Prime broking braced for new era after Archegos collapse
Credit Suisse’s decision to exit the business highlights how the industry that serves hedge funds is changing
On an overcast morning in early 2016, the then Irish Taoiseach Enda Kenny opened Credit Suisse’s new trading floor in Dublin and declared that the city had joined “a small club of trading locations worldwide”.
The office would serve as the trading hub for the Swiss bank’s global prime broking division, a business that helps grease the wheels of hedge fund clients by lending them money and stock to execute trades.
But almost six years later, hopes that Dublin could grow into a significant outpost in the bank’s global operations have evaporated.
Instead the future of the office and its 90-strong staff have been swept up in the fallout from the collapse of Archegos Capital, an obscure family office whose demise left its prime brokers with $10bn in losses and the wider industry confronting its biggest upheaval since the global financial crisis.
European and US banks have long used prime broking, a business with steady if unspectacular returns, as a way of forging more lucrative relationships with hedge funds and, in smaller numbers, family offices.
Archegos, run by Bill Hwang, an alumnus of legendary hedge fund Tiger Global, was one such client. By the time it was incinerated over a weekend in late March, Archegos counted several of the world’s largest banks, including UBS and Morgan Stanley, as prime brokers.
The $5.5bn trading loss Credit Suisse suffered was the worst in its 165-year history, stinging the bank into action. Last week the lender said that it would all but exit a business it has been in since 1996.
While the bank was the highest-profile casualty, prime broking executives and industry analysts say the consequences of Archegos could yet prove far reaching, with regulators considering tougher rules and smaller players reassessing whether the business is still worth it.
“The immediate impact from Archegos has been much more concentration of business in the hands of the biggest prime brokers,” said Youssef Intabli, research director at Coalition Greenwich, which tracks investment banking trends.
“Hedge funds have chosen banks that are reliable and are good in risk management, offer a range of products and have very strong execution. Smaller and more niche players have lost out,” he added.
Japanese bank Nomura, the second-hardest hit from the Archegos debacle with losses of $2.9bn, has also bid a retreat. The lender decided to pull out of offering cash prime broking in Europe and the US this summer, though it will continue to provide the services in Japan.
“The balances you need to make this business profitable suggest we will be left with just seven or eight global players after Archegos has shaken through the market,” said one investment banker who oversees a prime brokerage.
“There will be the Wall Street giants, plus two or three from Europe, and that will be it. No one else will be able to compete at that scale,” they cautioned.
The three market leaders — JPMorgan, Morgan Stanley and Goldman Sachs — oversee as much prime broking assets as the next nine players combined, according to Coalition data.
The scale of the damage wrought by Archegos sprang from a reckless use of leverage. Hwang persuaded several investment banks to extend billions of dollars in credit to the family office to juice up its concentrated bets on US and Chinese stocks.
Its use of a type of derivative known as total return swaps ensured that none of the prime brokers knew how exposed each other was to Archegos.
It is an area that industry executives expect regulators to home in on. The Federal Reserve and the UK’s Prudential Regulation Authority are assessing whether to introduce more stringent oversight.
Credit Suisse’s prime broking business straddled its headquarters in Zurich, its two main investment bank centres in New York and London, and Dublin, where the bank won Ireland’s first ever “third country branch” licence which enabled it to operate there with limited local supervision.
“Any time you have this kind of thing . . . all the dials get turned up to 10,” said a regulatory expert at one investment bank. “The amount of oversight that goes into this, internal from the board and from the regulator, is going to be high.”
For the banks who offer prime broking, particularly the smaller ones, there is a hard-nosed decision on whether the business is still attractive given the slim revenues it generates.
“You’re not expecting to make a tonne of money directly, but it is supposed to allow you to deepen the relationship with the client,” said the head of another investment bank that has a prime broking division. “It’s the anchor for the relationship, but it doesn’t make sense to offer it by itself.”
