Hedge Fund Industry Concerned About UK Prime Brokerage in Wake of Investment Bank Collapse

In the wake of the collapse of a major international investment bank, the Managed Funds Association expressed concern about the ongoing viability of the UK’s prime brokerage industry. In a letter to the Governor of the Bank of England, MFA CEO Richard Baker urged the central bank to intervene to expedite the release of billions in assets now frozen in the UK as the result of the insolvency of Lehman Brothers, Inc.

The former House leader also highlighted the systemic risks resulting from the Lehman insolvency, including the loss of an estimated $40-$70 billion in liquidity now frozen at Lehman Brothers International Europe, the potential destabilization of financial firms as assets are moved away from prime brokers, and the potential failure of firms with significant financial exposure to LBIE. In his letter, Mr. Baker recommended an expedited administration process that would reduce systemic risks, inject much-needed liquidity and financial stability into capital markets and keep the UK’s prime brokerage industry viable. Nothing less than the future of the UK’s prime brokerage industry is at stake.

The MFA also noted a marked discrepancy, in terms of confidence and speed of response, between the administrators’ proposals and the protocol promulgated by the Securities Investor Protection Corporation Trustee in the US, who is responsible for the liquidation of Lehman Brothers Inc. The scale of the problem is enormous, said the MFA.

The administration of LBIE has resulted in client assets held by LBIE under prime brokerage arrangements being taken out of the market, with LBIE clients that are hedge funds unable to access their assets, trade them or properly value them. In turn, this is leading to suspensions of fund redemptions and NAV calculations in some cases, which is freezing sections of the market.

In Mr. Baker’s view, the current approach outlined by LBIE administrators involves a lengthy process with no definitive date for distribution of client assets. This process creates systemic risk and adds more uncertainty to global markets. The MFA encourages the Lehman administrator to take immediate action to reduce the uncertainty and mitigate systemic risk by distributing these assets in an expedited manner. The Bank of England must intervene to coordinate and clarify the process and remove obstacles that prevent the quick and orderly release of client assets from LBIE.

More granularly, the MFA proposed a plan to prioritize distribution to LIBE’s clients by reference to the applicable systemic significance of their exposures. The MFA believes that this approach will allow the administrators to distribute assets in the context of systemic risk concern.

The MFA also advocates a combined industry and government response involving the Bank of England, the Financial Services Authority and industry participants to give LBIE’s administrators reassurance regarding their liabilities. This would remove the liability risk component for the administrators, reasoned Baker, and allow them to return client assets without fear of liability to other creditors.

The MFA also proposes enhancing the transparency and clarity of the administration process and related client positions. Also, clarity must be provided for existing short positions and developing a protocol for the closure of these positions in order to allow LBIE clients to manage their exposure to market risk.

In order to unlock as many assets as quickly as possible, the MFA urged the LBIE administrators to prioritize LBIE's prime brokerage clients by reference to the applicable systemic significance of their exposures. For each such client, the administrators should engage with the client to agree on the net sums owed by the client to LBIE (or vice versa) under each agreement to which the client is party with LBIE. Any live short positions should also be closed out, if necessary, by a payment of cash from the client to LBIE (after having taken account of any net sums owed by LBIE to the client). The long segregated assets should then be released to those clients.