As the hedge fund industry expands into newer markets and asset classes, smaller prime brokers can carve out boutique offerings in niche and specialist areas – but scalability challenges remain.
As the hedge fund industry expands into newer markets and asset classes, smaller prime brokers can carve out boutique offerings in niche and specialist areas – but scalability challenges remain.
While investment banking behemoths like Goldman Sachs, JPMorgan and Morgan Stanley continue to dominate the prime brokerage landscape in terms of mandate numbers and sheer asset volumes, many market participants see the expansion of hedge funds into new markets and asset classes, coupled with continued innovation in investment strategies and trading instruments along with tighter risk limits, as fueling demand for a wider spread of prime brokers to service a broader base of managers of all shapes and sizes.
Industry experts note how the smaller and more boutique primes have been on the leading edge of certain new asset classes, establishing specialist footholds and market share in sectors such as digital currencies and cannabis stocks, areas where larger investment banks have been seen to tread more cautiously given the potential regulatory and reputational pitfalls.
Thriving
For other mid-tier PBs, opportunities lie in capitalising on demand for regional coverage, such as offering Asian or European capital markets expertise where they may generate capital flows beyond core US markets.
Eamon McCooey, head of prime services at Wells Fargo says: “When you deal with these multi-billion-dollar hedge funds that have global financing businesses, there are niches for other institutions to come in and service and capture a meaningful wallet share. The large funds want that diversification – they don’t want all of their assets at a single prime broker. A lot of the large funds have internal risk limits on their exposure to a single counterpart that requires diversification.”
“In a crowded and commoditised field where primes are ever expanding, we are constantly looking for new ways to differentiate,” says Alexandra Krystal, managing director, head of prime services sales and capital introductions at CIBC Capital Markets.
“Hedge funds are coming to CIBC for the geographic diversification along with the strong balance sheet and strong credit rating,” Krystal adds.
“CIBC Prime Brokerage looks like a boutique Canadian prime brokerage covering most of what the global bulge bracket prime brokers do, along with a geographic diversification, a strong balance sheet, commitment from senior management, and an upward trajectory.
She continues: “We want to help managers understand that we have built this business to access a true credit and multi-strategy house, which in our view are products that are underserved relative to the equity space. The result is hedge funds are getting the opportunity to trade with a service provider that has a platform tailored for a more active credit trading strategy.”
At the same time, boutique prime brokers have also looked to carve out a more efficient and personalised prime brokerage and custody experience for clients, tapping into outsourced trading solutions free from the administrative bureaucracy and legacy technology often found in large investment banks and certain discount brokers.
Dale Klynhout, managing director at Lazarus Capital Partners, and founder of its prime brokerage business, told Hedgeweek recently how Lazarus is operationally leaner compared to larger prime brokers, which allows for faster resolution times to manager requests and queries. “Emerging managers require cost efficient processes, outsourced trading desks and operational agility with minimal risk, along with time to ensure consistent growth within the early cycle of their growth,” Klynhout said.
Pointing to her firm’s “thoughtful and strategic” approach to price and margining for investment grade and non-investment grade corporates, SPACs, converts, and equities, among other offerings, Krystal says: “In terms of where we fit within the prime brokerage space, we believe we are a complementary addition or alternative to the largest and most successful prime brokerages.”
Elsewhere, the increased trading volumes and renewed volatility characterising prevailing market conditions may also bode well for smaller PBs looking to grab a piece of the action.
“The likes of Cowen, Jefferies, BTIG, Mitsubishi, Scotia, I could go on – they’re all thriving,” says Joel Press.
Credible
“They’re not just simply surviving – they’re all doing amazingly well because the dynamics of the markets, such as trading volumes, are so large. I see the prime brokerage business over the next five years exploding with trading volumes and credit risk allocation, so you need to have other primes to help spread the risk and provide a broader range of execution.”
On the flipside, however, some see smaller prime brokers potentially bumping up against operational hurdles further down the line, stemming from the scalability challenges inherent in the prime brokerage sector.
Outlining the challenges faced by many mid-tier prime brokerage shops, Stephane Marchand, head of international prime finance and clearing sales at JPMorgan, says: “You can either be fully in and try to challenge the top three, or you are a smaller niche player. The asset management industry is going through the same cycle – the cost is so high from a technology point of view, and from an innovation point of view, that you need to be extremely big to maintain a top three position, or you can choose to remain a niche player. From asset management to markets and investment banking, it’s all about scale today.”
“The problem in the business running sub-scale is that all of the money to be made in prime is sitting with the biggest clients. Prime is the ultimate scale business,” observes Michael Webb, global head of prime equities at Barclays.
“For the smaller primes, the problem is that it’s a very negatively convex trade – if the hedge fund that you deal with stays small, you’re not going to get a greater share of the wallet. But if that hedge fund becomes big, then they go into the big bucket – they need the larger primes’ big infrastructure – to clear, to execute, to settle, to asset service, often in lots of regions.
“With some of those mini-primes, they are hoping that their clients become bigger than when they first got them, but don’t become big enough so that they leave for the big league. So it’s hard to have sustainable returns in that space. You’re fighting for a small piece of the wallet.”
Underlining this point, he adds: “It’s going to get more and more expensive to run a prime broker, just as it’s going to get more and more expensive to run a hedge fund.”
Still, a number of the prime brokers in the second or mid-tier space have the capabilities to become a credible alternative or complement to the bulge bracket prime brokers, according to Jack Seibald, managing director and global co-head of prime brokerage and outsourced trading at Cowen.
“While they certainly don’t have the balance sheets that the bulge bracket firms do, in terms of capabilities such as global access, servicing clients, trading in foreign markets, and custody in foreign securities, they can certainly be considered reasonably credible alternatives or a complement, particularly when considering some of the additional services they can offer,” Seibald says.
“In more and more instances, we’re being looked at as an incremental prime solution, where funds are growing beyond certain levels of assets and they need to diversify their counterparty risk. And so rather than going to yet another bulge bracket firm because they already have a couple of them, they are adding a firm like Cowen to their stable.”
Read the full Charting New Territory: The future of hedge fund prime brokerage Insight Report here.
