Fed and BoE step up scrutiny of bank exposure to trading firms after Jane Street loss
Regulators intensify questioning of prime brokers after blow-up at AI-focused hedge fund Situational Awareness
Costas Mourselas and Martin Arnold in London and Jill R Shah in New York
The Bank of England and US Federal Reserve have stepped up scrutiny of bank exposures to large trading firms after turmoil at AI-focused hedge fund Situational Awareness caused large losses at Jane Street.
The regulators are asking global banks about their exposure to trading firms and market makers including New York-based Jane Street and Ken Griffin’s Citadel Securities, according to people familiar with the matter.
The watchdogs had already made understanding banks’ exposure to so-called non-bank financial intermediaries — a broad category that incorporates private credit providers among others — a longer-term priority.
But they intensified their efforts to understand the position relating to trading firms and market makers in the wake of the sell-off and Jane Street’s losses, the people said.
Regulators wanted information about the firms’ risk appetite, how banks’ exposure to them evolved during the day and how risk controls operated, one of the people said.
The BoE’s Prudential Regulation Authority (PRA), the Fed and Jane Street declined to comment.
Specialist trading firms and market makers such as Jane Street, Citadel Securities, Susquehanna and Hudson River Trading have enjoyed a meteoric rise since banks stepped back from proprietary trading in the wake of the 2008 financial crisis.
Many trading firms have their roots in the relatively low-risk business of market making, where they fulfil buy and sell orders for thousands of different securities, pocketing a small spread each time they do so.
But they have since diversified and built large proprietary trading businesses where they take directional bets — including, in Jane Street’s case, equity stakes in some businesses.
Unlike hedge funds such as Citadel, Millennium and DE Shaw, the firms typically exclusively manage the capital of founders and internal employees, allowing them the freedom to take risks without answering to external investors.
Jane Street has become the world’s most profitable trading firm, with $40bn in revenues last year.
However, in July, it lost $15bn as a long AI rally went into reverse.
In part, that was due to multibillion-dollar losses sustained by Leopold Aschenbrenner’s hedge fund Situational Awareness, in which Jane Street had invested.
Even after the loss, Jane Street had by early August generated $40bn in net trading revenues since the start of the year, eclipsing last year’s record gains.
But the scale of the loss indicated that Jane Street, which also has a stake in Anthropic, appeared to take far more risk than a typical market maker.
The growth of trading firms and their increasing systemic importance has made them more of a focus for regulators, which are seeking to understand how they might transmit risks across the financial system.
Banks help trading firms and hedge funds access markets via prime brokerage relationships, extending leverage to the groups to help them juice returns.
Prime broking has become big business for banks, helping to power record profits across Wall Street.
Lenders finance equities trades, lend against bonds and execute and clear derivatives transactions on clients’ behalf.
That means they face potential losses if one of these firms defaults on trades financed by the bank.
If regulators believe banks are taking on excessive risks in financing certain firms, they can increase the amount of high quality liquid assets the banks are required to hold to help them survive a potential market sell-off or the collapse of a large client.
The BoE has also probed the rapid growth of financing Asian equities by London-based prime brokers this year, after a few AI-driven stocks such as SK Hynix made extraordinary gains.
The PRA said in its business plan in April that it had “seen many firms strengthen end-of-day monitoring and stress testing, however rising intraday exposures — particularly for firms providing market access, clearing, and financing to electronic market-makers — continues to pose potential risks”.
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