Transform Your Investments: The Optimus Prime Brokerage Experience

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As each year draws to a close, we encounter a trend that may be termed the “December Document Drop”.

There is nothing especially malevolent or out of the ordinary about this — it merely reflects the reality that numerous official entities have yearly agendas combined with challenging responsibilities. Employees naturally desire to clear their desks and complete their objectives so they can embark on new endeavors following the holiday season.

However, this does imply that occasionally events emerge that aren’t adequately acknowledged. Potentially significant proposals may go unnoticed until a later assessment prompts someone to react strongly.

As a prospective illustration of this trend, examine the Financial Stability Board’s consultative document on “Leverage In Non-Financial Intermediation”, which was released in the week preceding Christmas.

This is the most recent entry in a collection of publications from the global assembly of regulators addressing concerns related to “Non-Bank Financial Intermediaries”. These were previously referred to as “shadow banks” until the consensus shifted to find a more engaging title.

The consultation itself pertains to a subject that is, in fact, quite engrossing. It could reasonably be labeled the “post-Archegos report”, although it also highlights that the UK’s Liability Driven Investment crisis and the 2022 nickel market squeeze exemplify the complications that may arise when major institutions engage in leveraged positions within crowded transactions.

As articulated in the report:

. . . The accumulation of leverage can present notable threats to financial stability if not adequately regulated. The transmission of shocks through leverage mainly occurs via two avenues: the position liquidation pathway and the counterparty channel. The position liquidation pathway functions when leverage leads to substantial or unforeseen liquidity demands stemming from collateral or margin calls, compelling leveraged entities to liquidate assets to obtain funds. Deleveraging and asset disposals can also occur when investors aspire to preserve a targeted level of leverage on their balance sheets or aim to maintain a stable value-at-risk within their portfolios. Subsequent asset sales, particularly under strained market circumstances, may further depress asset valuations, resulting in a feedback loop of additional liquidity demands and sales among market players exposed to the same asset class.

But how can this be mitigated? The Financial Stability Board acts as a sort of overarching regulator. It does not establish any rules on its own; rather, it serves as a forum where broad “principles” are agreed upon among various global entities, which subsequently develop “standards” aimed at national regulators, which will ideally at some future date be transformed into enforceable rules by the authorities responsible for compliance.

This complicates its ability to impose direct restrictions on leverage, especially when many of the entities that concern the FSB are beyond the conventional regulatory framework. Archegos, for instance, was a family office without external investors — traditionally, it has been viewed as none of the regulators’ concern if a wealthy individual opts to undertake something unwise with their funds.

One of the strategies proposed by the FSB is to engage through prime brokerages (“leverage providers” as termed in the report) that are responsible for facilitating much of the problematic activity.

Nevertheless, banks can only assist if they are aware of ongoing activities. And in Archegos’s case, the primary reason Bill Hwang was permitted to assume such enormous risks was due to his use of multiple brokers, none of whom were aware that he was maintaining identical positions with each one.

This leads to a suggestion that part of the resolution is “private disclosure”:

Recommendation 7: Regulatory bodies, alongside SSBs, should assess the sufficiency of prevailing private disclosure practices between leveraged non-bank financial entities and leverage providers, including the level of detail, frequency, and promptness of such practices. Where appropriate, they should contemplate establishing mechanisms and/or minimum standards to enhance the efficacy of these disclosure practices.

Alright, what does that entail?

Authorities should contemplate applying the following principles:

■ Certain types of information and data disclosed should reflect the strategies, products, and markets in which the client operates, ensuring that the information provided is pertinent and effective for the leverage provider’s risk management.

■ Clients should supply aggregated information about their exposures across all entities or vehicles managed under a unified strategy or decision-making framework, capturing the effects of a coordinated liquidation across the client’s full spectrum of interrelated investment products or vehicles.

Alright, what does that convey?

It’s not entirely definitive — one of the characteristics of being a meta-meta regulator is that you must articulate everything in highly generalized terms. However, it strongly appears that the FSB is advocating for substantial investors to be mandated to provide their “leverage providers” full disclosure of all their positions, enabling prime brokers to manage their risks accurately and amalgamate their information to be aware of congested trades.

It sounds quite innocuous when framed this way. Who could be against transparency? In fact, this could potentially serve as a regulatory explosive device introduced into the operations of the hedge fund sector.

Essentially, there are very compelling reasons why large funds typically engage multiple prime brokers, ensuring that no single entity has a complete insight into their positions. That type of information (especially if it’s “detailed” and “timely”) is incredibly valuable to counterparties.

Even without considering the likelihood of literal front-running, simply being aware of market positioning, which trades may be crowded, and where the “strong hands” and “weak hands” are in terms of who has spare borrowing capacity and who is fully leveraged is extremely beneficial.

Generally, information equates to power and power translates to money within financial markets. If this consultation results in a requirement for large funds to disclose their positions to their prime brokerages, this will not only create significant competitive leverage for a large prime brokerage operation, but it will also significantly shift the advantage toward the sellside over the buyside.