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

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