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Claude Brown, Clifford Chance

New regulations set to raise costs and erode margins

By James Williams – Prime brokers are bracing themselves for a swathe of new regulations that will place them under fresh operational and cost pressure. “The operational expense and sheer implementation cost under all this new regulation is not something prime brokers will be able to pass on easily to their clients, so I expect their profit margins will be impacted by implementing the regulatory changes over the next two years,” comments Claude Brown, prime brokerage expert at law firm Clifford Chance.

These are challenging times for prime brokers. On the one hand their hedge fund clients are becoming more demanding by wanting better solutions at lower cost, at a time when trading volumes are down significantly and leverage levels remain modest at around the 2.5 to 2.5x mark. On the other hand, they’re facing increased costs of doing business because of the raft of regulation coming down stream.

As anyone will tell you, to be a major player in the prime brokerage arena means having enough “skin in the game”. Firms either have to be fully committed to building out their platform offering, or go home.

How, then, might things play out as global regulation kicks in? Before touching on the key regulatory points, it’s worth saying that in the next couple of years there is likely to be further consolidation in the market. Already this year Wells Fargo has acquired Merlin Securities: more will follow.

This will be in response to Basel III increasing the Tier 1 capital ratio requirements on banks. Currently banks only need to hold a capital ratio of 2 per cent of common equity in Tier 1 assets, but that is set to rise to 4.5 per cent. Factor in the 2.5 per cent “liquidity buffer” for risk-weighted assets and the funding of a prime brokerage business – which has never been a high margin business for banks – is likely to get harder and more expensive.

“My feeling is that Basel III will result in some more consolidation. Reduced trading volumes plus the other bits of regulation coming down the line might prompt some people to say this is no longer a business they want to carry on with, or to expand. I also think any expansion by prime brokers into emerging markets will be substantially curtailed,” says Brown.

Ironically, the fact that primes use netting for “quasi-secure” lending and implement leverage based on security over a client’s assets actually means that they are already well positioned as the future of the new regulatory environment moves toward secured lending.

Of perhaps greater concern is the AIFM Directive in Europe, which is likely to require prime brokers to undertake a substantial re-structuring exercise. Under the Directive any hedge fund will need to have a depositary who will be liable for any loss of securities held in custody, even due to the actions of unaffiliated third party sub-custodians.

Put simply, prime brokers are going to need to firewall themselves from the bank’s depositary function (if it has one). As one prime broker stated, this will involve creating new contractual relationships between depositaries and primes, adding that they themselves were now currently “working with all the top custodians, who will become depositaries, to jointly address the issues our clients will face”.

“Basically, this is going to create a lot more noise around the way a prime broker operates,” says Brown. “In essence, the rule is that the prime broker cannot be both a counterparty and a depositary unless it can show what is called “functional and hierarchical separation” for its custodial business. Generally speaking, most financial institutions that have custodial services have them embedded within that financial institution and not as a separate legal entity.”

This means that those who stay in the game are going to have to restructure themselves so as to ensure the depositary function is completely separate from the prime brokerage business. Clearly, there’s a cost, both material and operational, to doing this. The whole point of having a depositary function alongside the prime brokerage is for banks to create synergies. Under the Directive, banks will have to run an autonomous organisation within an autonomous organisation – rather like the Russian doll – and in one fell swoop remove the very operational efficiency it was designed to achieve through this forced separation.

Adds Brown: “For those that get the separation in place, even if the depositary is within the same group it’s unlikely to be in the same jurisdiction. Some might have custody services in London within the universal bank but actually they’ve got separate legal entities that can do third party custody services in, say, Luxembourg. Even though they are part of the same group there will be inefficiencies in the movement of securities and operational infrastructure.

“If you went through a hypothetical default scenario with a fund, if everything is in the same organisation you want to move quickly to shut it down, net off your positions, close out your OTC derivatives etc. In multiple entities within one organisation it may not be the smoothest operation but it’s 100 times smoother than it would be by having to use third party custodians and trying to unwind positions in different jurisdictions.”

The degree to which prime brokers are affected by the AIFMD will depend on whether they are “pure” prime brokers – that is institutions like Goldman Sachs and Morgan Stanley – or whether they are universal banks that have decided to do prime brokerage. These institutions, provided they effectively re-structure themselves based on the above, will find it easier to provide the depositary function. For the independent prime brokers, it might prove tougher.

Says Richard Frase, partner at Dechert LLP: “The track record for an independent prime broker and an independent depositary, if you look at what’s happened in Ireland, is quite a bouncy ride in terms of getting agreement at the launch of a fund. Any prime broker who can manage to work through that sort of arrangement should be in a good position under the new regime.”

Another key concern for primes is the liability issue under the Directive. Up until this year a lot of trust was placed in ESMA’s recommendations that securities being held as collateral would not have to be treated within the strict liability requirements under the Directive. That’s no longer the case.

But there are options. “One is to do what FoFs do, which is to place a charge over assets held with the depositary. Legally, this ought to work but operationally it creates problems,” comments Frase.

“Another option is to pass liability on to the sub-custodians, who then agree to assume liability directly to the investors. That’s something which we’ve tried to achieve in the past and been told it’s impossible. If they did manage to achieve this something good would come out of the Directive.

“A further option could be to persuade the manager to waive the requirement that they accept full liability, though this puts the responsibility back on to the manager. You might possibly be able to rationalise this if you were looking at an emerging market-type fund.”

Clearly, then, prime brokers face a structural and liability issue under the Directive, which will make it more expensive to do business. They will also need to pay closer attention to their funding models under Basel III. Technology vendors are aware of these regulatory pressures and are working hard to help prime brokers, and the wider investment fund industry, keep on top of things.

As EJ Liotta, global head of PrimeOne Solutions, explains: “The prime brokerage industry is facing a high degree of pressure around funding. Many firms operate on the basis of using short-term funding sources and finance clients for much longer periods creating a fundamental mismatch between asset and liability durations. We have capabilities that clearly show funding mismatches, thus providing an opportunity to reduce risk.“Our re-hypothecation engine will also help prime brokers monitor their ability to use clients’ assets more efficiently.”

This issue of prime brokers using the repo markets and re-hypothecation to finance a lot of the services they provide is also important in light of the fact that the Financial Stability Board (FSB) last month released a white paper on the potential regulation of the shadow banking market, entitled Global Shadow Banking Monitoring Report 2012. The objective here is to ascertain the degree of potential systemic risk created by such activity. Says Frase: “Is there a mismatch between the assets raised by prime brokers on the back of clients’ securities and their obligations on the other side? The answer might be no but it’s likely to be re-examined again.”

It’s too early to tell what impact potential shadow banking regulation will have on primes but Brown thinks it could actually be a positive development because it would, in effect, level the playing field: i.e. bring hedge funds and other non-banking institutions who are increasingly starting to lend into a regulatory framework.

On the systemic risk issue, Brown observes: “If your hedge fund clients are getting into lending activities, how do you know whether or not they are lending to one of your big corporate clients? That creates a systemic risk that you can’t even see.”

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