You know the finance bomb is ticking but how big will the explosion be?

As the finance system is assailed by scandal and failure, Simon Evans charts the dangerous liaisons between hedge funds and prime brokers
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The Independent Online

Last Tuesday evening, a City trader is said to have tapped out a brief email at his desk. The memo, to a select band of colleagues and clients, told of how HBOS, the bank that owns the Halifax, was seeking urgent talks with Bank of England officials to stave off a Northern Rock-style bankruptcy.

No such meeting was ever in the offing but that the email was later revealed to be without foundation probably didn't much matter to the trader.

Shares in HBOS lost more than a quarter of their value, only recovering after words of reassurance from the Bank and a terse warning from City regulator the Financial Services Authority (FSA) on the promulgation of rumours in the Square Mile.

Profiting on the rumours through "short selling" of HBOS shares allowed some traders to scoop millions in profits from the collapse of the bank's share price. The champagne corks may have popped briefly but the trades are now the subject of an FSA investigation.

Shorting involves people selling stock or bonds they do not own. The idea is to borrow shares, say, when a particular company's stock is riding high and then offload them – in the expectation the price is heading for a fall. They will then be repurchased later at a lower price, hopefully yielding a big profit.

Figures from Data Explorers, a City firm that monitors the extent of short-selling in the market, show how last Tuesday the cost of borrowing stock in HBOS increased, meaning there was more shorting going on than normal. Clearly the word was out.

Facilitating the whole shorting process is the preserve of the investment banks through their so-called "prime brokerage" desks. The growth of the hedge fund market means prime brokerage, once the poor relation of the trading floor, has become a moneyspinner for banks.

If prime brokers were thrust into the spotlight in Britain last week, across the Atlantic the hitherto low-key business was playing a key role in the collapse of Bear Stearns, the once-august investment bank.

Bear, a powerhouse in the US clearing market with, until recently, one of the most impeccable pedigrees on Wall Street, serviced the needs of hundreds of hedge funds, primarily dealing in fixed-income trading through its prime desk.

Estimates suggest it handled hedge fund assets worth as much as $136bn (£68bn).

But the collapse of a hedge fund run by Carlyle Group in Europe, in which Bear is believed to have had an exposure, sparked concerns that the bank's financial position was deteriorating beyond repair. That in turn prompted fears it would be forced to file for Chapter 11 bankruptcy cover.

Hedge fund clients were left with little choice but to run for cover, which, led by giants such as Citadel, they did in their droves – a sort of computerised bank run. The game was up but, once again, prime brokerage was at the heart of the affair – a role with which it might become familiar in the coming months after decades out of the spotlight.

For those heading to work in the investment banking arena, prime brokerage isn't typically the destination of choice. It lacks the glamour of a proprietary trading desk or the sheer complexity of a quantitative, or market-modelling, team.

Prime brokers typically offer three main services to their clients: financing or lending cash to hedge funds at a margin; securities lending to facilitate short-selling; and custodial services – the clearing of stocks and bonds through the financial system.

Fees and commissions for some of these services are thought to be worth as much as 5 per cent of asset value per year. It's lucrative stuff, with heads of prime brokers becoming some of Wall Street's best-paid and sought-after bosses.

In recent years, the services offered by prime desks to hedge funds have widened as the race to scoop market share intensifies. Dog walking and advising on schools for managers' children are some of the more unconventional services on offer.

The complexity of the relationship between hedge funds and prime brokers has also increased markedly in recent years, with larger funds typically employing multiple brokers. One US hedge fund is thought to work with more than 20 banks.

As a result, it's almost impossible to gauge how much borrowing exposure some funds are racking up. You might know the bomb is ticking but do you have any idea how big the explosion could be?

No wonder the regulators have taken an interest. Alarmed by a perceived "cosying up" between hedge funds and prime brokers, the FSA has been conducting a twice-yearly survey over the past four years assessing the exposure of the brokerage desks to their hedge fund clients.

But the regulator faces an uphill struggle. With so many of these clients residing in countries outside the FSA's jurisdiction, the building of a complete picture will almost certainly prove beyond it. In all likelihood, the FSA will only ever have a small portion of the jigsaw on which to base its decisions.

"Regulators can learn a lot from prime brokerage but there remains significant resistance from the industry to open up further – why should they?" was one former prime broker's take on the state of play.

However, if suggestions prove true that the Treasury Select Committee, under its formidable chairman John McFall, is ready to shine its light on hedge funds and their activities once again, then an imperative to open up might be around the corner.

McFall and Co's ambush of the highly secretive private equity industry last year forced a radical rethink among the buyout world's leading protagonists. Some believe a light shone on prime brokerage could yield a lot more uncomfortable secrets.

If last week is anything to go by, markets will stay highly volatile for some time yet, and that means prime brokers will remain in the glare of the spotlight for the foreseeable future.

Next month, Citigroup, UBS and Merrill Lynch – firms with huge prime brokerage operations – issue first-quarter earnings numbers. All three have been heavily sold off in recent months, with UBS the favourite topic on the City rumour mill at the end of last week. A further wobble in sentiment could see its prime brokerage clients head for the door.

In the UK, Alliance & Leicester and Bradford & Bingley are at the heart of industry chatter.

In the highly charged, rumour-fuelled market of 2008 prime brokers find themselves cast in a central role. Their actions will go a long way towards deciding in which direction the credit crisis lurches next.

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