By James Williams – On 4 August 2014, the Wall Street Journal reported that Goldman Sachs had commenced culling its hedge fund client roster, offloading managers who simply weren’t generating enough return on equity. Fast forward to 7 December 2014. Reuters reported that Credit Suisse was considering scaling down its prime brokerage business, as Switzerland contemplates imposing a tier one capital ratio of 4 per cent on its banks by 2019, 1 per cent higher than the Basel III ratio.
This is the start of a process of serious soul searching for tier one primes as they weigh up the costs of using balance sheet and to whom this increasingly scarce commodity should be offered.
Hedge funds that aren’t utilising credit lines, or holding a cash surplus in their accounts will either be asked to leave or face higher charges. Shorting stocks will increase and managers who have historically used significant leverage to run their strategies could be impacted.
Fixed income arbitrage funds – one of the most leveraged strategies at 13 times NAV – could be hit hardest, with returns falling an estimated 40–80bp according to Barclays. Multi-strategy hedge funds, especially those active in credit and convertible arbitrage, would also feel the squeeze, with an estimated performance drop of 15–30bp.
So it’s fair to say that regulation is set to throw the cat among the pigeons. If tier one primes proceed to cull hedge funds, it will – and is already creating – significant opportunities for new entrants.
One such entrant is ABN AMRO Clearing. The firm has built out a cash and, to a lesser extent, synthetic prime services business using a holistic operational model that avoids many of the legacy system issues of established primes. Crucially, by working with managers in this way, ABN AMRO is in a better position to understand their full potential, even if they aren’t generating high revenues across the board.
“Managers like a global approach but historically they’ve had to face one prime broker but different legal entities; one doing FX, one doing securities services, one doing clearing and another one doing investment banking. This is how some of the large names built their PB offering. When every department has to look at their own P&L, suddenly they say ‘We don’t like this client let’s ask them to leave’, even though they might be a good client in other departments.
“We have the chance to be one single legal entity for a manager. Profitability on OTC clearing might not be great, for example, but we look at the client more holistically and that allows us to make a clearer decision on whether to continue to give them leverage and finance,” explains Gildas Le Treut, Global Head of Prime Services at ABN AMRO Clearing.
As ABN AMRO Clearing manages the collateral from one single point of entry, they can see at any moment the full risk that they bear on any one client. This helps them to price their services more accurately.
The silo-based business divisions that tier one banks have built over the years and cobbled together as ‘prime services’ are today being exposed as brutally inefficient.
One could argue, therefore, that Basel III is a catalyst for positive change; primes have to now engage in a deep-dive analysis of every piece of business they have in terms of defining their resources: manpower, operational support as well as the amount of balance sheet being chewed up by holding an account and trying to ascertain how to improve the return on equity by tweaking things.
“As they go through that analysis, account by account, it’s not unlikely that they would find that the costs related to servicing certain types of accounts trading certain asset classes are higher than others. That might cause a bank to draw a conclusion on the asset class, as opposed to just the underlying managers,” says Jack Seibald, managing member at Concept Capital Markets LLC, one of North America’s leading introducing brokers.
“If accounts A, B, C and D that all trade a similar asset class have higher resource utilisation and no commensurately higher revenue stream than accounts E, F, G and H, which trade a different asset class with a better revenue-to-cost, it may lead the bank to conclude that it might not be worth continuing to support the less economically attractive asset class as a whole,” adds Seibald.
Seibald raises an interesting point here. Ultimately, no prime broker wants to lose clients. But if, as expected, Basel III prompts them to get their house in order, one might see tier one primes returning to their core competencies, potentially supporting key asset classes in which they know they can deliver excellence and balance sheet optimisation. And turn their back on asset classes that simply do not make economic sense.
That will require a fundamental shift in mind set.
Infrastructure and the rise of new entrants
After all, prior to 2008, prime brokers went after as many managers and supported every type of hedge fund strategy possible and it worked; revenues were booming, managers were trading in volume and leverage levels were high. But the financial crash changed all that. Suddenly, trading volumes slumped, managers embarked on a multi-prime mission and prime brokers were left with out-of-date technology infrastructures that could no longer provide the efficiency needed to operate in a post-regulatory world.
“It’s not like anyone’s dropped the ball. Banks were aligned with the environment that suited them at that time and the technology solutions they had worked perfectly well. Now that business model has shifted. Regulation is forcing people to change and become more efficient and better understand the quality of their relationships. It’s all about quality and efficiency today, to benefit everyone,” comments EJ Liotta (pictured), Global Head of PrimeOne Solutions, part of CoreOne Technologies which provides a gateway for new entrants to the prime finance space without the complexity and cost burden of having to build internal technology infrastructures.