Credit Suisse, for example, earned just $16m of revenue in 2020 from its relationship with Archegos. Despite acknowledging that quitting prime broking would hurt its equities capital markets division as hedge fund clients no longer used other services, Credit Suisse said its balance sheet could be more profitably deployed.
Chief financial officer David Mathers said these were sacrifices it was willing to make to focus more squarely on wealth management, which had little overlap with the prime business.
“We are making a very deliberate strategic decision to exit a business which has very high leverage, is highly transactional in nature and has a very high degree of complexity,” he said last week. “I think it’s exactly the right thing to do.”
Credit Suisse said exiting prime broking would cost it $600m in revenues but be offset by $400m of cost savings. Analysts at Berenberg estimate the move will result in a 4 per cent hit to the group’s revenues in 2023.
While the Archegos scandal has cast a shadow over prime broking, some banks are undeterred and trying to capitalise.
French lender BNP Paribas, which has long aspired to be one of the top three in an industry dominated by Wall Street, has been picking up hedge fund clients from Credit Suisse over the past six months, according to bankers at several different lenders.
“If you have a strong prime business, you not only service hedge funds’ equities needs, they can also do credit, rates and foreign exchange trading with you,” said Olivier Osty, head of global markets at BNP Paribas’ investment bank. “This halo effect is really key.”
Credit Suisse this week struck a deal recommending its clients transfer to BNP, which bought Deutsche Bank’s prime finance unit two years ago. The French lender expects to capture up to half of Credit Suisse’s prime assets, enough, it hopes, to overtake Barclays in the rankings.
“A lot of Credit Suisse clients said they already had [relationships with] two US banks, and they needed some diversification. So the biggest beneficiary has been the old Deutsche business that is now owned by BNP, and to a lesser extent UBS,” said a London-based executive at a US bank. “The fallout has really helped the other Europeans.”
If the windfall for some rivals from Credit Suisse’s exit has been sudden, any changes to how the industry is regulated are likely to be slower.
Weeks following the collapse of Archegos, Federal Reserve chair Jay Powell voiced concern at the scale of losses “in a business that is generally thought to present relatively well understood risks”.
Seven months later, the Fed’s examination of the episode is ongoing. In the UK, the PRA said it has been talking to firms and other regulators as “part of our ongoing supervisory approach” since the banks revealed the losses.
Swiss regulators started enforcement proceedings against Credit Suisse over risk management failures and ordered short term fixes, including a capital surcharge. A spokesman for the regulator, Finma, declined to comment on the case.
As regulators in Japan also weigh up changes, industry executives anticipate any new rules will force more transparency in trades, especially when dealing with derivatives.
“It’s a very specific business with a very specific risk, where you don’t exactly know the size of the risk and funding footprint of your client,” said the head of one investment bank. “It’s virtually the only area in banking where you don’t know everything your clients are doing.”
Hedge funds learn the hard way in bonds shock
Mayfair set should believe policymakers who say it is not their job to look after them
Few will shed a tear for the travails of the Mayfair set, and nor should they. Of late, many macro hedge fund managers who seek to make money out of big economic and monetary shifts have had what can politely be described as a complete nightmare.
To the immense amusement of online meme creators, some of the most prestigious funds in the business bet big on the global interest rate outlook and lost, bigly. Adding insult to injury, the damage stemmed largely from rinky-dink UK government bonds — a crucial pillar of the British financial system but not exactly the glamorous end of the global debt market.
The episode is studded with exasperated traders, multibillion-dollar losses, and frustration that the Bank of England should have the audacity to torpedo Very Serious Bond Bets. If anyone is going to do that, it should be the Fed, surely? The European Central Bank at a push. (As one US investor put it to us this week: “No offence to our British friends . . . But dude, you don’t matter that much. Why are you driving our market?”)
Behind the punctured egos and schadenfreude, however, lies a serious message for investors of all types. In short, it is wise to buckle up.
