The prime brokerage landscape is changing. The largest names still dominate in terms of market share, with Goldman Sachs and Morgan Stanley at the vanguard. But in a year when the established order has been overturned – think Brexit and the Trump election victory – the large investment bank-owned primes cannot afford to rest on their laurels.
This is because the nature of hedge fund managers is changing. Those spinning out of existing hedge fund groups and setting up their own funds are largely millennials who have grown up with the Internet and who bring a different mindset to the industry. They want quality service, top-rate technology solutions, a prime broker that will be nimble and responsive to their needs.
This is working to the advantage of boutique independent prime brokers who sit below the established order.
"The more that larger primes pare down their smaller clients, the more we've taken on new clients as we have strategically positioned ourselves in that space. Regulation plays a role in the sense that its become more difficult to be a client in this space, particularly smaller managers. What we try to do is institutionalise them," says Sean Trager, who runs the prime brokerage division within Wedbush Securities.
"We've seen a lot of consolidation and attrition in the PB space. Mini primes have either folded into larger firms, or partnered up with one another to become a greater force on the Street. What they've failed to do is offer a self-clearing model by blending efficiencies. Prime brokerage, by its very nature, is providing DMA, securities lending, financing and providing research. The only way you can do that successfully is by creating product and offering a service out of your own back yard as opposed to soliciting it from a third party."
Last year, Concept Capital became a part of Cowen Group, rebranding itself as Cowen Prime Services. As one of the co-heads of the business, Jack Seibald is all too aware of the need to support emerging hedge funds with a high-touch service and reduce their operating overheads. As such, alongside its successful prime brokerage business (which acts as an introducing prime), Cowen Prime Services has, over recent years, ramped up its outsourced capabilities with outsourced trading, in particular, proving particularly effective – not to just for smaller managers but established names who need to reduce their costs.
"If you dial back the clock, what was once institutionally acceptable to allocators is very different to how their perspective today. The concept of outsourcing certain non-investment related functions has become acceptable so long as the providers of those services are appropriately staffed and have the appropriate investments in technology and infrastructure. Today, it is relatively easy for investment managers using outsourced solutions to check the box on ODD questionnaires from large institutional investors.
"The millennial hedge fund manager has grown up with the attitude that you don't need to buy a car but rather use Uber; they're essentially outsourcing the driving function. The notion of outsourcing is acceptable, understood and practical for millennials. The way these younger managers embrace technology is very different to the older generation of fund managers. Younger managers want more flexibility in terms of how they receive and digest data from their prime broker," explains Seibald.
There is also less of a stigma associated with not choosing a bulge bracket prime.
Newer managers are more open-minded; they want to know what they are getting, what they are paying, and whether it is worth it. There's more of a willingness to accept alternatives, away from the bulge bracket primes, suggests Seibald.
The level of technology that a prime broker can bring to bear could well become a key differentiator; if indeed it hasn't happened already. Those that have the technology backbone in place to deliver a plethora of fund information and market price information will be best placed to adapt to the new world order.
"I believe we are well positioned to respond," suggests Trager. "We acquired a technology firm around five years ago called Lime Brokerage. Lime is a technology provider with low latency solutions, unilateral market access, reporting and risk mitigation tools. This has made us a lot more efficient as we can do a lot of things for our clients that our third party providers were doing previously.
"We feed a lot of fund information straight to the client's fund administrator(s), which helps keep the costs down. We send direct feeds to all the administrators which removes a whole layer of reporting for them and a layer of underlying costs to the client."
Wedbush has been offering customisable algorithms to its hedge fund clients for quite some time. It offers everything from a hedge fund in a box – where the client can write their own code – to risk mitigation tools with scenario testing. The manager can plug in their portfolio and see what would happen if the price of gold spiked, for example.
"What we are doing is helping the person running USD30 million in AUM get the same benefit and advantage as the person running a billion dollar fund. Most folks launching funds today are tech savvy and looking for technology resources and services. We are properly positioned to provide our services to them and help them with their launch," adds Trager.
One of the more recent entrants to the PB space is Apex Clearing. Apex is keen to leverage its technology backbone to make an impact and shake up the natural order. When asked whether the technology capabilities that it can offer its PB clients are potentially even greater than they would get at a Tier 1 prime, William Capuzzi, CEO of Apex Clearing, does not hesitate: "One hundred per cent. We're reinventing the way a prime broker provides service. We know the next generation of millennials really well. They are trying to find alternative ways of investing and I think what's going to happen is, if you fast forward five years, the lines are going to get blurred between retail passive investment and active hedge fund investment.
