Coronavirus crisis heralds major changes to the hedge fund/prime broker dynamic

Business partnership

With the broader hedge fund industry facing multiple challenges around rising costs, squeezed profits, and a shifting regulatory backdrop, the prime brokerage sector will need to juggle future disruptions and sweeping changes in client activity as a result of the coronavirus pandemic.

In a new market commentary, Anthony Bennett, head of prime brokerage at Capco, a global technology and management consultancy dedicated to the financial services industry, examined the potentially far-reaching fallout of the Covid-19 crisis on the hedge funds/PB relationship, with future success possibly hinging on the degree of diversification within a PB’s business.

Gauging perspectives through recent conversations with leading prime brokers, Bennett suggested primes have largely weathered Q1’s historic volatility and de-risking and “passed the initial tests” of the recent crisis.

The sector’s successes stem from mainly from previous investment in platform maintenance, automation of tasks, and close management of client exposure, he said.

While many challenger primes have been able to grow their business in recent years by concentrating on the burgeoning quantitative hedge fund sector, the largest and most diverse PBs have continued to fare best.

Looking ahead, Bennett predicted a “rebirth” of equity long-short hedge fund strategies, as well as pivots to credit and fixed income, amid signs that the industry is nearing “peak quant”.

Such a shift would raise major questions around fledgling PBs’ business mix, scalability, technology, liquidity, execution and their ability to invest to support large scale activity in new areas.

“Many primes questioned how much new investment will go into quant hedge funds, when so many fund managers have been chasing the same pockets of opportunity to so little effect in terms of performance,” he said.

“Will these firms now look to invest in their classic prime brokerage framework instead? That is yet to become clear, and typically remains something the established prime market leaders have been consistently good at, and therefore difficult for challengers to gain market share.”

He said sticking to models that can be supported is a sound strategy for many primes.

“To become a dominant player in the equity long/short supporting prime space requires time – to both develop the required level of franchise maturity, as well as research, inventory and access-driven products.”

Bennett’s deep-dive analysis also explored regulatory changes and business models within the prime brokerage industry.

He noted how post-2008 regulatory reforms have so far had a positive impact on mitigating the effects of the current crisis, such as in areas relating to client asset protection.

But he warned that the timetable for proposed rule changes affecting primes has been thrown into question by the pandemic.

“Primes are not awash with discretionary spend, but this will be a period during which regulators will scrutinise operations and compliance in some detail, hence governance and controls will need to be documented and be shown to have worked.”

He added: “To retain a commercial edge, prime business heads are laser-focused on controllable costs.”