Digital Assets Report

Newsletter

Like this article?

Sign up to our free newsletter

Revenue options grow as regulation unfolds

Related Topics

Prime brokerage divisions are focused on the task at hand of maximising their revenues at a time when the largest bank-owned operators face stiff competition from specialised, boutique primes, keen to offer clients a more inclusive, high-touch service. 

The more diverse one’s revenue streams, the better. The days of taking in as many hedge funds as possible, on the assumption that trade revenues and commissions would boost a bank’s coffers, are long gone. This myopic approach, without fully understanding the total book of business a hedge fund might be doing beyond merely the equities desk, feels oddly out of place in 2018, when technological advances offer no excuse to continue looking at clients in isolation.

This is what specialist primes are bringing to the table and it is beholden upon tier one primes to keep pace and overcome legacy infrastructure. Yes, a hedge fund must offer a compelling return on equity. That is inevitable under Basel III. But the more prime brokers understand how and where clients are consuming balance sheet, the better able they will be to tailor their services and remain profitable.

“For us, the stock lending business will become more important, going forward,” says Jack Seibald, Global Co-Head of Cowen Prime Services LLC, the prime services division at Cowen who last year acquired Convergex. “The securities lending team has done a terrific job in putting together the structure to make it easy for clients to avail themselves of the opportunity. 

“As we finalise some of the self-clearing capabilities that we acquired through Convergex, we will be able to make the process even simpler. In an environment where managers are looking to outperform, we can call a manager and say, ‘We notice you are long X security and our securities lending team is noticing that short selling interest is high. Would you like us to lend it out and if so, here’s the rebate rate we can offer you?’”

That enhances a manager’s return in the fund, it adds to performance. 

A lot of the large primes custody assets under margin agreements, meaning they can lend out those securities through the process of rehypothecation without having to ask the manager’s permission or offer them any rebate. 

“We’re looking at this as an opportunity to help managers make incremental returns, not by doing anything new or radical, but simply by allowing them to participate in the lending of securities. They should have that opportunity to monetise as they are the ones making the investment,” adds Seibald. 

Sean Capstick is Head of Prime Brokerage at London-based GPP. He confirms that stock lending revenue has been a decent driver of growth for the business. 

“Obviously markets have gone up in a straight line for seven-plus years. There are a lot of people with long-bias directionality in their portfolios so shorting stocks has been less prominent than it has been historically. Managers are necessarily a lot more selective. That said, it continues to be a good revenue earner for us. The GC market is over-catered to, there are more names being offered than there is demand, generally speaking. It is in the specialist areas, where pricing tends to be higher and we have a good source of special names, that we can generate a good source of revenue.” 

He confirms that GPP has a more competitive element to pricing at a time when people are questioning stock lending levels: “When a client comes to us requesting a special name, whereas in the past there would have been some opacity in the price quoted, today we are able to get a much more transparent, competitive price.”

The M&A route is one way for prime brokerages to build out their revenue stream. Convergex had a meaningful presence in global execution. Combining that capability with Cowen Prime’s London office should add meaningfully to Cowen’s repertoire, with Seibald confirming: “There are still some further opportunities to capitalise on in 2018 following the Convergex integration.”

Another institution that has used M&A to its advantage is Societe Generale, who back in 2014 acquired full ownership of Newedge following the purchase of Credit Agricole’s 50 per cent stake in the business. 

This has given Societe Generale Prime Services a strong footprint in listed derivatives. 

“We’ve invested a lot in the equity prime brokerage business and we’ve benefited from Societe Generale’s inventory and balance sheet,” comments Alexia Weiller, Global Head of Prime Solutions. “We’ve also got a fast growing fixed income PB business and we continue to innovate in this area. We are now offering repo clearing for the buy-side.”

By self-clearing, as opposed to using the inter-bank markets, it is possible to get more of a netting benefit. 

“By clearing their repos, the clients will benefit from a broader access to liquidity, no bilateral contractual agreements to manage, and greater capacity as the impact on balance sheet, leverage and liquidity are optimised,” says Weiller.

