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By James Williams – Two of the more obvious trends that have occurred in prime brokerage post-Lehman’s are perhaps, unsurprisingly, intrinsically linked to counterparty risk. The first is the move away from mono-prime to multi-prime mandates. The second, more recent trend, is the growth in prime custody solutions, accelerated in part by the likes of HSBC and JP Morgan, both colossal global custodians, entering the prime brokerage arena.

Both trends are rooted in a common objective: to minimise counterparty risk. The fact that MF Global imploded last month, amidst allegations that client accounts were being used intraday for its own trading purposes, put the spotlight on how safe exactly client’s assets are. Some rumour mongers began targeting mid-tier investment bank Jefferies, who responded swiftly by cutting their exposure to Club Med debt securities by half.

The firm’s prime brokerage business has had a clearing partnership with JP Morgan since 2008 and gives its clients the option of putting their assets in custody with the tier one investment bank, should they wish. “We’ve called clients and said, ‘look, with all this noise, if you’re uncomfortable let’s move your assets over to JP Morgan’. We have nothing to hide, we don’t want to sit there and just say ‘trust us, don’t worry’. That’s the worst thing you can do. We just said to clients ‘you can do this, it’s your choice’, and we’ve had lots of people thank us for telling them,” explains Jefferies’ Glen Dailey (pictured).

Hedge fund managers, who pride themselves on adept risk management, are increasingly looking to segregate their assets and it’s a trend that Citigroup’s Mark Harrison expects to see continuing into 2012.

“Every prime broker has to be able to offer some kind of custody solution. Asset protection and segregation is something every manager is focused on,” says Harrison. “We have significantly more money held in client money segregated accounts than we did last year.” The other trend being observed, he says, is that managers are keeping limited cash with the prime brokers, pooling it centrally either through money market funds or a custodian.

That’s not to say that all hedge fund managers are segregating assets with their broker or third party custodian. These things cost money. Global billion-dollar funds are more likely to use several prime brokers and a separate custodian. A start-up fund will stick with one prime broker and probably won’t even choose to segregate assets until it reaches critical mass of say USD100million. Also, highly levered funds that use all of their assets have no particular need for prime custody.

Prime brokers that offer full segregation of assets via prime custody under one brand are no doubt able to structure more competitive pricing than a third party custodian but it’s another tier of risk management that most start-ups probably can’t afford.

According to Teresa Heitsenrether at JP Morgan, recent market dislocations have heightened interest in prime custody: “We think it’s an essential part of the offering and comes up regularly in our discussions with clients.”

By leveraging its global custody platform, JP Morgan integrates its prime brokerage service in Europe with its prime custody service, using a completely separate set of reporting which helps ease the operational burden on managers. And this goes back to the issue of cost. As Heitsenrether explains: “The concerns we hear most frequently from managers are the increased operational challenges and the costs of using a third party custodian.”

Although prime custody assets in Europe are relatively small at present, Heitsenrether reckons that AUC in its US custody solution, which has been up and running since the Bear Stearns days, “has seen a fivefold increase” this year.

Increased client segregation suggests that re-hypothecation levels are falling, given that prime brokers can’t touch the assets. Post-Lehman’s, it’s become a far more transparent issue. Up until last year, prime brokers didn’t have to fully disclose what they were re-hypothecating. Then the FSA proposed introducing a requirement “for contractual re-hypothecation provisions to be summarised in a disclosure annex attached to each PBA (Prime Brokerage Agreement)”. Now, all prime brokers have to show exactly what’s being re-hypothecated. That’s an encouraging trend.

Some prime brokers like Citigroup are now capping levels with Harrison confirming: “We have a policy that we’ll only ever re-hypothecate up to 200 per cent.” In the US, it is capped at 140 per cent.

One prime brokerage executive, who asked not to be named, emphasized that they were transparent on what would realistically be re-hypothecated and what impact that would have on a manager’s pricing.

Certainly, managers better understand the economics of the business and aren’t pushing for 100 per cent – or no exposure – because by doing so pushes up prime brokers’ costs of funding. Anything less than 140 per cent has cost implications.

Richard Frase at Dechert LLP agreed that managers are monitoring this activity more closely but stressed: “Generally, the prime broker will say that anything below 140 per cent will cost more, and at this point the manager settles for 140 per cent.”

A fund’s returns, re-hypothecation limits and term structures are all elements of pricing a prime broker needs to consider. As for the managers themselves, selecting a prime broker they’ve already worked with plays a big part in the selection process and typically leads to more favourable cost terms.

