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

Mathias S. Kruttli, Phillip J. Monin and Sumudu Watugala

Journal of Financial Economics, 2022, vol. 146, issue 3, 965-988

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.

Keywords: Hedge funds; Prime brokers; Credit networks; Rehypothecation; Collateral (search for similar items in EconPapers)
JEL-codes: G01 G11 G23 G24 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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Related works:
Working Paper: The Life of the Counterparty: Shock Propagation in Hedge Fund-Prime Broker Credit Networks (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:146:y:2022:i:3:p:965-988

DOI: 10.1016/j.jfineco.2022.02.002

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