Setting a clear strategy to grow one’s market share is critical in the cut and thrust world of prime brokerage. Without a singular focus on where that growth should come from (in terms of client base), it is impossible to invest in the right areas of infrastructure. This is something that JP Morgan has committed to in recent years. It has invested significantly in infrastructure, such that it now has what it regards as a global product offering. As reported by the Financial Times*, it has overtaken Goldman Sachs to become the #2 ranked prime brokerage in terms of advising hedge funds and hopes the PB business will bring in “halo revenue” by driving more business to its equities desk and e-trading platform.

To underscore its success, the bank’s PB business has enjoyed a 22 per cent growth since 2014, thanks largely to onboarding quantitative funds in Europe, which allowed JP Morgan to grow its revenues by 40 per cent in the region. 

Turning pennies into dollars

In a similar trading vein, though not related exclusively to quantitative funds, another brokerage division that has seen good activity with respect to cryptocurrencies, is Wedbush Securities. 

“Over the last year we have seen a surge of investing in cryptocurrency-related companies and block chain technology,” confirms Sean Trager, who heads up Prime Brokerage Services. “Whereas larger fund managers and bulge bracket firms alike shied away from, and even turned their noses up at this relatively new space and sector, emerging hedge fund managers efficiently deployed capital and strategically invested, in many cases leading to record returns.  

“My team and I were fortunate enough to facilitate trading in bit coin service companies, derivative products and block chain firms alike over the last year, contributing to our own record volumes and revenue targets.”

Cryptocurrency developments are happening at breakneck speed. Some are drawing comparisons to the dawn of the dot.com boom at the turn of the century. Trager says that his watch list consists of a multitude of public companies investing in this space, “and I spent much of 2017 watching pennies turn into dollars”.

“While I have never seen asset appreciation of this magnitude, I am equally taken aback by the unprecedented volatility. The wider trend is perhaps that technology and political ideology alike now play as great a role in financial markets, and more specifically in economic trends, as the government and banks do,” remarks Trager.

Asked what other key revenue drivers Wedbush has focused on over the past 12 months, Trager responds: “We spent the better part of 2017 increasing efficiency as it pertains to seamlessly processing and trading securities in a low latency environment, free of internalisation of order flow and parasitic order flow.  

“Our agency model allows us to solely and independently represent the interests of our clients deriving revenue from commission and interest income alike.  Essentially, we only generate revenue when we add value and work for it.”

Technology is proving highly effective at enabling prime brokers to drive efficiencies and lower the costs of doing business; which, in turn, help them to maximise their profits. One example of this relates to how brokers source data vendors; something that can be an expensive exercise and which Jefferies Prime Brokerage recently sought to address; read the blog here: https://www.ibm.com/blogs/think/2017/08/42477/. 

To give its clients the ability to query and check portfolio positions and risk exposures in real time, run stress scenarios, do VaR calculations and so on, Jefferies partnered with IBM’s Watson Financial Services team – a moniker that shows just how closely Silicon Valley now operates on Wall Street – to develop cloud-based technologies that would help achieve superior data efficiency. As the blog confirms, since embarking on the project, Jefferies Prime Brokerage has reduced its reliance on higher-fee data vendors by 90 per cent. 

Seibald confirms that Cowen Prime constantly looks to reduce the cost of the services that it avails itself of. 

“That’s an ongoing process,” says Seibald. “In the prime business, we go through a regular review of all the expenses related to market data, to IT systems and so on. We want to deliver better services in a less expensive way to our clients. On the research side, the team is using innovative ways to come up with better, more complete ways of providing analysis on companies, sectors, markets, and we are doing the same thing with respect to electronic trading. 

“We’ve spent a great deal of effort looking at changes taking place in market structure and developing new trading venues based on the results of that work. We need to keep finding ways to do business more effectively and find ways to distinguish what we do; not for the sake of being different, but to help clients outperform.”

2017 was a very good year for GPP, and a pretty good year for hedge funds, in terms of performance. Assets going into the industry are at all-time highs, well over USD3 trillion in total AUM. Start-up numbers were strong and as Capstick suggests: “I would say it’s been one of the best years for us in terms of number of new launches in quite some time. 

