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The life of the counterparty: Shock propagation in hedge fund-prime broker credit networks

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  • Kruttli, Mathias S.
  • Monin, Phillip J.
  • Watugala, Sumudu W.

Abstract

Using novel credit data, we show that hedge fund borrowing is significantly overcollateralized, primarily with rehypothecable securities. An idiosyncratic liquidity shock to a major prime broker significantly decreases credit to connected hedge funds. The dominant channel behind this shock transmission is credit supply reduction rather than precautionary demand reduction. Funds posting more rehypothecable collateral are less affected because their collateral alleviates prime broker liquidity constraints. Exposed funds subsequently have lower aggregate credit with worse terms, suggesting imperfect substitutability across hedge fund credit sources. Funds subject to the decrease in balance sheet leverage subsequently increase portfolio illiquidity, embedded leverage, and derivatives exposure.

Suggested Citation

  • Kruttli, Mathias S. & Monin, Phillip J. & Watugala, Sumudu W., 2022. "The life of the counterparty: Shock propagation in hedge fund-prime broker credit networks," Journal of Financial Economics, Elsevier, vol. 146(3), pages 965-988.
    • Handle: RePEc:eee:jfinec:v:146:y:2022:i:3:p:965-988
    DOI: 10.1016/j.jfineco.2022.02.002
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    More about this item

    Keywords

    Hedge funds; Prime brokers; Credit networks; Rehypothecation; Collateral;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G01 - Financial Economics - - General - - - Financial Crises

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