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Deutsche Bank highlights big problems for small hedge funds

Hedge funds have shorted Deutsche Bank stock all year: Reporter

The role played by hedge funds in the market volatility surrounding Deutsche Bank has once again highlighted the pressures faced by smaller asset managers amid an already challenging climate for the industry.

Deutsche Bank CEO John Cryan's opening line in his letter to employees last week pinned some of the blame for lender's share price plummet on "speculation in the media" that some hedge fund clients had reduced business with the German lender. Cryan was referring to prime brokerage activities, wherein banks provide a bundled and tailored package of services to hedge funds, such as securities lending or cash management.

One hedge fund professional who asked to remain anonymous because of the sensitivity of business relations told CNBC over the phone that the larger hedge funds named in the press as having withdrawn business, likely had enough negotiating leverage to return to Deutsche Bank before long if they wished.

Did hedge funds contribute to Deutsche Bank instability?

This contrasts with the experience of smaller hedge funds who are finding it increasingly difficult to engage a prime broker at all, with another manager, who also asked to remain anonymous because of the sensitivity of business relations, telling CNBC that unless funds were able to raise a significant amount of capital themselves – around $250 million – and demonstrate that they have the potential and capacity to generate significant trades, their business is increasingly unwanted by the larger service providers.

Given a recent wave of consolidation in the prime brokerage industry on the back of a wave of new regulatory obligations and a reassessment of profitability potential, the number of top-notch prime brokerage providers for hedge funds to approach has dwindled.

For example, RBS and Nomura shuttered some of their operations in recent years while UBS has restructured towards a more balance sheet-light model.

The result is a shrinking core of leading prime brokers, which now includes Goldman Sachs, Morgan Stanley, Deutsche Bank and JPMorgan on the equities side and Citi, JPMorgan and Barclays on the FX side.

Another manager told CNBC anonymously, again because of the sensitivity of the business, that whereas smaller funds used to have the luxury of multiple prime brokers, now they generally had only one, thereby reducing their ability to extract bargaining leverage or potentially switch up service providers as seamlessly as done by several of Deutsche Bank's larger hedge fund clients last week.

Press reports have intimated liquidity concerns were instrumental in driving the estimated 10 hedge fund clients to withdraw business from Deutsche Bank. The creditworthiness consideration has been of even greater concern for hedge funds given events following Lehman Brothers' collapse, when some funds that were prime brokerage clients of the fallen investment bank had their assets frozen until legal complications were resolved. In the more extreme cases, certain funds were only re-granted access to their assets recently despite Lehman Brothers' demise now occurring over eight years ago.

Settlement looming for Deutsche Bank

Frozen assets raise the issue of how to value them until they are released as well as spurring untimely de-leveraging by funds suddenly forced to hold large cash balances. It also raises the dire potential for jittery investors to call for their funds if there is a sizeable paper loss, forcing a possible firesale of other assets.

While a large and liquid fund has a greater chance of withstanding an asset freeze, a smaller fund with less of a funding buffer can be more susceptible to buckling under such strain.

In a climate where smaller hedge funds are already disproportionately burdened by the additional cost and time implications of regulatory initiatives, the incremental difficulties resulting from an increasingly hard to access prime brokerage industry are certain to be unwelcome for these managers.

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