First, a quick recap on what went wrong. One element is that betting on a turn in the global interest rate environment is hugely popular, and investors often pick hedge funds to do this heavy lifting for them. “Clients are more interested in hedge funds than they have been for four years,” says Peter van Dooijeweert, managing director at Man Solutions at Man Group.
These funds do not really exist to take staid, boring positions. Instead, investors want them to be bold, and they are. “Clients want the volatility,” says van Dooijeweert. “You are hiring them to make you 40 per cent. That means they will have rainy days. Ideally not a deluge that floods the basement, but rainy days.”
The Kremlinology of picking meaning out of central bankers’ statements is a key way for funds to do this — a highly specialised sport of reading between the lines.
Alan Greenspan, chair of the Federal Reserve from 1987 to 2006, was sphinx-like in his comments. As he once famously remarked: “I know you think you understand what you thought I said but I’m not sure you realise that what you heard is not what I meant.”
Jean-Claude Trichet, president of the ECB from 2003 to 2011, operated a system of policy-by-code word. Euro traders and others judged the likelihood of interest rate rises on whether he said inflation warranted “vigilance”, “strong vigilance” or, if he was really worried, “very strong vigilance”.
Some central bankers are better at “speaking markets” than others. Mario Draghi, ECB president through the business end of the Greek debt crisis was il maestro of this art, nudging the euro or European government bond yields higher or lower as desired with knowing references to arcane financial indicators.
Traders felt they knew and trusted him, so when he declared in the summer of 2012 that the ECB would do “whatever it takes” to preserve the euro, they knew he meant it. No details required; just those three little words were enough to put the region’s entire bond market on a steadier footing.
His successor, Christine Lagarde, discovered the hard way that slip-ups can be costly. In one of her first press conferences in the top job, she suggested it was not the ECB’s job to keep the bond market in check. Cue an ugly slide in Italian government bonds, and a rapid apology.
That brings us to Andrew Bailey, governor of the BoE, grappling with the undoubtedly tricky task of seeking to explain what the central bank might, or might not do, in response to a global surge in inflation. Bailey had already signalled rising unease with inflation but in mid-October, he stepped up the tone, saying “we will have to act”.
Sure, there were caveats, ifs and buts, and hints are not promises. Still, this threw gilts in to a bet on imminent rate rises, putting wagers on greater patience through the woodchipper. The punchline: the BoE ended up holding fire in its rate-setting meeting just days later.
This matters beyond the quilted-jackets-and-boat-shoes crowd of hedge fund land for several reasons. One is that the shockwaves that emanated from the gilts market (and arguably also from Australian government bonds) in to Treasuries and Bunds offer a reminder on how interconnected the financial system is.
Another is that while central bankers often say they are not there to help hedge funds make money, market participants often do not believe them. This demonstrates they should.
Very clearly, the overall financial system coped just fine. Policymakers are not trying to shake up markets just for giggles, but as long as financial stability is not compromised, it is not really their problem. This could prove an important point as central banks gradually withdraw their support — a process almost guaranteed to inject volatility. Investors who truly believe policymakers would quickly step in to stop any markets rot might want to think again.
Toshiba board to rule out deal to take whole group private
Japanese industrial conglomerate will propose three-way split following shareholder discontent
Toshiba’s board is poised to rule out pursuing a deal to take the whole company private and is preparing to reveal an alternative plan to split the business in three that some investors say they may reject, according to people familiar with the matter.
A $20bn offer for the conglomerate by UK private equity group CVC in April boosted the share price and it has stayed high since then on hopes Toshiba would go ahead with what would be Japan’s biggest-ever buyout.
But after a rare and successful revolt by shareholders demanding either a buyout deal or a radical restructuring, Toshiba was forced to assemble a special committee to examine options for reducing the company’s hefty “conglomerate discount”.
