By Duncan Crawford – Revenue pressures coupled with increased costs are forcing many in the industry to overhaul their business models in an attempt to capture new revenue streams. The alternatives industry has radically changed and the turmoil created by this has been particularly damaging to prime brokers, many of whom operate revenue models focused on stable client securities balances and securities trading volumes.
While the bulk of a traditional hedge fund manager’s investment thesis is implemented through equity and/or fixed income transactions, cost pressures are forcing prime brokers to diversify towards servicing strategies that utilise instruments other than cash equities and bonds, such as listed derivatives clearing, synthetic and FX prime brokerage. Top-line revenue for prime brokers has been compressed due to increased central bank intervention in global markets, as well as low market volatility. This has resulted in a decrease in their clients’ leverage, a fall in trading volumes across all instruments and the emergence of the inconsistent ‘risk-on/risk-off’ approach.
From a bottom-line perspective, the challenges are the same for prime brokers and their clients. With so much legislation impacting the industry, the cost of doing business is increasing for all participants but the smallest fund managers are being hit the hardest.
From an investor’s perspective the last five years have been characterised by poor returns and asset erosion, but the quest for alpha remains. Herd mentality may have resulted in assets flowing predominately to the largest hedge fund managers, but this will likely result in a homogenisation of returns as deployment of capital becomes more onerous and managers chase the same trades.
Consequently, we are observing a return to prominence of emerging managers, many of which are prop desk spin-outs. Investors are being persuaded by the increased agility of these funds with more attractive risk/return characteristics and employing fee structures more closely aligned with investor interests.
Furthermore, the investor community is ascribing more importance to liquidity and transparency on the back of several prominent fraud cases. One direct trend resulting from this is the emergence of separately managed accounts. This represents a significant opportunity for those prime brokers that are able to deliver an increased understanding of the asset owner, the trading counterparty and the credit risks involved.
Additionally, servicing managed accounts can be a counterintuitive concept for a prime broker to amalgamate into their strategy, as it typically requires an operational acceptance of multiple smaller accounts being traded by the same manager, each for a different investor and with lower trading levels.
At Newedge we believe that successfully implementing a workable managed accounts strategy for all clients will be a key differentiator in the future.
I have worked in the industry for more than 20 years and prime brokers have shown a unique ability to transform and prosper in the face of upheaval. I believe the changes we are observing will bring out the best in many of us: certainly, a return to stability and growth is within the industry’s grasp.
The continued emergence of Alternative Mutual Funds, for example, promises to offer a more diversified, and hopefully, more stable investor base for the industry.
For us all to emerge bigger and better than ever, prime brokers must evolve alongside fund managers and investors, and capitalise on the opportunities that have been borne out of change.
Duncan Crawaford is co-global head, Newedge Alternative Investment Solutions