"We're already starting to see this. There's a company called Hedgeable (a New York-based private wealth manager) that was established by a couple of guys who ran a hedge fund but found it difficult to grow assets. At Hedgeable, they apply hedge fund principals to retail fintech, providing a robo solution that has many of the same attributes of a hedge fund. The premise is to gain assets you can't just look to your classic institutional investors," says Capuzzi.
The landscape is changing and prime brokers need to be aware of this. In Capuzzi's view, "you've got to try and create a bridge between the classic old school way of operating a hedge fund and a new school way that fits with the millennial generation that has a mobile device in their hands at all times."
As the prime brokerage model evolves into something more tech-heavy, this should help bulge bracket primes as they look to optimise their balance sheets. For the time being, however, some are jettisoning strategies and managers because they cannot absorb the risk. This is because Dodd-Frank and Basel III rules are forcing banks to adhere to Liquidity Coverage Ratios (LCRs), which require them to hold onto sufficient High Quality Liquid Assets (HQLA) to manage down a 30-day market stress event.
If a strategy is sucking up too much balance sheet, the banks just won't support it. This is not necessarily something that affects non-bank primes like Apex but Capuzzi caveats the point by saying:
"The premise is that if you have technology right it shouldn't matter too much if it is a credit strategy, a stat arb strategy or a long/short fund; we can provide solutions to all of them. Where it gets tricky is around the issue of capital usage. Some strategies are more capital intensive than others. Those hedge funds (i.e. fixed income arb) have had a good ride up until now.
"We are no different than the banks in the sense that if someone wants access to capital we have it, but they've got to pay for it. I think those funds are challenged with trying to generate alpha, while at the same time incurring higher costs based upon the amount of capital they need to put to work to deploy the strategy. For some funds their strategy is flawed, largely because they haven't come to grips with the cost of capital.
"The industry created the problem by providing leverage at a discounted rate. That's been snapped back now. The guys who play straight down the fairway (long/shorts, global macro) are a lot easier to support in terms of helping them generate alpha and succeed because they are less capital intensive."
To highlight the pressure that the banks are under, this month Deutsche Bank said it would cease providing some coverage for approximately 3,400 actively trading clients in its global markets division.
A Deutsche Bank spokesperson confirmed the contents of a memo in which it said it would perform a detailed review by the trading division of the German lender's client list "to identify clients with whom it is not strategically viable for us to continue to do business".
The action, reported Zerohedge, is aimed at balancing "risk, revenue and profitability". The cuts affect Institutional Client Group debt and equity sales, sales trading and equity structuring clients, according to the memo.
One aspect of technology that could improve prime brokers' ability to support millennial hedge funds going forward is the continued electronification of the bond markets. This remains a huge reservoir of untapped potential as fixed income markets gradually adopt more electronic trading protocols.
Steve Sanders is EVP, Marketing and Product Development, Interactive Brokers. He comments: "We are a leader in pushing the trade lifecycle electronically. We are connected to a number of global electronic trading venues. I believe some 20 per cent of all bond trading today is now electronic and it's moving higher. One of the causes of that is regulation and the capital requirements that banks face; pushing the bond markets into the electronic realm reduces costs.
"We therefore think we are well placed to cope as the markets evolve. The days of calling brokers and trying to negotiate trade prices over the phone are over. We have a great bond offering, a great FX offering, futures and options, stocks; we cover all the major asset classes."
This represents a huge opportunity for Interactive Brokers, in part because the banks are unwilling to hold large volumes of inventory.
"I think the trend is towards further electronic trading of bonds but I cannot predict how fast that trend will develop or how big a move we will see in any given year. Either way, we will continue to bring out new tools and automate regulatory requirements into our system to keep the costs low for our clients," affirms Sanders.
James Alexander is Chief Commercial Officer at Invast Global, whose PurePrime service, which uses a prime-of-prime model, gives clients unparalleled liquidity and transparency. He views the electronification of fixed income as playing directly to the strengths of Invast, which gives clients access to more than 20 bank and non-bank FX Liquidity Providers (`LPs') and allow them to structure their own liquidity mix in real time.
Clients are able to see the LPs within their aggregated feed, both pre-trade and post-trade. This is revolutionary transparency for Prime-of-Prime clients and ensures there are no hidden mark-ups.
