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Chicago Booth BUSF 35150 - Prime Brokers and Derivatives Dealers

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WORKING PAPER Prime Brokers and Derivatives Dealers Squam Lake Working Group on Financial Regulation April 20101 Squam Lake Working Group on Financial Regulation The Squam Lake Working Group on Financial Regulation is a nonpartisan, nonaffiliated group of fifteen academics who have come together to offer guidance on the reform of financial regulation. The group first convened in fall 2008, amid the deepening capital markets crisis. Although in-formed by this crisis—its events and the ongoing policy responses—the group is intentionally fo-cused on longer-term issues. It aspires to help guide reform of capital markets—their structure, function, and regulation. This guidance is based on the group’s collective academic, private sector, and public policy experience. To achieve its goal, the Squam Lake Working Group is developing a set of principles and their implications that are aimed at different parts of the financial system: at individual firms, at financial firms collectively, and at the linkages that connect financial firms to the broader economy. The members of the group are Martin N. Baily Brookings Institution Andrew B. Bernard Dartmouth College John Y. Campbell Harvard University John H. Cochrane University of Chicago Douglas W. Diamond University of Chicago Darrell Duffie Stanford University Kenneth R. French Dartmouth College Anil K Kashyap University of Chicago Frederic S. Mishkin Columbia University Raghuram G. Rajan University of Chicago David S. Scharfstein* Harvard University Robert J. Shiller Yale University Hyun Song Shin† Princeton University Matthew J. Slaughter Dartmouth College Jeremy C. Stein Harvard University René M. Stulz Ohio State University * David Scharfstein withdrew from the group when he accepted a position at the Treasury Depart-ment in September 2009. † Hyun Song Shin withdrew from the group in January 2010 to serve as chief adviser on international economics to South Korean president Lee Myung-bak.2 PRIME BROKERS, DERIVATIVES DEALERS, AND RUNS Runs by prime-brokerage clients and derivatives counterparties were a central cause of the World Financial Crisis. Worried about potential losses, many hedge funds withdrew their assets from bro-kerage accounts at Bear Stearns and Lehman Brothers in the weeks before these banks failed. Al-though Morgan Stanley did not fail, it also suffered from the withdrawal of prime brokerage assets. These runs, together with runs by short-term creditors, precipitated Bear Stearns’ and Lehman’s de-mise.1 Even if these firms would have failed anyway, the runs made their failures much more sudden and chaotic, and made coherent policy responses much harder. In this paper we consider why clients “ran,” how such runs precipitated failure by substantially re-ducing the broker’s liquidity, and what changes might ameliorate this unstable situation. Two conditions are needed to generate a run. First, customers must have the incentive to with-draw their assets before bankruptcy occurs and at least the quickest ones must have the ability. Second, customer withdrawals must weaken the broker’s financial position, making failure more likely and reinforcing the incentive for customers to claim their assets. We focus here on two forms of investor exposures to large banks: through the loss of assets placed in prime brokerage accounts, and through losses incurred as a derivatives counterparty, when the bank fails. “Prime brokerage” is the package of services that securities broker-dealers offer to large active in-vestors, especially hedge funds. These services typically include trade execution, settlement, account-ing and other record keeping, financing, and, critically, holding the customers’ cash and securities. The relationship between a prime broker and its clients has the two features necessary for a run. First, even though securities entrusted to a prime broker belong to the client, it can be difficult or im-possible for the client to extract its securities once the prime broker fails. As a result, customers are likely to withdraw their assets at the first sign that their prime broker is in difficulty. Second, as we explain below, prime brokers often use their clients’ assets as an important access to funding or “li-quidity.” When a substantial number of clients leave, the broker must either quickly find new financ-ing or sell assets to raise capital. As a result, concern that a prime broker is in trouble can be self-fulfilling. Over-the-counter (OTC) derivatives relationships pose a similar problem. OTC counterparties have incentives to withdraw or restructure their contracts if they suspect the broker will fail. And the collateral provided by over-the-counter derivatives counterparties is another important source of dealer liquidity. Large broker-dealers are widely considered to be systemically important, so the potential for runs is a problem for the financial system. Regulatory changes that (1) reduce the incentive for customers to run, (2) reduce the liquidity effects of the decision to run, and (3) reduce the reliance of broker-dealers on run-prone financing can make the financial system more stable. These changes are worth making if the benefits to society exceed the costs to dealers, their customers, and the rest of the indus-try. Our recommendations focus on segregation of assets. A customer’s assets are segregated from those of its broker if the assets are held in a separate account that is legally distinct from the broker’s accounts. If its assets are not segregated, the customer merely holds a contractual claim against the3 broker. In the event of bankruptcy by the broker, the customer owning unsegregated assets may need to pursue claims against the dealer in court. Thus, segregation reduces the client’s incentive to run. The market for prime brokerage services is competitive and the customers are well-informed. Thus, when prime brokers and their customers use nonsegregated accounts, one can infer that the private costs of segregation outweigh the private benefits. Because of the potential systemic cost of a run, however, the broker and its customers do not bear all the costs of their decision to use nonsegre-gated accounts. To encourage greater segregation, we recommend higher regulatory liquidity requirements for dealer banks that use the assets of clients and counterparties as a source of liquidity. We also recom-mend the international

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