The committee’s plan, due to be put forward on Friday, would split Toshiba into three companies and leave open the possibility that at least one of the businesses — most probably a company specialising in smaller devices and semiconductors — could be sold to private equity.
One of the three companies, which will predominantly hold Toshiba’s infrastructure, nuclear and heavy engineering operations, along with sensitive technology in areas such as artificial intelligence and quantum computing, is likely to fall under the protection of Japan’s newly tightened Foreign Exchange and Foreign Trade Act.
Another company would operate as an asset management division and hold Toshiba’s 40 per cent stake in Kioxia, the memory business it part sold to private equity group Bain Capital in 2018. The company’s successful office and retail machinery manufacturer, Toshiba Tec, would also be part of this division.
The proposed restructuring of Toshiba, which must win the approval of shareholders at an extraordinary general meeting, is the result of four months of intensive deliberations over how to restore the fortunes of a company that came close to collapse in 2017.
As part of the financial engineering deployed to try and end that period of turmoil, Toshiba issued new shares. A large proportion of these ended up in the hands of activist investors who have proved capable of defeating management in shareholder votes.
Since the plan for the three-way split was leaked this week, nine investors representing about 30 per cent of Toshiba’s share register have told the Financial Times that they found the proposal disappointing and unrealistic.
“If the split is a fallback plan, then it is acceptable but only if it’s after the company starts a sales process [to private equity] and it fails,” said one shareholder.
Several shareholders said they were disappointed that a break-up plan had emerged as the favoured option over selling the entire company to private equity, which some believe would release more value.
“From the little information we have at this point, a three-way split does not sound like something we are going to support. I think there are still going to be investors that won’t believe there isn’t a PE deal out there for the whole company,” said one shareholder.
AQR hedge fund parts with 5 top managers and closes struggling division
Assets have declined by almost half to $137bn at computer-powered investment group
Computer-powered hedge fund group AQR Capital Management is to remove five partners from its ranks and trim its bond arm, continuing to retrench operations after several lean years for many systematic trading strategies.
The $137bn investment group led by Clifford Asness has been a pioneer of “quantitative” investment strategies that attempt to profit from long-term market signals, rather than traditional human traders and fund managers.
AQR’s assets under management peaked at $226bn in mid-2018, but since then many of the main strategies it uses have fizzled, deflating its size and leading to several rounds of job cuts at the Greenwich, Connecticut-based hedge fund manager.
The firm on Thursday announced internally that five of its top executives would be leaving and its bond investing side reorganised, with its struggling “long-only” fixed-income arm that started in 2014 being shuttered altogether, according to people familiar with the matter.
AQR declined to comment on the moves, but Suzanne Escousse, a partner at the firm, said in a statement: “We remain committed to systematically trading fixed income in our long-short, alternative and risk parity strategies as we have done since AQR’s inception.”
The five “principals” were Michael Katz, head of portfolio implementation; Michael Patchen, head of risk; Ari Levine, senior researcher; Scott Richardson, co-head of fixed income research; and Christopher Palazzolo, AQR’s head of responsible investments, said people familiar with the matter. The exits will leave 38 principals at the firm.
Their departures follow the announcement earlier this year that Ronen Israel, a senior principal and 22-year veteran of AQR, would be stepping down to help start a biotechnology company. That led all of AQR’s investment team to report directly to Asness and fellow founder John Liew.
AQR manages a panoply of investment vehicles, ranging from more traditional, expensive hedge funds to cheaper, simpler funds that merely harness one of many of the market “factors” identified by academics over the years. In some respects, this involves quantifying what traditional fund managers have always done, automating it and thus doing it more cheaply.
Systematically buying “value” stocks — cheap and unpopular shares that have historically yielded market-beating gains — has over the past decade suffered its deepest and longest setback, but since 2018 many of AQR’s other strategies started struggling, compounding its woes.
