nov 3, 2006 14:59:32 GMT -4
=DJ Fed Official Warns Of Concerns Over Prime Broker Growth
.
By Laurence Norman
Of DOW JONES NEWSWIRES
MIAMI (Dow Jones)--A Federal Reserve official Friday issued a frank warning to Wall Street banks, telling them to tread carefully in their dealings with hedge funds amid the recent growth of the fixed income prime brokerage industry.
Michael Nelson, vice president and counsel at the New York Fed, warned regulators have a number of concerns with the rapid expansion of fixed income prime brokers, which offer financing and a variety of back-office services to hedge funds.
High on the list of concerns is a prime broker's ability to handle the surges in trading volumes that can result from acting as a broker for the hedge fund industry.
Prime brokerage can be a money maker, he acknowledged, but that does not mean an entity is "prepared for a spike in volume and (for) how you're going to handle that."
He said those entities that already have trouble "confirming and operationally handling trades" are "probably not going to be a good prime broker."
"Your firm should be careful and prudent when it comes to starting a prime brokerage businesses," Nelson said during a panel discussion at a conference on fixed income securities operations hosted by the Securities Industry and Financial Markets Association in Miami.
The stern warnings come in the wake of the financial industry's struggles to deal with the explosion in credit derivative trades in recent years. Regulators, including the New York Fed - the Fed's point bank for market operations - stepped in last year to corral the industry into cleaning up a massive backlog of unsettled trades amid concerns that this could undermine the stability of the financial system.
Those concerns are also behind Nelson's warnings to the prime brokers. This is an issue that is not "going to disappear." It will be "even more on the agenda in the coming year and in the coming years," he said.
Nelson's comments come in the context of broader consideration of whether the hedge fund industry - which now boasts 8,000 funds with some $1.2 trillion in assets under management - needs regulating and what should be done in this regard.
New York Fed President Timothy Geithner said recently he does not believe direct regulation is appropriate at this stage, although that may change in the future. Members of Congress have also upped their scrutiny on the issue.
Must Say No
In his comments, Nelson outlined a series of other concerns about the prime broker fixed income industry. He said that in the intensely competitive bid to capture hedge fund business, it is important "we don't see a race to the bottom" where firms "lose perspective" and relax controls to win business.
"People say prime brokers never give up a trade," he said. As a regulator, "that's precisely when I prick up my ears." Prime brokers must be prepared to say "no, I'm not taking over that trade" and to work out in advance when that response is appropriate.
In this context, he noted that many firms maintain separate prime broker units who go out and seek business. He said there must be a dialogue between the prime broker unit and others in the firm to ensure firms do not take on business or commitments they are not well placed to handle.
Nelson said the fact that hedge funds do business with several prime brokers also raises questions for the latter since it means a bank very often cannot ask to see a hedge fund's complete book. Consequently, while a prime broker's direct business with that hedge fund may be very safe, the broker could still be exposed to much riskier business a hedge fund may be conducting through another prime broker.
This is "something I hope that firms are worrying about. That's something that we certainly worry about at the New York Fed," Nelson said, while acknowledging that this is not a problem specific to fixed income prime brokers.
With hedge funds also sometimes able to trade in a prime broker's name, banks should also think about reputational risk.
Need To Improve Prime Brokers' Documentation
Nelson said regulators also have concerns about documentation issues, where fixed income prime brokers lag behind others in the industry, for example, those in the foreign exchange business.
"I'm not sure that documentation really describes what's going on and makes it transparent," so that management and industry supervisors know what "really is happening."
The documentation should spell out the risks of a prime broker's exposure to a hedge fund.
He also said regulators are concerned about the "inconsistency...and lack of transparency" over precisely when a trade's risk is transferred between the prime broker, its client and the executing bank for a trade.
Nelson's concerns met a receptive ear in Jim Hraska, senior vice president, global financing and prime services at Lehman Brothers.
He acknowledged the pressures on prime brokers to deliver an array of services to the ballooning hedge fund industry, noting that it's estimated hedge funds will have $2 trillion under management in the next two years.
It's important to win business "but you also don't want to be held prisoner" by clients, he said.
He said prime brokers have "had to actually pull the reins back a little bit" over the past couple of years.
"We can't just be yes men any more to our clients..." It's okay to push back" sometimes, he said.
-By Laurence Norman, Dow Jones Newswires, 201-938-2096; laurence.norman@dowjones.com
(END) Dow Jones Newswires
November 03, 2006 13:49 ET (18:49 GMT)
Copyright (c) 2006 Dow Jones & Company, Inc.- - 01 49 PM EST 11-03-06
.
