The US Securities and Exchange Commission (SEC) has launched an inquiry into the prime brokerage divisions of several major Wall Street banks, including Goldman Sachs, Morgan Stanley, Bank of America, JPMorgan Chase, and Citigroup. The subpoenas request information about their risk management practices, client onboarding procedures, and overall exposure to highly leveraged hedge funds. This investigation follows the dramatic downturn of Leopold Aschenbrenner's AI-focused hedge fund, Situational Awareness, which saw a peak of $45 billion in assets before facing significant losses and liquidity issues in July. The SEC's action indicates a heightened scrutiny of the potential systemic risks posed by the prime brokerage business, especially after the Archegos Capital Management collapse in 2021.
The SEC's focus is on understanding whether banks adequately assessed and managed the risks associated with providing leverage to funds like Situational Awareness. The fund, which had borrowed billions from these banks, experienced a rapid unwinding of its highly leveraged bets on AI-linked stocks, leading to substantial margin calls. While prime brokers claim they emerged unscathed due to tighter risk management post-Archegos, collecting more collateral daily and having recourse to both public and private investments (including a $5 billion stake in Anthropic), the SEC is looking into the effectiveness of these measures.
Bank of America CEO Brian Moynihan described the Situational Awareness incident as a "warning shot," acknowledging the need for vigilance regarding elevated valuations and leverage in the market. The episode highlights the intense competition among banks in the prime brokerage sector, which has seen hedge fund borrowing nearly double to $3.2 trillion over the past five years. Goldman Sachs, for example, reported a record $3.26 billion in equities financing revenue in Q2, demonstrating the lucrative yet risky nature of this business.
Jane Street, a significant investor in Situational Awareness, reported a $15 billion hit in July, largely attributed to its exposure to the fund and the broader AI stock selloff. Despite this, Jane Street's year-to-date trading revenue exceeded $40 billion. The firm stated that its investment in Situational Awareness, though experiencing a large drawdown in July, was still up over the entire period of investment. Jane Street indicated it would become "more selective" about risk and had reduced its exposure in the affected areas. The SEC's probe seeks to ensure that banks' internal controls and risk frameworks are robust enough to withstand such volatile market events, preventing a repeat of past crises driven by excessive leverage.