However, many of its main strategies started regaining traction in the last few months of 2020, and the recovery has continued. “While 2018 to 2020 was actually the toughest period I’ve seen yet, the first three months of 2021 have made for one of the strongest starts to a year we have had in our history,” Asness told the Financial Times earlier this year. “I wouldn’t be surprised if this recovery was the biggest and the longest.”
Jay Horgen, the chief executive of Affiliated Managers Group — a listed investment firm that owns a slice of AQR — indicated in a recent conference call that the turnround has continued since then. “We’re encouraged by the turn in performance at our quant managers, notably AQR,” he told analysts. “This represents an asymmetric upside to us.”
Xi set to stay in office until at least 2028
Xi Jinping tightens grip on power, Belarus threatens to cut gas transit to EU, Hong Kong jails protester over political chants
How well did you keep up with the news this week? Take our quiz.
The Chinese Communist party has passed its first “historical resolution” in 40 years, in a development likely to pave the way for President Xi Jinping to stay in office until at least 2028.
The resolution — formally adopted by the party’s central committee at the end of its annual meeting, or plenum, yesterday — declared that Xi’s leadership was “the key to the great rejuvenation of the Chinese nation”, according to a summary published by the official Xinhua news agency.
The central committee typically holds one plenum a year, attended by its 370 full and alternate members at a military hotel on the western outskirts of Beijing. This week’s plenum opened on Monday and is particularly significant because it comes just a year before a party congress will appoint a new leadership team to serve until 2027.
Communist China’s two most revered leaders, Mao Zedong and Deng Xiaoping, used similar resolutions to secure their grip on power in 1945 and 1981, respectively. By declaring that “the great rejuvenation of the Chinese nation has entered an irreversible historical process” under Xi’s leadership, the party has in effect anointed him as an equal of Mao and Deng, eclipsing his predecessors Hu Jintao and Jiang Zemin.
Millicom makes big bet on Guatemala in $2.2bn telecoms deal
Investment from Luxembourg-headquartered company is the largest on record for the Central American country
Telecoms company Millicom said on Thursday it will buy out its venture partner in Guatemala and take full control of its operations in a $2.2bn deal, the largest ever single foreign investment in the Central American country.
Millicom, which sells mobile and broadband services in Latin America and Africa, previously owned 55 per cent of its Guatemala operation. The deal will see it take sole control, buying out its partner, Panama-based Miffin Associates, which is controlled by Mario López Estrada, one of Guatemala’s richest men.
The transaction will boost free cash flow to equity by about $200m in 2021, and give it more exposure to a country with a stable economy and currency, said Mauricio Ramos, Millicom chief executive.
“We all hear so very much about politics and immigration and corruption but underneath that there is a growing economy, a very young population and digital adoption rates that are like none you see anywhere around the world,” Ramos told the Financial Times.
A group of international banks would provide bridge financing for the deal, which would then be refinanced by debt and a new equity rights offering in the first quarter of 2022, the company said.
The $2.2bn deal is larger than total annual foreign direct investment in Guatemala for any year since at least 1970, World Bank data show.
Millicom, which is headquartered in Luxembourg and publicly listed in New York and Stockholm, said earlier this year that it would sell its last Africa operation, as it shifts to focus squarely on its nine markets in Latin America. That sale is still subject to regulatory approvals.
Tigo, Millicom’s brand in Guatemala, is the largest mobile provider in the country, ahead of Mexican billionaire Carlos Slim’s América Móvil, with which it competes across the region.
“We see them on the street every day, fighting for every single consumer out there,” Ramos said of his competitor. “We certainly hold our own and we will continue to do so.”
The purchase is also a vote of confidence in the economy of Guatemala at a time when the US government is trying to encourage development to stop its citizens migrating north.
Guatemala’s gross domestic product is expected to grow 5 per cent this year. The country has a population of about 18m and the largest economy in Central America, according to the World Bank. Despite its relative economic stability, more than 45 per cent of its people live in poverty.