“Leverage levels have remained robust throughout the year and looking at our current leverage levels, they continue to be at a pretty decent level. Confidence continues to be high among fund managers given where the markets are. We’ve gone from GBP1.5 billion of assets to GBP4 billion of assets over the last 18 months. Our revenues are at all-time highs and growing rapidly. We’ve added three hedge funds a month, on average, this year and we now have over 70 hedge fund clients in total.”

Favourable markets will always go a long way to helping fuel the revenues generated by prime brokers. In that sense, the macro picture continues to look good as global economic indicators appear promising. Trump’s decision to cut US corporate tax to 21 per cent could have huge implications for US equity markets, and as hedge funds increase their conviction levels, prime brokers have reason to feel upbeat.

Not that primes can rest on their laurels, however. New managers, from the millennial generation, expect far more transparency and quality of service from their primes and they aren’t afraid to say so. This is something that bank primes have to adjust if they are to remain competitive. There is still kudos attached to saying one’s prime broker is Goldman Sachs or Morgan Stanley, but it is not a given that every manager will be seduced by a name.

“We have an ongoing dialogue with our clients, we keep them updated whenever we add any new providers and the additional capabilities that might give them. We talk to clients about all parts of our service offering – whether it’s margin financing, stock lending costs, whatever it may be. We provide comprehensive pricing schedules. Everything is very transparent and our legal process is highly robust in terms of implementing those pricing schedules,” comments Capstick.

Jerry Lees is Chairman of Linear Investments. He confirms that Linear’s ability to generate complementary sources of revenue “helps us to cope with market swings”. 

“On the one hand we have a flat fee structure coming out of the compliance and appointed representative business where we provide a regulatory hosting solution for new managers. Those monthly fees underpin regular basic operating and facility costs. 

“Then we have prime brokerage and agency clients trading through us into global markets. The agency execution business is a bit more volatile but it’s still lucrative. We have a number of agency clients who pay us every month and as we gradually build out the PB business we are increasing those fees as well.

“We are growing our balance sheet and custody assets substantially quarter by quarter. The significant assets will potentially enable expanded repo and stock lending services subject to client approvals and we see this as becoming an increasingly important part of Linear’s business.

“We are onboarding substantial assets during 2018 as we continue to grow our PB client base and expect to be in excess of USD2 billion,” explains Lees.

One area that could prove useful, if done strategically and smartly, is the whole approach to research unbundling under MiFID II. This has just gone live in Europe and it will require sell-side institutions to think far more carefully about how they produce and price their research, as it will need to be sold to their hedge fund clients on a separate basis, wholly independent of trading commissions. 

This could lead to a revenue reduction if the right steps aren’t taken and as such, research has the potential to be an even more important value-add than at any time previously. 

Of course, quite how this will impact the PB model globally is yet to be determined. Could MiFID II usher in a global standard and lead to research unbundling in the US and Asia markets? That is hard to say. What is certain is that some organisations like Cowen are well placed to support their clients in this regulatory environment.

Cowen has its own institutional research capability but it has also developed, in part internally and in part through acquisition, the capability to perform un-conflicted trade execution for clients. 

The acquisition in this instance is Westminster Research Associates, whose unbundled aggregation model allows clients to keep sensitive research spend data private from sell-side executing brokers. Moreover, it has a Research Payment Account (RPA) administration service. Its integrated research portal supports the acquisition of research from over 4,000 providers with a fully audited payment process. 

“Managers are going to become much more discerning over the research they consume. There will be a cutback on how much research they consume from their brokers. They’ll only want to pay for the research that has proven to be most effective for them. They’re no longer going to pay for mediocre research,” concludes Seibald.


Sources:
1. https://www.ft.com/content/0761ead6-0f10-11e7-a88c-50ba212dce4d 
2. https://www.ibm.com/blogs/think/2017/08/42477/ 

 

Like this article? Sign up to our free newsletter

Most Popular

Further Reading

Featured