"Our clients don't have to go out and establish brokerage relationships, or establish networks to borrow securities; we have all the infrastructure in place for them. We will go out and source stocks to borrow across five or six liquidity pools. In addition, easy to borrow stocks are already in the back-end of our platform for clients to short straight away.
"The model we offer is flexible, easy to use, low cost and there are no monthly minimums in most cases. Our solution is all set up and ready to go. This is what marks us out from traditional PBs," says Alexander.
Another boutique prime broker offering something similar, using the mini prime model, is London-based Linear Investments.
Technology is a key element of its business according to Linear's Chairman, Jerry Lees. "We are running state-of-the-art market surveillance with real-time monitoring. Our TCA system can prove best execution to clients on real-time basis.
"We are on our third version of our margin management system optimising margining and control, we have also implemented Advent Geneva for middle and back-office operations. We are live with our EMS system, Xconnect, and we are preparing to launch our own OMS product so that people will be able to see all their positions on any device. The advantage of all of this is it reduces the pressure on our middle and back-office teams, allowing expansion of our client services. The more you automate, the faster you get the information out," says Lees.
As more banks cull smaller hedge funds from their books to focus on the largest managers it is creating a vacuum which Linear, and others, are working hard to fill.
"I believe we are in the right place at the right time," continues Lees. "We opened our trading floor with an extra 100 desks only a couple of months ago and it's now full.
"We have created an environment where everyone is able to share infrastructure, share ideas, share costs; a We-Financial. Managers can draw on what they need from one location and focus on growing their business. It's a model that is used in other industries across the world; we're applying it to the financial industry."
Transparency please
Greater technology brings greater transparency. At Cowen Prime Services, this is also being achieved by offering outsourced trade support.
"The OMS is electronically linked to our traders. Our traders, who function as an extension of the manager, can see the client's portfolio and the client can see all live trades; when they enter a trade it populates the system. One of our traders then electronically messages off the order to the respective executing broker. The process is fully transparent to the manager and the executing broker.
"Not only will the client see that the order has been messaged to the specific executing broker, they will see the order being filled tick by tick. The manager therefore has the ability to see everything that happens from the time the order is entered to the time the order is completely filled. They can compare the order to the average price of the stock relative to their order and see the quality of execution," explains Seibald.
That level of transparency is not necessarily forthcoming at the larger primes where they might cross orders to make a spread.
"I don't think there is much incentive for larger primes to open up and become more transparent," suggests Sanders. "They make a lot of money from remaining opaque. I'm not sure it's really in their interests to develop the technology like ours. For years people have been trying to develop exchanges that you can go to and find out borrow rates. AQS was one of them that openly failed because the participants didn't want to make it transparent, as it would reduce the money they made.
"We've always been a technology company that operates in the trading business. Our programmers and technologists are fundamental to our success and our ability to automate solutions and to provide services at the lowest possible cost."
Seibald concedes that, from a transparency perspective, it's still a bit more of the Wild West with respect to providing prices on hard to borrow stocks.
"You might have a security that has materially different borrow rates at three or four different banks depending on whether they have stock available in their system or not.
"Where firms like Cowen have tried to be helpful to clients is on the stock lending side, which allows our clients to lend out stocks they own and generate income for their funds. We have lots of clients who invest in small- and mid-cap securities.
"Often those are deeply researched positions that managers hold for long periods of time, and they are often on hard-to-borrow lists from our various clearing firms. We have a program that identifies such position among our client holdings and when appropriate, offer clients the opportunity to term them out and earn a specifically defined portion – a substantial majority – of the interest earned from such a loan.
"There is a tendency to make sec lending a more transparent process but generally speaking I don't think some of the larger primes are too aggressive on wanting to share their rates with clients," comments Seibald.
Prime brokers like Cowen, Interactive Brokers, Wedbush etc., have had to work hard to make a name for themselves by being more cost-efficient and transparent. This augurs will for the future in supporting millennial hedge funds.
"We're in a world where if you try to do anything that isn't transparent it just isn't going to work out well in the long run," says Seibald.
Apex's Capuzzi offers a final thought: "As we swim upstream and provide the technology for managers to operate in a multi-custodial world I think we are going to attract bigger and bigger funds.
"We are a prime broker first and foremost, and we also execute. I say that because what's happened in the industry is that many firms started as execution firms for the buy-side and then said, `Oh, and by the way we can clear your trades'. We take the opposite approach. We focus first on custody of the assets, on credit risk management and provide a layer of technology above that to execute a client's trades.
"We have a great trading desk. But the first thing to get right is to custody the assets before worrying about execution."