Closing Stock Market SummaryThe S&P 500 increased 0.1% on Thursday in a tight-ranged session. The Nasdaq Composite (+0.5%) and Russell 2000 (+0.8%) outperformed the benchmark index with decent gains, while the Dow Jones Industrial Average fell 0.4%.
Walt Disney (DIS 162.09, -12.36, -7.1%) was a heavy drag on the Dow, falling 7% after missing earnings expectations amid a sharper-than-expected slowdown in Disney+ streaming subscriptions. As for the broader market, there was a meager attempt to rebound from recent losses.
That was partly due to the lack of guidance from the Treasury market (closed for Veterans Day), the absence of economic data, an intraday turnaround in Amazon.com (AMZN 3472.50, -9.55, -0.3%), hawkish Fed expectations for next year, and a sense that the market was still overextended and needed more time to cool off.
Six of the 11 S&P 500 sectors closed higher, while five closed lower. The materials (+0.9%) and information technology (+0.5%) sectors finished atop the standings with modest gains, while the communication services (-0.5%) and utilities (-0.6%) sectors underperformed. No sector gained or lost more than 1.0%.
The Philadelphia Semiconductor Index (+1.9%), however, did put forth a strong rebound-minded performance with a 2% gain.
Rivian (RIVN 122.99, +22.26, +22.1%), meanwhile, stayed hot with a 22% gain following its strong IPO yesterday. Fellow growth stocks Affirm Holdings (AFRM 151.83, +18.30, +13.7%), SoFi Technologies (SOFI 22.97, +2.55, +12.5%), and Opendoor Technologies (OPEN 22.56, +3.04, +15.6%) rallied on pleasing earnings news.
Beyond Meat (BYND 81.93, -12.55, -13.3%) and Bumble (BMBL 38.56, -9.19, -19.3%), on the other hand, fell sharply following their earnings reports.
Outside equities, the U.S. Dollar Index advanced 0.4% to 95.18. -- its highest level since July 2020. WTI crude futures ($81.37/bbl, +0.20, +0.3%) inched higher after falling 3.5% yesterday.
Looking ahead, investors will receive the preliminary University of Michigan Index of Consumer Sentiment for November and the JOLTS - Job Opening report for September on Friday.
- S&P 500 +23.8% YTD
- Nasdaq Composite +21.9% YTD
- Russell 2000 +22.0% YTD
- Dow Jones Industrial Average +17.4% YTD
After Hours Summary: BLNK +5.8%, FLO +2.5% higher on earnings; RIDE -11%, LHDX -10.9%, BEEM -9% lower on earningsAfter Hours Gainers:
Companies trading higher in after hours in reaction to earnings/guidance: CODX +13.5%, SFT +7.9%, PHUN +6.4%, BLNK +5.8%, OPNT +5.6%, FLO +2.5%, PAGS +2.1%, RYAN +1.8%, AVIR +0.9%
Companies trading higher in after hours in reaction to news: EBS +3.8% (authorizes $250 mln share repurchase program), BIIB +2.7% (phase 3 data show positive correlation between ADUHELM and decline in Alzheimer's), SPOT +0.3% (to acquire Findaway, a leader in digital audiobook distribution), X +0.2% (says it will permanently de-risk portion of pension plan), TNL +0.1% (increases dividend)
After Hours Losers:
Companies trading lower in after hours in reaction to earnings/guidance: RIDE -11%, LHDX -10.9%, BEEM -9%, JAMF -7%, MCW -5.8%, ARRY -3.7% (also to acquire Soluciones Tecnicas Integrales Norland), LAZR -1.4%, GAN -0.1%
Companies trading lower in after hours in reaction to news: AFIB -23.4% (announces the initiation of AcQForce PFA-CE), SCM -4% (stock offering), INNV -0.6% (receives approval from Indiana to develop program for elderly), LAZ -0.2% (talks to acquire Brigade Cap Mgmt fall apart over conflict concerns, according to Bloomberg)