One of the unintended consequences of market regulation is that it has, to some extent, leveled the playing field. In what was once a fiercely competitive environment dominated by bank-owned prime brokers, in recent years a slew of new entrants has emerged, offering different service models for managers to consider.
Indeed, in early December, ING Capital Markets LLC were the latest to say that they were expanding into PB with the launch of a synthetic prime brokerage platform to provide global, cross-asset portfolio swap products.
"We offer the flexibility of a multi-asset portfolio swap which is operationally efficient, streamlined and provides additional collateral and portfolio margin benefits," said Michael Baudo, Regional Head of Financial Markets Americas and Global Head of Securities Finance. "We are excited to launch a platform that differentiates itself and adds value to clients while drawing upon the more than 20 years of experience our team has been providing securities finance solutions to the market."
Cost of balance sheet is now a forensic exercise for Tier 1 primes. Hedge funds can no longer assume that they will get what they ask for in terms of leverage and financing. This has caused a degree of recalibration, for both managers and primes, as they seek out the best course of action to remain viable and profitable.
Over at Societe Generale Prime Services (SGPS), Duncan Crawford, Global Head of Hedge Fund Sales, stresses the point that, in response to market regulation, "we are fully aware of all the balance sheet implications of everything we do. We know exactly how profitable we are.
"Our costs of doing business at Newedge was becoming prohibitive but they have come down since becoming a part of Societe Generale. The bank deleveraged during the financial crisis. Some are in a more difficult situation and still deleveraging but Societe Generale is very lean."
Societe Generale is somewhat unique in the sense that prior to acquiring Newedge, although it operated a small cash prime brokerage business it had a significant stock lending business, facing off as lenders to Newedge's competitors. This involved the same balance sheet usage as lending direct to hedge funds. As such, the bank is adapting to Basel III with no significant uptick in balance sheet allocation as it provides securities lending to hedge funds within SGPS. If anything, the bank is now making more money as a result.
A portfolio approach
"We are busy expanding our equity PB business; this remains the prize that everyone wants," says Crawford. "Where some of our competitors are having to retract into their silos we are fortunate in that our Prime Services business is a distinct business unit. We're not part of equities, we're not part of fixed income. The service that we offer is a portfolio approach to prime brokerage where all of the asset classes and instruments our hedge fund clients use sit within one regulatory framework, one risk environment, and one reporting environment."
Many bank-owned primes are not structured in this way and it could be argued that one of the reasons so many smaller hedge funds are being culled is because the banks that operate these prime brokerage businesses simply do not see the hedge fund in its entirety. For example, a manager might be generating moderate trade flow in equities each month, and giving its prime broker the bare minimum in terms of revenue, but might, at the same time, be trading a significant FX book.
If the equities desk doesn't see this FX flow and jettisons the client, they potentially end up shooting themselves in the foot. Determining the value of a hedge fund has to be done holistically, not piecemeal.
"We are willing to take on less attractive fixed income PB business (balance sheet heavy) if we are also getting a book of listed derivatives from that client. It's the overall mix that hedge funds have to offer us. It's about working with a hedge fund, talking with them and treating the relationship as a partnership where we know what they need and vice-versa. It's important they know where we can help and where we cannot," says Crawford.
That lack of an holistic overview of a hedge fund might, in part, explain why certain balance-sheet intensive strategies like fixed income arbitrage have become more expensive to trade.
"At the beginning of the year we were thinking that we didn't really want to support fixed income because it is pretty heavy on the balance sheet. But actually, we are pleasantly surprised by what we are seeing from the fixed income books. There is a good chance we may actually onboard more fixed income portfolios in 2017 than we envisaged at the start of this year," confirms Crawford.
At Wedbush Securities, the fact that it self-clears and lends securities on the short side directly out of its own inventory means that it is in much better spot than most other prime brokers. As Sean Trager, who heads up the prime brokerage business, states: "We can be more aggressive with our rates because we are not paying an intermediary. That cost saving then flows through to the underlying fund manager.
"Let's say a hedge fund is using an introducing broker and Goldman is lending a particular security at 50 basis points. The clearing firm that the IB uses might then mark it up another 10 basis points. With us, there is no mark up. You're going directly to the source."
On the cost point, Trager confirms that in addition to Wedbush owning its own clearing firm and technology routing firm, "we are providing direct market access using pipes which we are already using for our own business. This means we can really keep control of cost."
He confirms that in order to keep close track on the return on asset for each hedge fund client, Wedbush does not offer a standard multiplier per se with respect to leverage. "We do things on a case-by-case basis and we look at the exposure we have with certain portfolios. It's important for everyone to realise – from the PB to the manager to the investor – that leverage cannot supplement capital."
Legacy technology infrastructures and silo-based business units have, to some degree, hindered Tier 1 primes. At the end of the day, running a successful prime brokerage business is devilishly hard. The more nimble, and the more integrated the prime broker is with respect to the end client, the better equipped they will be at staying profitable.
