Regulation continues to bite and influence the way investment banks structure their business activities. Most notably for the hedge fund industry, the banks are being forced to reassess their activities pertaining to prime brokerage. Five years ago, banks remained in denial about the impact regulatory reforms would have. But then a black swan event occurred.
On 15 January 2015, the Swiss National Bank decided to de-peg the Swiss franc from the euro, sending the markets into turmoil and leaving a trail of casualties. Within a twenty-minute period, between 9.30am and 9.50am UK time, the CHF went into hyper drive, appreciating almost 30 per cent as it pulled away from its three-year peg at 1.20 francs per euro to reach 0.85 before falling back close to parity.
“Suddenly, overnight, FX became a much more volatile asset class,” says Gavin White, CEO of Invast Global, a subsidiary of Japanese listed Invast Securities Co Ltd. Employing a prime-of-prime model, Invast leads the industry in the provision of multi-asset high-quality, non-bank Prime Services. “Since the Basel capital requirements are weighted according to the “risk” or “volatility” of the asset class, the banks were forced overnight to take the Basel requirements seriously with regard to their FX-related activities, particularly FXPB.”
Basel III aims to strengthen banks’ balance sheets (by increasing liquidity) and decrease the amount of leverage. Leverage constraints are forcing bank-owned primes to focus on finding efficiencies in terms of how they use balance sheet for securities financing, both long and short. While new metrics, such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are requiring banks to think carefully about how they deploy assets to fund their PB clients.
It is White’s contention that while FX PB was the first to reel from the effects of regulation, leading to the offboarding of thousands of smaller clients (including hedge funds) as banks focused on those who offered clear economic value – benefiting Invast Global and other non-bank primes – the industry is about to go through a second wave of contraction. One which will see bank PBs reduce their activities in all asset classes now that the Basel reforms are more clearly understood.
“Our business has tripled this year alone. This shift is happening but it still has a long way to go. It is our view that the banks are going to be significantly constrained in their activities for, potentially, many decades to come,” comments White.
He says that Invast Global has been winning clients thanks to its ability to commercialise small and medium-sized clients that the banks cannot.
“We are nimble and focused. Specialists in our field. We utilise technology to ensure our service is cost-effective and bespoke for each client. We don’t have the overheads of the global banks, nor the organisational complexities. Importantly, we don’t attract the regulatory burdens of the banks. We are filling a vacuum in the industry, which we take very seriously. It is the small/medium managers that form the foundation of a healthy hedge fund industry. If this segment is left out in the cold, they won’t have the access and facilities to grow into the industry leaders of tomorrow.”
Assuming White is correct and that more contraction takes place in the banking PB arena, this will create a lacuna in the marketplace for non-bank institutions to capitalise on, who are not constrained by the likes of Basel III.
To that end, Invast Global is aggressively growing its PB business beyond purely FX, to support clients in a multi-asset capacity, including Metals, Commodities, global Equities and Futures.
“We intend to move into many other activities the banks are being forced to withdraw from,” says White. “There are numerous business lines within the global investment banks which are being disrupted. Clearing, Execution, Facilitation, Research, Reporting, Cap Intro … the list goes on. It will be interesting to see how things shake loose. We have built a specialist brokerage model that aims to benefit from these changes.”
To quantify the effects of regulation, a recent white paper written by Quinlan & Associates estimates that over USD13 billion in revenues has been off-boarded by the top 15 global banks alone since 2014, as a result of culling what they refer to as ‘tail clients’; these include corporate clients as well as hedge funds, asset managers and family offices.
The paper argues that “we believe many banks have also become rather short-sighted in their strategic objectives by ignoring a sizeable and fast-growing fee pool of tail accounts”, as they look to focus more of their resources on a small percentage of high value, high revenue clients.
This is good news for non-bank primes who are very happy to win new client business, providing them with market liquidity and ancillary services many simply do not get with Tier 1 primes.
White views the current situation as history repeating itself.
Almost one hundred years ago, following the Great War, banks invested heavily in the stock markets as Europe sought to rebuild. As more money flowed in, and the banks made increased profits, confidence grew and they developed and distributed complex structured products. Then, in 1929, the stock markets collapsed, there were runs on the banks and subsequent liquidations. Mums and Dads lost life savings as banks closed their doors across the US. And then the Great Depression set in.
Public outcry resulted in the implementation of the Glass-Steagall Act, where the US sought to separate the activities of commercial banks from those of investment banks. Most investment banks chose to operate as commercial banks, and in their place, non-bank behemoths emerged: Goldman Sachs, Merrill and so on.
But over the decades, the GSA was steadily chipped away, culminating in a repeal by the US Congress in November 1999. The door was thrown open for commercial banks to ride the coat tails of investment banks and before long, they were engaging in financial engineering, trading CDOs and other complex derivatives for short-term gains. The same confidence as that seen in the ‘20s led to greater risks being taken – including by investment banks like Lehman Bros, which ended up leveraged to the hilt – and culminated in the ’08 Global Financial Crisis.
Now, banks are facing the same fate as the GSA in 1933, as they adjust to life under Dodd-Frank, Basel III, MiFID II. The screw is turning, and prime brokerage activities have become more restricted as a result.
Asked how he sees the next few years playing out as the prime brokerage model continues to evolve, White responds: “There will be some big winners in the non-bank prime services space. The Investment Banks of the future are being spawned right now. But they will be a new type of business. Lean, focused, utilising latest technologies to provide better, cheaper services. It is an exciting space.”
