Prime Brokerage Agreements in Hong Kong: Legal Framework for Hedge Funds

Introduction

Prime brokerage is the suite of services provided by investment banks and specialist brokers to institutional clients — principally hedge funds — encompassing securities financing, custody, clearing, settlement, and ancillary services such as capital introduction and risk reporting. The prime brokerage relationship is central to hedge fund operations: it determines how the fund finances leveraged positions, where its assets are held, and the terms on which those assets can be used by the prime broker.

For Hong Kong-based hedge fund managers, the legal framework governing prime brokerage relationships is a critical area of operational and legal risk management.

Structure of the Prime Brokerage Relationship

The prime brokerage relationship is documented primarily through:

• The Prime Brokerage Agreement (PBA): The master agreement governing the overall relationship, including services, fees, margin, and general terms
• ISDA Master Agreement: For OTC derivatives transactions with the prime broker
• Securities Lending Agreement: For short-selling and securities borrowing transactions
• Tri-Party Repo or Stock Loan Agreements: For financing arrangements
• Custody Agreement: For the custody of assets held with the prime broker

Many prime brokers use proprietary documentation frameworks rather than fully standardised agreements, although key provisions are influenced by industry standard documentation.

Rehypothecation and Asset Reuse

One of the most commercially significant — and legally complex — aspects of prime brokerage is rehypothecation: the right of the prime broker to reuse or repledge assets posted by the client as collateral. Rehypothecation allows the prime broker to use the hedge fund's assets to finance its own operations or meet other client obligations.

The SFC requires licensed corporations that hold client assets to comply with the Client Securities Rules. Under these rules, rehypothecation of client securities is permitted only where the client has specifically consented in writing. The SFC has issued guidance on the disclosure of rehypothecation risks, and clients should understand the extent to which their assets can be used by the prime broker and what happens in the event of the prime broker's insolvency.

Margin and Collateral

The prime broker extends credit to the hedge fund for leveraged positions, secured by the fund's assets held in the prime brokerage account. Key margin-related provisions in the PBA include:

• Initial margin requirements (the minimum collateral required to open a position)
• Variation margin (daily margin calls as positions move against the fund)
• Concentrated position haircuts (larger margin requirements for concentrated or illiquid positions)
• The prime broker's right to increase margin requirements, close out positions, or liquidate assets in the event of a margin default

Default and Close-Out

Upon a default by either party (e.g., the hedge fund failing to meet a margin call, or the prime broker becoming insolvent), the non-defaulting party has the right to close out outstanding transactions and net off amounts owed. The legal effectiveness of close-out netting in Hong Kong is supported by statute (Financial Netting (Corporate Finance Law) Ordinance) and the ISDA framework.

The collapse of major prime brokers during the 2008 financial crisis highlighted the risk of asset shortfalls for hedge funds in prime broker insolvency scenarios. Hedge funds with significant prime brokerage relationships should conduct due diligence on the prime broker's creditworthiness and consider spreading assets across multiple prime brokers.

SFC Requirements for Prime Brokers

Prime brokers operating in Hong Kong must be licensed by the SFC for the regulated activities they undertake (Type 1 – dealing in securities, Type 2 – dealing in futures contracts, Type 8 – securities margin financing). They are subject to the SFC's financial resources rules, client asset segregation requirements, and conduct of business obligations under the Code of Conduct for Persons Licensed by or Registered with the SFC.

How Alan Wong LLP Can Assist

Alan Wong LLP advises hedge fund managers and institutional investors on prime brokerage documentation, the negotiation of key terms (rehypothecation limits, close-out provisions, margin terms), and the assessment of legal risks in prime brokerage relationships. We also advise on the regulatory framework applicable to prime brokers in Hong Kong and assist with related agreements including ISDA documentation and custody arrangements.