By Laurence Norman
Of DOW JONES NEWSWIRES
MIAMI (Dow Jones)--A Federal Reserve official Friday issued a frank warning to Wall Street banks, telling them to tread carefully in their dealings with hedge funds amid the recent growth of the fixed income prime brokerage industry.
Michael Nelson, vice president and counsel at the New York Fed, warned regulators have a number of concerns with the rapid expansion of fixed income prime brokers, which offer financing and a variety of back-office services to hedge funds.
High on the list of concerns is a prime broker's ability to handle the surges in trading volumes that can result from acting as a broker for the hedge fund industry.
Prime brokerage can be a money maker, he acknowledged, but that does not mean an entity is "prepared for a spike in volume and (for) how you're going to handle that."
He said those entities that already have trouble "confirming and operationally handling trades" are "probably not going to be a good prime broker."
"Your firm should be careful and prudent when it comes to starting a prime brokerage businesses," Nelson said during a panel discussion at a conference on fixed income securities operations hosted by the Securities Industry and Financial Markets Association in Miami.
The stern warnings come in the wake of the financial industry's struggles to deal with the explosion in credit derivative trades in recent years. Regulators, including the New York Fed - the Fed's point bank for market operations - stepped in last year to corral the industry into cleaning up a massive backlog of unsettled trades amid concerns that this could undermine the stability of the financial system.
Those concerns are also behind Nelson's warnings to the prime brokers. This is an issue that is not "going to disappear." It will be "even more on the agenda in the coming year and in the coming years," he said.
Nelson's comments come in the context of broader consideration of whether the hedge fund industry - which now boasts 8,000 funds with some $1.2 trillion in assets under management - needs regulating and what should be done in this regard.
New York Fed President Timothy Geithner said recently he does not believe direct regulation is appropriate at this stage, although that may change in the future. Members of Congress have also upped their scrutiny on the issue.
Must Say No
In his comments, Nelson outlined a series of other concerns about the prime broker fixed income industry. He said that in the intensely competitive bid to capture hedge fund business, it is important "we don't see a race to the bottom" where firms "lose perspective" and relax controls to win business.
"People say prime brokers never give up a trade," he said. As a regulator, "that's precisely when I prick up my ears." Prime brokers must be prepared to say "no, I'm not taking over that trade" and to work out in advance when that response is appropriate.
In this context, he noted that many firms maintain separate prime broker units who go out and seek business. He said there must be a dialogue between the prime broker unit and others in the firm to ensure firms do not take on business or commitments they are not well placed to handle.
Nelson said the fact that hedge funds do business with several prime brokers also raises questions for the latter since it means a bank very often cannot ask to see a hedge fund's complete book. Consequently, while a prime broker's direct business with that hedge fund may be very safe, the broker could still be exposed to much riskier business a hedge fund may be conducting through another prime broker.
This is "something I hope that firms are worrying about. That's something that we certainly worry about at the New York Fed," Nelson said, while acknowledging that this is not a problem specific to fixed income prime brokers.
With hedge funds also sometimes able to trade in a prime broker's name, banks should also think about reputational risk.
Need To Improve Prime Brokers' Documentation
Nelson said regulators also have concerns about documentation issues, where fixed income prime brokers lag behind others in the industry, for example, those in the foreign exchange business.
"I'm not sure that documentation really describes what's going on and makes it transparent," so that management and industry supervisors know what "really is happening."
The documentation should spell out the risks of a prime broker's exposure to a hedge fund.
He also said regulators are concerned about the "inconsistency...and lack of transparency" over precisely when a trade's risk is transferred between the prime broker, its client and the executing bank for a trade.
Nelson's concerns met a receptive ear in Jim Hraska, senior vice president, global financing and prime services at Lehman Brothers.
He acknowledged the pressures on prime brokers to deliver an array of services to the ballooning hedge fund industry, noting that it's estimated hedge funds will have $2 trillion under management in the next two years.
It's important to win business "but you also don't want to be held prisoner" by clients, he said.
He said prime brokers have "had to actually pull the reins back a little bit" over the past couple of years.
"We can't just be yes men any more to our clients..." It's okay to push back" sometimes, he said.
-By Laurence Norman, Dow Jones Newswires, 201-938-2096; laurence.norman@dowjones.com
(END) Dow Jones Newswires
November 03, 2006 13:49 ET (18:49 GMT)
Copyright (c) 2006 Dow Jones & Company, Inc.- - 01 49 PM EST 11-03-06