The PrimeOne Solutions team comes from a global banking background so they know the issues that tier one primes face today. The technology infrastructure they’ve built, spanning global cash and synthetic PB and securities lending, is giving new entrants and tier two primes the ability to start building out their own prime services solutions to compete with the established players.
Their clients include tier one banks that would generally be considered tier two primes i.e. they’ve been in the prime finance space to a limited extent but are now turning it into a more substantial business, mini primes, both introducing and self-funded and self-clearing mini primes.
“In addition, we are starting to deal with tier one primes who are facing up to the infrastructure challenges. They have an issue that needs to be solved and we can honestly say that we are the only vendor equipped in this marketplace to help them solve that problem on a global scale across their entire platform,” says Chris Chanod, Global Head of Business Development, PrimeOne Solutions. “The minimum revenue targets on a USD150m hedge fund have increased on average from USD150-200k pre-crisis to greater than USD500k annually.”
Liotta notes that the order of magnitude PrimeOne Solutions can offer in terms of cost reduction is approximately 80 per cent.
“We can re-platform tier one primes to get their costs in line with the current state of the industry. In the tier two realm, the perfect storm has metastasized where tier one primes are jettisoning smaller hedge funds. So now you have this demand coming down the pipe that is providing an opportunity for tier two primes with strong balance sheets. The argument not to get involved in the past was because it was overly complicated from an IT technology perspective. We now solve that problem,” says Liotta.
One new entrant availing of PrimeOne Solutions is Canadian bank, Scotiabank.
“Ten years ago, I might have needed to fund the entire technology platform internally and that would have come with a multi-million dollar price tag. We felt the ongoing costs for this particular technology was best suited to us using a vendor.
“We are potentially the only Canadian bank that has a full suite of prime services solutions that is consistent with the larger tier one banks; i.e. cash and synthetics PB, global securities lending, trade execution services and capital introductions, all under the roof of prime services,” comments John Stracquadanio, head of prime services, Scotiabank.
Aside from the infrastructure benefits, Scotiabank is just one example of how banks are entering the prime services space with a balance sheet where they can price services correctly, as opposed to pre-crisis “when perhaps some banks were utlilising their balance sheets too quickly and too cheaply”, suggests Stracquadanio.
“The key point to make is that we are coming from a different starting place. We don’t necessarily have the same urgency to shed balance sheet like other prime services providers. The market is re-pricing as we speak and we have the opportunity to be the recipient of pricing which is much more reflective of the risk and cost of the balance sheet. We are starting from a position of adding as opposed to subtracting, and at the right price.”
Managers might need to cull their prime brokers
JP Morgan recently published a white paper on the impact of regulation and how managers might need to reassess their PB relationships. In the paper, they write: “Managers should understand in detail the holistic value of their relationship with the prime broker’s organisation, considering all elements of wallet allocation – long and short financing – along with the non-capital/balance sheet consumptive services such as custody and fund administration as well as execution. This may necessitate a review of service providers resulting in a concentration of the total wallet amongst a smaller group of banks that provide the full service suite of investor services.”
Much of the media debate is through the prism of the prime brokers and how they need to adjust to Basel III but hedge funds themselves need to take a hard-headed approach to maintaining their prime brokerage relationships, and, if need be, jettisoning those that are not providing cost efficiencies. An interesting paper was published by TABB Group in November 2014 entitled: Equity Prime Brokerage: Exploring Uncharted Territory.
In 2009, the average number of tier one prime brokerage relationships was 4.8. By 2011, that number had fallen to 2.8 and by 2012, it had fallen still further to 1.8; a necessary development as managers could no longer continue spreading their business too thin. After all, why would a prime broker service 20 per cent of the book?
What is particularly revealing in TABB Group’s report is the spread differential among six leading prime brokers regionally. Given their size and influence, one would expect the spread differential in different parts of the world to be similar: after all, they’re all providing the same service. But if one takes Japan, for example, across those six primes the spread differential was an incredible 140 basis points. For South America/Mexico/Africa/Middle East the spread differential was 120 basis points.
This encapsulates the scale of inefficiency that exists in the leading prime brokerages. Managers need to wise up to this and stop believing that they are getting the best prices.
