Prime brokers respond to shifting composition of the hedge fund industry
Faced with the challenges brought on by the shifts in the hedge fund industry and the changing regulatory landscape, prime brokers are attempting to differentiate themselves through unique product offerings, as well as their ability to leverage proprietary technologies and organisational efficiencies.
This is according to Ernst & Young's survey of prime brokers, The balancing act: how to navigate the evolving challenges of the prime brokerage industry.
The firm surveyed executives from eight prime brokers to explore a variety of topics, including organisational structure, new business (including pricing and lockup agreements), client monitoring and revenue management as it relates to securities lending. The survey reveals trends around how prime brokers manage products, including ETFs, equity reverse repos, stock-for-stock transactions and tri-party structures.
"The prime brokerage industry today is under tremendous pressure to respond to the shifting landscape," says Mark DiMaio, principal, banking and capital markets, Ernst & Young. "Therefore, the industry is focusing on how to better quantify operational costs in order to increase the profitability margins of new and current clients. Prime brokers need to understand these costs to tier clients effectively."
Key findings from the report include:
Client acceptance process: According to the survey, most brokers (70 per cent) have a formal acceptance process for new clients and take similar steps when considering a new client, such as a pre-qualification and verbal agreement followed by due diligence and approval by the acceptance committee or the senior management group. That said, given the range of hedge fund strategies, client acceptance requires a significant amount of judgment and does not present much opportunity to find efficiencies. However, firms that begin by gaining a better understanding of the potential operational cost of a client under consideration will be best placed to decide whether the relationship will be profitable over the long term.
Client onboarding and monitoring: The survey shows that prime brokers can potentially gain advantages by introducing better technology into the onboarding process. Less than half (44 per cent) of firms surveyed say they use a semi-automated process for capturing data and tracking onboarding progress and completion, and none of the firms surveyed have a tool that configures and integrates all prime brokerage systems with client information and unique business requirements, meaning no firm is able to fully automate client set-up.
Organisational structure: Only one prime broker surveyed is a standalone, separate and distinct business unit. The others work in the same silos that affect the business, such as securities lending, FX and OTC clearing. The majority (57 per cent) of the brokers surveyed have service-level agreements between centralized back-office support and prime business lines and use varying tactics for performing work such as P&L generation, confirmation and affirmation and reconciliation. All participants reported that they use a broker/dealer structure combined with an international entity that allows them to move their derivatives business offshore, effectively reducing their balance sheet burden and lowering regulatory capital.
Liquidity management: Liquidity management is an area that could benefit from better data management processes and technology. The majority (71 per cent) of prime brokers surveyed stated that they do not have a method for notifying their treasury group of large cash inflows and outflows, while the 29 per cent that do, use email and phone calls to inform treasury. However, prime brokers say that they speak with their clients about the best times for cash deposits and how funds expect the prime broker to help to manage their liquidity needs.
Revenue allocation: The survey showed that there is no standard way that prime brokers allocate revenue between the securities lending desk and the source of the long. The survey also found that collateral agreements are usually written into the prime brokerage agreement. However, hard-to-borrow securities require collateral negotiation on a case-by-case basis.
Lockup agreements: More than 70 per cent of respondents surveyed offer lockup agreements, with the most popular terms being 30, 60 and 90 days, though 29 per cent provide lockups for as long as 365 days, depending on the client relationship. A longer lockup is usually granted if a hedge fund has illiquid positions that would make a prolonged period necessary to duplicate positions with another prime broker. Both centralized and decentralized approaches are used to monitor lockups, with the former consisting of dedicated groups monitoring and the latter involving multiple groups each monitoring a different lockup requirement.
Enhanced leverage: Three-quarters of prime brokers surveyed offer margin relief to their clients beyond the Federal Reserve's Regulation T margin limit of 50 per cent through enhanced leverage and portfolio managing. While enhanced leverage levels of 6:1 and higher are possible for large and healthy hedge funds, regulators may still look askance at prime brokers who push the envelope. There was no consensus among the respondents regarding who should monitor the non-cash collateral provided in the enhanced leverage transaction.
Arthur Tully, co-leader of EY's global hedge funds services, says: "Firms must learn to adapt to the pressures on fees and the multi-prime trends that have resulted from the changes in the hedge fund industry. While firms have started to recognise these challenges, the survey reinforces the need for brokers to develop ways to better integrate their systems with client's information and enhance their ability to quantify associated operational costs."
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