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January 15, 2020  

Prime Brokers Skittish on Risk in Options Plays

A change in risk requirements that Jefferies’ prime-brokerage unit imposed on options-trading hedge fund clients has resulted in problems for some of those managers.

The tougher rules, which generally require managers who trade options to provide more upfront collateral, are the result of a recent risk review undertaken by Jefferies.

The change led volatility-arbitrage firm NorCap Advisors to abruptly switch prime brokers at yearend, causing it to exit some positions early and give up expected gains. In another case, Lattice Capital was forced to modify its trading rather than try to raise money to meet the increased risk-equity collateral.

Other prime brokers also appear to be closely examining the trading strategies of potential and existing volatility-arbitrage clients. Executives said they’ve recently seen existing clients of Jefferies and other prime brokers hunting for new brokers that impose less stringent collateral requirements. Those sources said their own banks were taking few if any such new clients.

Jefferies’ review was evidently part of a periodic risk assessment it conducts for all of its clients’ trading strategies. Beyond that standard assessment, however, some sources said brokers are increasingly concerned that the high-flying equity market is primed for a correction, which could have an outsized impact on some volatility-focused traders.

For firms dealing in options that pay out to counterparties should equity indexes fall precipitously, catastrophic losses can result for ill-prepared managers, potentially leaving funds owing more than they manage. In such cases, prime brokers are on the hook to pay out contracts.

“Now everyone is getting nervous that the rally is going too far, too long,” one options trader said. “We are going through that phase again where the prime brokers are looking at it very closely.”

The reviews involving NorCap and Lattice apparently weren’t triggered by underlying problems with the managers, both of which run funds that have grown substantially in the past year on strong profits and capital inflows.

NorCap’s largest fund, NorCap Diversified Premium Fund, ended the year up 12.3%. The firm’s assets were $231 million on Sept. 30, up from $157 million a year earlier.

But in an investor note sent out this week, NorCap wrote that its performance in December was hurt “by an issue with our prime broker, requiring us to exit from their services and from some of its [S&P 500 Index] positions before we could realize their full premium potential.”

The note didn’t name Jefferies or explain the problem further. But its Diversified Premium fund lost 3% in December. Its smaller vehicles were also down for the month, with NorCap GovPlus off 3.1% and NorCap EquityPlus dipping 1.7%. But GovPlus was up 12.9% for the year, while EquityPlus rose 20.4%. Through November, Diversified Premium Fund had an annualized return of 10.4% since its launch in 2008.

Dallas-based NorCap, led by founder and former Morgan Keegan & Co. principal David Norcom, might have minimized the disruption if it worked with an additional prime broker — but it was using only Jefferies. The firm’s three funds are now trading with a new, unidentified prime broker.

NorCap wrote that it “intends to add a second prime broker soon” and noted that its strategies and risk processes remain the same.

Lattice’s Dynamic Alpha Fund was up 18.3% last year. It shows an annualized return of 18% since 2016, when the fund adopted its current strategy of selling exchange-traded funds and index options. The fund’s assets totaled $227 million at yearend 2019, up from $153 million at the start of the year.

While Lattice is, at least for now, continuing to use Jefferies as its sole primer broker for the fund, the firm is in talks with different prime brokers to handle trades for a planned vehicle, an offshore master-feeder fund for non-U.S. investors. That fund is expected to launch in February.

The investment programs at Lattice, based in Kirkland, Wash., are led by chief investment officer Fariba Ronnasi. Ronnasi also is president and chief investment officer of Elite Wealth Management, which runs some $500 million.