“As managers themselves get more efficient and realise they are getting less from their prime broker(s) overall they will become more particular about who they work with,” says Radi Khasawneh, author of the TABB Group paper.
“There still isn’t enough independent data available on transaction cost analysis (TCA) in equities and fixed income. But if you talk to highly leveraged hedge funds – the Citadel’s and Renaissance Technologies of this world – they need a clear idea of how the cost of trading will affect the strategy to optimise the way they trade with their PBs. They’ve been doing it for years. The point is, everyone else is going to have to run to catch up.”
To that end, Khasawneh does not think it is a negative that primes are culling hedge funds because the industry needs to go through “a period of right-sizing”.
“In the fixed income markets, with OTC clearing and the electronification of trading, it’s all about efficiency. I don’t get the sense that anyone within the prime brokerage space has found an answer yet to achieving greater efficiency,” opines Khasawneh.
A fragmentation of the field: more specialist PBs?
One might well find that as primes focus on how to deploy their balance sheet more strategically that they become more specialist, rather than generalist. Firms like Newedge, for example, have a leading reputation for supporting CTAs and global macro strategies.
“Regarding specialisation, I think banks would have a much easier time leveraging their resources and capabilities by doing more within fewer business lines; the cost effectiveness would be clear. What that might actually mean is that they won’t be able to service the entirety of an account. If they decide to no longer provide financing on certain securities or no longer accept certain assets as collateral, what will that mean for managers running multi-strategy funds with both an equity and fixed income component?” comments Seibald.
Khasawneh thinks that the general premise of prime brokers becoming more specialist is possible, but notes that the core strengths of the largest and most successful primes are vast.
“Large primes can still offer everything to everyone, even if they do retreat to their core strengths. They have the capacity to service everyone but it will still allow niche players who wish to operate and specialise in a certain area.
“We’ve seen that happen in the US treasury markets with smaller dealers moving in to compete with primary dealers by specialising in a specific area of the yield curve or in specific instruments.
“There’s similarly a real service opportunity in prime brokerage for firms who have regional strengths or preferred strategies they like to service on the financing side or custody side. You’ll see a fragmentation of the service offering which will make things interesting,” comments Khasawneh.
“If you think about what the intention of some of these new regulations are, like what’s come out of Basel III, it’s to take away concentrated risk from a small number of counterparts and spread that risk to a wider audience of potential players. It’s creating a scenario such that whereas previously all the risk was concentrated in a small number of tier one primes, that risk is beginning to spread to other participants in other regions. It’s analogous to 2009 when managers wanted to spread their counterparty risk.
“I think we’ll see a growing number of new entrants providing balance sheet or collateral in line with their particular area of specialty. I think the days of building universal platforms to service everyone are gone,” states Stracquadanio.
Chanod confirms that PrimeOne Solutions is actively working through the analysis phase of some tier one primes’ infrastructure and providing potential solutions to solve their cost and efficiency issues.
“They recognise that something needs to change. We can simply craft our solution to their needs in a very quick period of time and the cost savings, in our evaluations, have been so impressive for them that saying they are excited by the opportunity is an understatement,” enthuses Chanod.
ABN AMRO Clearings’ Le Treut concludes with the final thought on the opportunities ahead: “You need to grow in small steps. Work with the strategies you are good at supporting and which fit your business model. I believe we will see more of a return to cash PB, specifically for us where we can demonstrate full transparency on asset segregation and margin protection. The days of Lehman where nobody knew where the assets and collateral were are over now that we have AIFMD and EMIR.”
Concept Capital’s Jack Seibald on rising costs
“I think securities lending and financing costs to hedge funds will go up irrespective of whether benchmark rates go up or not. The more important point to make, however, is not whether rates will go up but that spreads will widen. The banks are going to require a wider spread on the lending they engage in.
“When rules are written by regulators in the aftermath of crises they’re not necessarily thinking through the potential consequences of those rules and what it may mean for markets. Those investors who engaging in short selling are:
• Providing an important source of liquidity to the market
• Providing a counterbalance to those who are long-only.
“Regulations will simply make short selling more expensive and there could be a myriad of unforeseen consequences for the markets in terms of liquidity and how they function.
“I’m sure a lot of large hedge funds are actively going through internal discussions with their primes to understand all of the implications because they need to be prepared. They can’t just wake up one day and start operating under a whole new set of rules. I’ve been around markets long enough to know that when you change the rules by which the markets function, it will have an impact, and it won’t be immaterial.”
