Prime brokerage is a system that full-service firms have developed to clear and settle trades for active market participants. Neuberger Berman created the first prime brokerage in the early 1950s to service the first hedge fund, founded by Alfred Winslow Jones. U.S. securities regulations, however, took no notice of this now very prominent feature of the financial markets until 1994. In that year, the U.S. Securities and Exchange Commission stated that it would not recommend action under certain securities laws provided that business was conducted in accordance with specified conditions.
J.S. Aikman’s new book has the commercially astute title When Prime Brokers Fail, which capitalizes on systemic risk fears generated by the global financial crisis that began in 2008. Chapters 1 and 13 deal directly with the repercussions of those traumatic events. The remainder of the book is mostly a manual on prime brokerage, from securities lending and financing to legal and compliance considerations.
Understanding these nuts-and-bolts matters has assumed greatly increased importance since the collapse of Lehman Brothers. Notes Aikman, “Traditionally, prime brokers have been concerned about hedge funds blowing up, not the other way around.” From the client’s viewpoint, knowing whether one’s assets are properly segregated and accounted for—and, in today’s global marketplace, what the governing regulatory regime will be in the event of a failure—is essential.
A consultant to money managers and financial institutions, Aikman covers his subject with encyclopedic thoroughness. He helpfully includes a glossary, an extensive bibliography, lists of prime brokers and securities lenders, and a due diligence questionnaire for prime brokers. In addition to offering hedge funds valuable guidance on selecting a prime broker, he provides investors with tips for selecting a hedge fund.
Even readers who know their way around the financial markets will make some arresting discoveries in When Prime Brokers Fail. For example, they may be surprised to learn that, by some estimates, outstanding over-the-counter derivatives now exceed $1 quadrillion, a figure more than 100 times larger than the amount of the listed variety found on the world’s largest stock exchange. Many readers are probably also unaware of the difficulties that can arise in voting on corporate actions when stocks have been used for securities lending. A related issue involves attempts by activist hedge funds with major derivatives positions to induce changes in companies’ management, given that the companies are obligated only to hear and address shareholders’ concerns.
Tighter editing would have eliminated such minor flaws as the discussion of hypothecation well before the term is defined (as “the client’s pledge to allow collateral to be used to satisfy any outstanding debt”). Such quibbles aside, When Prime Brokers Fail has immense practical value, given the stakes. Not only are claims to assets imperiled by bankruptcies of financial institutions, but also, as demonstrated by the Madoff scandal, assets can vanish altogether in a large-scale fraud that escapes the detection of market supervisors. At a minimum, it behooves investors and fiduciaries to know the right questions to ask regarding reliability and financial soundness when dealing with a prime broker or any other intermediary.
—M.S.F.