One firm that is reaping the rewards is Invast Global, whose prime-of-prime model is becoming a popular choice, at least among emerging managers in Asia Pacific. Whereas bank-owned primes utilise their own balance sheets to provide liquidity, Invast Global's agency model means that it has built a network of bank and non-bank liquidity providers to bring the best execution and transparency to its clients.
This instantly helps to overcome the cost issues that bank primes have with balance sheet-intensive strategies, as mentioned above.
"Hedge fund managers have very different trading styles; HFT-type trading, momentum and trend following strategies, arbitrage strategies. For an emerging manager, having the ability to say to your PB, `This is my strategy, what do you suggest on the liquidity side?' is very helpful.
"What this means is that by using us, they don't need to be liquidity experts. They just need to articulate what their strategy is. The feed we provide to any client will in part be unique. There might be similarities with other clients but we don't just take a feed and stick that with the best possible price on a client's book. That is not what liquidity management is all about.
"An emerging manager that trades a fundamental LSE strategy infrequently will receive a completely different feed to a HFT strategy. The LPs might be different, and the liquidity within those LPs might be different," explains James Alexander, Chief Commercial Officer at Invast Global.
This is not only helping fund managers, it is also proving advantageous to the Tier 1 primes who are struggling to justify keeping smaller clients on their balance sheets. They can simply redirect all of that client flow to Invast in a single relationship, in turn helping them to optimise the way they manage their risk capital.
"For an entity like ours that doesn't internalise any of the flow and passes on a lot of commercial benefits to our LPs and PBs, we are the least worst option for them. They might still want these clients but the regulatory environment doesn't allow it.
"Having an entity like ours that can pay for these clients but still share the commercial benefit is therefore a favourable situation. A lot of PoPs are missing that part of the equation. They don't necessarily have the balance sheet or an understanding of the commercial requirements to build strong PB relationships," adds Nick Briscoe, Director and Head of Prime Services at Invast.
The optics of prime brokerage have changed to such an extent that some of the newer entrants like Apex Clearing actually view regulatory change as a huge positive, or as CEO William Capuzzi says, "enormous tailwinds that have allowed us to get into the PB business".
This is not something that the bulge bracket primes are ever likely to say at a cocktail party. If anything, Dodd-Frank and Basel III has caused them to pare down their hedge fund rosters.
This retrenchment was all Apex Clearing needed as a sign to seize the market opportunity and specifically go out to target hedge funds with AUM under USD200 million.
"Until Apex stepped into the space, managers really only had two options. The first was to go to a mini prime like the one I ran at Convergex and work with an intermediary to one (or more) of the large banks. The advantage of this you indirectly get exposure to the likes of Goldman or Pershing; and hedge funds (and their investors) like to hear those names. But the challenge is that a mini prime's pricing for a smaller fund is difficult because there are two pairs of hands that are waiting to be paid; the intermediary and the prime broker.
"The second was to go directly to a big name like Goldman or Pershing. However, this really only works for the biggest funds given the fee basis that they will charge in order to offset the overhead of complying with the new regulatory landscape.
"It therefore made sense for us to take the Fintech backbone of Apex and apply it to the hedge fund space. We provide small and emerging hedge fund managers with the transparency, the reporting, the complete toolset that a billion dollar hedge fund would get, so that they can compete effectively in the market," explains Capuzzi.
Invast's Alexander also thinks the business will benefit substantially from increased regulatory tailwinds.
"Facilities like ours allow emerging managers to prove their wares at a low-cost basis, with a low hurdle to entry, and that can allow them to build a track record for their investors. You do not get the equivalent low-cost service with a standard prime broker.
"Overall, with regulatory tailwinds, an increased prevalence of quant-based hedge fund strategies that like to source different types of liquidity, and emerging managers looking to prove themselves in a low-cost way, there are reasons for us to be optimistic," remarks Alexander.
Bank-owned primes like Societe Generale Prime Services show that applying a sensible, 360-degree overview of a hedge fund can go a long towards building a mutually beneficial and profitable relationship. Doubtless many of the bulge bracket names are aware of this and moving away from the old fashioned siloed approach to managing their balance sheet.
They need to because as independent players build their reputation, they will start to provide significant competition. Not immediately. But if the established names on the Street think it will continue to be business as usual over the coming yearsºwell, they need only look at politics in 2016 to appreciate that the status quo is not permanent.
"Thankfully we are not a SIFI (systematically important financial institution) and we do not fall under Basel III and Dodd-Frank. The same risk-weighted asset ratios and LCR ratios that the banks face do not apply to us. We apply our own ratios, however, because we want to remain competitive. We're not trying to win as many clients as possible. We have the appropriate level of capital for this business," asserts Capuzzi.
In conclusion, Crawford says: "The fact we bring a portfolio approach to prime brokerage across assets and service the whole book of business rather than just a slice of the book is an enormous benefit in this brave new world."
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