New capital and leverage ratios being mandated by the Basel III rules will penalise prime brokers whose securities financing operations will be incrementally included as risk exposure that requires a capital buffer.
TABB Group says that the rules, treatment of collateral and divergent cost of financing in prime brokerages are forcing a reassessment of internal benchmarking at a time when hedge funds and long-only funds are using fewer prime brokers since the financial crisis, a trend that continues downward, says Radi Khasawneh, a London-based TABB research analyst who wrote “Equity Prime Brokerage: Exploring Uncharted Territory.”
As brokers are focusing on key clients reassessing use of their bank’s balance sheet, given the new regulation and cost pressures, TABB has not seen a significant shift in the way client choices are being made, as the new regulatory and clearing regimes pull equity markets into the process currently being undergone in fixed income. Analysis of the likely cost of trading will be necessary and create a significant opportunity for hedge funds and long-only asset managers to create enterprise preserving opportunities.
“Complacency would be a mistake,” warns Khasawneh. For example, data suggests that there is already a significant divergence in the cost of financing for equities trades across prime brokers. “In fact, the spread differential in the cost of long-and short equity financing with the six most frequently used prime brokers is as big as 95 basis points in the telecommunications sector alone”.
In the US and Europe, a shift in attitude is emerging. Large, leveraged multi-strategy funds have long invested in an expanded treasury function that monitors cost of financing in conjunction with a more sophisticated risk and compliance division focused on regulation. Others will now have to replicate this. Rather than informing decisions on a trade-by-trade basis, their new functionality can feed into an overall picture of the financing performance of a portfolio, the value of client flow and the most efficient partner for strategic goals. While every fund will emphasize the need to create alpha as the main strategic imperative, TABB sees efficiency in all areas as key to delivering this and therefore a more important role for surveillance data.
A head-in-the-sand approach by the wider buy side universe, however, will not make the problem go away. Coming to an acceptable solution satisfying fiduciary obligations should be critical for most funds in the US and Europe, says Khasawneh. “Its importance will only increase in line with costs. The fewer data points available in the normal workflow, the more important this is, so paradoxically the smallest funds have the most to gain from incorporating a surveillance strategy.”
