By Jerry Lees (pictured), Linear Investments – A quasi-revolution is happening in prime brokerage. Post-2008, bulge bracket banks were non-discriminatory in the type of hedge fund business they onboarded as managers and their end investors sought to minimise counterparty risks post-Lehman Brothers by opening up accounts with multiple prime brokers. Today, the landscape is vastly different.
Basel III is having a profound impact on bulge bracket banks and their prime brokerage operations. The rules force banks to adhere to Liquidity Coverage Ratios (LCRs) which require them to hold onto sufficient High Quality Liquid Assets (HQLA) to manage down a 30-day market stress event. Meanwhile, Net Stable Funding Ratios (NSFR) seek to reduce the risk of liquidity mismatches and over-reliance on short-term funding.
As hedge fund cash held with prime brokers is viewed as short-term, it subjects banks to higher capital requirements. Smaller hedge fund managers or those that have struggled to grow their Assets under Management (AuM) have seen their prime brokers unilaterally terminate their relationships, often with limited notice.
Other prime brokers have resorted to increasing fees to unsustainable levels. Again, this gives cash-constrained hedge funds little alternative but to find a new prime broker, a process that is not always straightforward.
Financing is also under threat because of Basel III, a point that has been made in papers published by bulge bracket banks including Citi, Barclays and JP Morgan. Leveraged or illiquid hedge fund strategies could see financing drying up in what will ultimately lead to a precipitous decline in returns for investors.
A report by the prime services business at Barclays estimated the average hedge fund could see a fall in returns of between 10 basis points to 20 basis points. Leveraged strategies such as fixed income arbitrage could see an alarming fall of between 40 basis points and 80 basis points because of reduced prime brokerage financing. These numbers make for alarming reading, and will force a number of managers to rethink how they obtain their financing.
Other traditional prime brokerage services such as consultancy and capital introductions have been scaled back substantially at bulge bracket firms.
This means small to mid-sized hedge funds are going to struggle to find a viable prime brokerage relationship. It does, however, spell an opportunity for specialist prime brokerage providers such as Linear Investments. Linear Investments provides traditional prime brokerage services to small to mid-sized hedge funds, and puts client relationships at the forefront of what it does.
The specialist prime broker market in London has seen significant growth, partly driven by its ability to offer smaller hedge funds better financing terms, but also client service in the way of meaningful consultancy, best-in-breed technology and capital introductions that are tailored to the needs of smaller managers.
Specialist prime brokers will often have access and relationships with investors, such as funds of hedge funds, consultancies, family offices or high-net-worth-individuals, which are more supportive backers of smaller hedge funds than institutions. This hands-on approach enables managers to grow their businesses and build up a track record.
The prime brokerage landscape is changing, and specialist prime brokers will be very well-placed to cater for the changing requirements of small to mid-sized managers going forward.