Prime Brokerage Lock-ups

Understanding Lock-Ups in Prime Brokerage

What Is a Lock-Up in Prime Brokerage?

In the prime brokerage (PB) and hedge fund ecosystem, a lock-up is a contractual agreement between a prime broker and a hedge fund that restricts the prime broker from modifying specific terms of their relationship during a predetermined timeframe. These agreements are offered selectively by prime brokers, as they typically incur additional costs and regulatory burdens. Consequently, prime brokers usually require clients to meet certain revenue thresholds before agreeing to lock-up arrangements.

Why Lock-Ups Exist

The standard prime brokerage agreement (PBA) establishes a framework for providing services to hedge funds but doesn't commit to extending financing over a specific period. This creates a potential vulnerability for hedge funds, which may face more demanding financing terms during market stress when alternative financing options are limited. This risk is particularly significant for funds trading less liquid assets or employing highly leveraged strategies.

To address this uncertainty, a separate "side letter" to the PBA—known as a lock-up—can be established. This document effectively "locks up" certain financing terms to protect the hedge fund's interests during turbulent market conditions.

How Lock-Ups Work

While lock-ups are customized agreements that can vary significantly between different prime brokers and clients, they typically commit to maintaining stability in three key areas:

1. Margin terms
2. Pricing
3. The total funding commitment from the prime broker

It's important to understand that a lock-up agreement is not itself a financing facility, and the prime broker does not allocate a specific amount of funding exclusively for the client. Lock-up periods typically range from 28 to 90 days, though as bespoke arrangements, they can vary considerably in duration.

Key Considerations for Hedge Funds

When considering lock-up agreements, hedge funds should evaluate several factors:

• Cost-benefit     analysis: Lock-ups usually come with additional costs, making it essential to determine whether these expenses justify the benefits, especially since the advantages can be difficult to quantify.
• Effectiveness     during market stress: Since the lock-up only stabilizes margin terms     and pricing, funds must consider how their portfolio might perform during     market turbulence. Many margin policies already include adjustments for  market dislocations, which means funds might still face significant margin     increases during stress periods without any changes to the underlying     terms.
• Balance     composition flexibility: Lock-ups typically apply holistically rather     than focusing on specific balance types (e.g., margin debits). This means     that if a fund substantially changes its balance composition, the prime     broker may have grounds to reconsider its funding commitments.
• Regulatory     impact: Regulatory requirements often compel larger prime brokers to     include rescission or cancellation clauses in lock-up agreements. These     clauses reflect the expectation that non-institutional clients should     receive priority during periods of market stress.

Challenges for Prime Brokers

Prime brokers face several significant challenges when offering lock-up agreements:

• Regulatory     cost implications: In the post-Basel III regulatory environment,     lock-ups affect liquidity and funding calculations such as the Liquidity     Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), generating     additional costs for the prime broker. Longer lock-up periods typically     result in higher regulatory costs.
• Risk     calculation complexity: Clients with lock-ups must be modelled separately in the bank's liquidity risk calculations, adding both cost and     complexity to risk management processes.
• Balancing     stakeholder expectations: Prime brokers must navigate between hedge     funds' desire for firm funding commitments and regulators' concerns about     the nature of the business. Regulators generally view prime brokerage as     an overnight funding business, but lock-ups can make it appear more like a     term financing operation, creating tension between regulatory compliance     and client satisfaction.

Conclusion

Lock-up agreements in prime brokerage remain frequently misunderstood, particularly during market stress when hedge funds and prime brokers may have divergent interpretations of their obligations.

While hedge funds naturally seek financing stability, the current regulatory framework makes it challenging for prime brokers to offer explicit, long-term commitments. The most sophisticated hedge funds recognize these limitations and prepare for potential disruptions in funding markets by taking a strategic approach to counterparty management, rather than relying exclusively on lock-up provisions.

‍