Brokerages often focus on tighter spreads and better pricing when engaging a new liquidity provider (LP). However, liquidity agreements require careful review. Several factors must be considered when entering or renegotiating such agreements, whether with a Prime-of-Prime or Prime Broker .

Segregation of Assets

Firms should determine if their assets are segregated from the LP’s own funds and those of other clients. If there is no segregation, the jurisdictional rules and risks involved must be assessed. In cases of omnibus accounts, brokerages should consider the implications if another client in the pool becomes insolvent.

Collateral Management

Collateral, or margin, is cash or securities posted to an LP. Key considerations include whether the brokerage retains ownership, applicable discounts, and the timeframe for collateral delivery. Additionally, firms should assess whether they can reclaim excess collateral.

Collateral transfers are often absolute, meaning the LP gains full ownership. This creates credit exposure, making the brokerage an unsecured creditor. LPs typically do not return collateral unless negotiated at a higher cost.

Rehypothecation Risks

LPs often reuse posted collateral for their own purposes, such as borrowing or lending. This practice reduces costs but increases counterparty risk. Removing rehypothecation rights from agreements is difficult, and brokerages should be aware that collateral may be used across an LP’s group entities.

Events of Default (EODs)

Firms should review default clauses, including whether they apply to the LP. They should check if they can suspend payments , close transactions, or set off amounts in case of an EOD. Additional termination events (ATEs), such as a decline in net asset value, should be reviewed or adjusted to avoid premature termination.

Termination Consequences

In case of termination, brokerages must ensure all transactions are closed out fairly. They should assess whether the LP can selectively close positions in its favor. The role of the calculation agent is also crucial, as it determines termination amounts. Firms should consider appointing an independent agent if the LP is in breach.

Additional Documentation Considerations

Other factors include the obligation for periodic due diligence, the rights of custodians over client assets, indemnities favoring the LP, and tax provisions such as gross-up clauses. Dispute resolution mechanisms and governing law should also be reviewed to ensure fair legal protections.

Brokerages must carefully examine these aspects before finalizing liquidity agreements to mitigate risks and safeguard their assets.