Prime Brokerage - Risks

Risks

Prime Brokers facilitate hedge fund leverage, primarily through loans secured by the long positions of their clients. In this regard, the Prime Broker is exposed to the risk of loss in the event that the value of collateral held as security declines below the loan value, and the client is unable to repay the deficit. Other forms of risk inherent in Prime Brokerage include operational risk and reputational risk.

Large prime brokerage firms today typically monitor the risk within client portfolios through house-designed "risk based" margin methodologies that consider the worst case loss of a portfolio based on liquidity, concentration, ownership, macroeconomic, investing strategies, and other risks of the portfolio. These risk scenarios usually involve a defined set of stress test scenarios, rules allowing risk offsets between the theoretical profit and losses (P&Ls) of these stress test scenarios for products of a common underlier, and offsets between groups of theoretical P&Ls based on correlations.

Liquidity penalties may be established using a rule-of-thumb for days-to-liquidate that 10% of the daily trading volume can be liquidated without overdue influence on the price. Therefore, a position 1x the daily trading volume would be assumed to take 10 business days to liquidate.

Stress testing entails running a series of what-if scenarios that identify the theoretical profits or losses for each position due to adverse market events.

Examples of stress test scenarios include:

• Flight to Quality
• 3%-15% up or down price movements used in Portfolio Margin