The Life of the Counterparty: Shock Propagation in Hedge Fund-Prime Broker Credit Networks

82 Pages Posted: 19 Mar 2018 Last revised: 22 Feb 2022

See all articles by Mathias S. Kruttli

Mathias S. Kruttli

Kelley Business School - Indiana University

Phillip Monin

Board of Governors of the Federal Reserve System

Sumudu W. Watugala

Indiana University - Kelley School of Business - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 16, 2022

Abstract

Using novel credit data, we show hedge fund borrowing is significantly overcollateralized, primarily with rehypothecable securities. An idiosyncratic liquidity shock to a major prime broker significantly decreases credit to connected hedge funds. The dominant channel behind this shock transmission is credit supply reduction instead of precautionary demand reduction. Funds posting more rehypothecable collateral are less affected because their collateral alleviates prime broker liquidity constraints. Exposed funds subsequently have lower aggregate credit with worse terms, suggesting imperfect substitutability across hedge fund credit sources. Funds subject to the decrease in balance sheet leverage subsequently increase portfolio embedded leverage and derivatives exposure.

Keywords: hedge funds, prime brokers, credit networks, rehypothecation, collateral

JEL Classification: G11, G23, G24, G01

Suggested Citation

Kruttli, Mathias S. and Monin, Phillip and Watugala, Sumudu W., The Life of the Counterparty: Shock Propagation in Hedge Fund-Prime Broker Credit Networks (February 16, 2022). Available at SSRN: https://ssrn.com/abstract=3140900 or http://dx.doi.org/10.2139/ssrn.3140900

Mathias S. Kruttli

Kelley Business School - Indiana University ( email )

Bloomington, IN 47405
United States

Phillip Monin

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sumudu W. Watugala (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

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