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FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks

A prime broker's hedge fund clients rehypothecate client collateral to fund the broker's inventory. Rumors about the broker's solvency spread. Which client action most directly drains the broker's liquidity?

Clients withdrawing free credit balances and moving assets to other prime brokers drains liquidity most directly. Those balances and rehypothecable assets fund the broker's inventory, so their removal forces the broker to replace funding quickly. Longer lock-ups or higher rehypothecation limits would help the broker, not hurt it.

  1. AClients increase their long positions held at the broker
  2. BClients withdraw free credit balances and move assets to other prime brokersCorrect
  3. CClients agree to longer margin lock-ups
  4. DClients raise the broker's rehypothecation limits

Explanation

Prime brokerage clients' free credit balances and rehypothecable assets are a source of funding for the broker. If clients withdraw them and transfer positions elsewhere, the broker loses that funding and must replace it. The other actions would add to or stabilize funding.

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