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

49 Pages Posted: 24 Oct 2019

See all articles by Mathias S. Kruttli

Mathias S. Kruttli

Board of Governors of the Federal Reserve System; University of Oxford - Oxford-Man Institute of Quantitative Finance

Phillip Monin

Board of Governors of the Federal Reserve System

Sumudu W. Watugala

Cornell University - SC Johnson College of Business

Multiple version iconThere are 2 versions of this paper

Date Written: September 2019

Abstract

The collapse of Lehman Brothers illustrated the importance of managing prime broker counterparty risks for hedge funds. Liquidity shocks to prime brokers can lead to cycles of deleveraging that produce losses at funds and potentially have harmful effects on financial market function and credit provision. While the hedge fund-prime broker credit network is highly concentrated, the average hedge fund in our sample borrows from three prime brokers and has a total credit exposure of $2.15 billion. We show that hedge fund borrowing tends to be overcollateralized and most of the collateral is allowed to be rehypothecated. Using a within fund-quarter empirical strategy, we identify the effects of an idiosyncratic liquidity shock to a major creditor. Such a shock results in significantly reduced borrowing due to the prime broker reducing credit supply instead of a precautionary reduction in credit demand from connected hedge funds. Borrowing by funds with more rehypothecable collateral is less affected because such collateral improves the constrained creditor's liquidity situation. Even large hedge funds simultaneously borrowing from multiple creditors see a significant reduction in their aggregate borrowing following the shock. Larger, more connected and better-performing hedge funds and those that do less OTC trading are better able to compensate for this loss.

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 (September 2019). OFR WP 19-03, Available at SSRN: https://ssrn.com/abstract=3473866 or http://dx.doi.org/10.2139/ssrn.3473866

Mathias S. Kruttli

Board of Governors of the Federal Reserve System ( email )

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

HOME PAGE: http://www.federalreserve.gov/econresdata/mathias-s-kruttli.htm

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
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Oxford, Oxfordshire OX2 6ED
United Kingdom

HOME PAGE: http://sites.google.com/site/mathiaskruttli/home

Phillip Monin (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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

Sumudu W. Watugala

Cornell University - SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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