Brokerages often focus on tighter spreads and better pricing
when engaging a new liquidity provider (LP). However, liquidity agreements
require careful review. Several factors must be considered when entering or
renegotiating such agreements, whether with a Prime-of-Prime or Prime Broker.
Segregation of Assets
Firms should determine if their assets are segregated from
the LP’s own funds and those of other clients. If there is no segregation, the
jurisdictional rules and risks involved must be assessed. In cases of omnibus
accounts, brokerages should consider the implications if another client in the
pool becomes insolvent.
Collateral Management
Collateral, or margin, is cash or securities posted to an
LP. Key considerations include whether the brokerage retains ownership,
applicable discounts, and the timeframe for collateral delivery. Additionally,
firms should assess whether they can reclaim excess collateral.
Collateral transfers are often absolute, meaning the LP
gains full ownership. This creates credit exposure, making the brokerage an
unsecured creditor. LPs typically do not return collateral unless negotiated at
a higher cost.
— Zurique Capital Research (@zuriquecapital) February 13, 2025
Rehypothecation Risks
LPs often reuse posted collateral for their own purposes,
such as borrowing or lending. This practice reduces costs but increases
counterparty risk. Removing rehypothecation rights from agreements is
difficult, and brokerages should be aware that collateral may be used across an
LP’s group entities.
Events of Default (EODs)
Firms should review default clauses, including whether they
apply to the LP. They should check if they can suspend payments, close
transactions, or set off amounts in case of an EOD. Additional termination
events (ATEs), such as a decline in net asset value, should be reviewed or
adjusted to avoid premature termination.
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Termination Consequences
In case of termination, brokerages must ensure all
transactions are closed out fairly. They should assess whether the LP can
selectively close positions in its favor. The role of the calculation agent is
also crucial, as it determines termination amounts. Firms should consider
appointing an independent agent if the LP is in breach.
Additional Documentation Considerations
Other factors include the obligation for periodic due
diligence, the rights of custodians over client assets, indemnities favoring
the LP, and tax provisions such as gross-up clauses. Dispute resolution
mechanisms and governing law should also be reviewed to ensure fair legal
protections.
Brokerages must carefully examine these aspects before
finalizing liquidity agreements to mitigate risks and safeguard their assets.
This article was written by Sophie Gerber, Astrid raetze at www.financemagnates.com.
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