Andrew Brown, COO of Skyline Capital Management, which launched last year, confirms that the founding team came from existing institutions. “For the prime brokers, they know who they’re backing. Two of the three prime brokers we short-listed were actually institutions the founding partners had come from.” He added: “We wanted to build relationships that didn’t just sit in the prime brokerage space but could be leveraged across various parts of the institution.”

Multi-prime is a well-established model today but this is just one of several prime brokerage models available. The common denominator is size of assets. Start-ups with less than USD100million go the mono-prime route, well-established funds with assets north of USD100million will likely choose two or three brokers, whilst the giant billion-dollar funds have multiple prime brokers and separate custodians.

Prime brokers are happy to be the second or third choice, provided the manager is doing meaningful business. It’s all about having enough skin in the game. As UBS’s Tim Wannenmacher posits: “How many brokers do you need before you spread yourself too thinly?”

“The age of the sole prime broker is not totally over but multi-prime is being driven by fund managers’ concerns with counterparty exposure, as well as investors. They want to see diversification and every round of due diligence they do with a fund, they’re going to ask that question,” comments Harrison.

Prime brokerage accounts are not cheap to service. A broker will think nothing of shutting an account if it’s not being used properly. Harrison says the objective is to be the ‘prime’ prime broker, of which Citi has a top 20 of clients in this category. There are clients who building and some who don’t currently do a lot but he says they keep them on the books “because we want to grow the relationship”.

“Multi-prime seems to be more of an option than it used to be but for a start-up the important thing is to get a prime broker who takes you seriously and you can work with,” says Frase. Even though Skyline Capital Management currently uses one prime broker, this might change moving forward as the firm grows.

“It’s a trade off between managing counterparty risk and the cost of doing that. Our intention is to add another prime broker with time but our priority at present is to keep fees in the fund as low as can be. Multi-prime needs to be a model you can support viably,” says Brown.

Heitsenrether believes fund managers are being thoughtful and understand they need to be relevant to the institution. “Some managers that are already diversified are reassessing that mix and thinking that diversification needs to be realigned because the world has changed.”

When Basel III comes into effect, banks will need to increase their tier one capital ratios to 4.5 per cent, with up to a 2.5 per cent countercyclical buffer. Leverage levels are at historic lows and overall fund performance has been quite poor in 2011. Add in the technology costs and the question arises: How much pressure are prime brokers’ margins under?

Patric de Gentile-Williams, COO of FRM Capital Advisors, the hedge fund seeding arm of FoF firm Financial Risk Management, has seen prime brokers becoming more ruthless about profitability. Many have culled relationships and refused to do business with smaller managers, leading to the emergence of mini primes like BTIG, Merlin. De Gentile-Williams notes that because banks’ own financing costs have gone up things like netting have become history. “That’s now become much harder to get, you have to be a pretty valued client to get that.”

Multi-prime reduces prime brokers’ business volumes with hedge funds, but perversely, it also reduces a manager’s ability to get attractive pricing. “I don’t think the main players are any more aggressive than they were but it’s probably harder for managers to get more attractive terms,” notes de Gentile-Williams.

Under increasing pressure to show a return on capital, it’s likely prime brokers will put greater focus on the profitability of hedge fund clients. Some will have to decide whether it’s worth staying in the game – this year has already seen Mizuho Securities close its Singapore prime brokerage operation in April this year.

More could feasibly follow if they’re not fully committed to what is a continuous investment process. “If you don’t have the scale I think it would be hard on the margin to compete and be profitable. If you’re a mini prime it’s more of a challenge,” opines Heitsenrether.

Dailey thinks there’s room out there for a handful of mini primes although admits one or two might go by the wayside. “I said two years there were too many brokers, there’s probably room for 12 and I think we’re pretty close to that number. Whether there’s one or two that consolidate moving forward I’m not sure.”

The way prime brokers finance hedge funds under Basel III will surely have to change. One undisclosed source says he’s ‘dumbfounded’ by the rates that universal banks currently finance hedge funds, claiming it makes no economic sense. “I don’t know how these banks are lending billions of dollars at 25 basis points. It’s been a race to the bottom,” he says.

“I think any reasonable person would say that the rates universal banks charge hedge funds, which are ridiculously low because of market competition, have to rise,” adds Dailey.

“I think the market will continue to improve pricing structures to more accurately reflect the liquidity of the underlying assets and the tenor of the financing. The anomaly of getting term financing at an overnight price is not sustainable,” comments Heitsenrether. She says that JP Morgan is talking with its clients about the need for a lock-up and what denotes an appropriate lock-up given the construct of a manager’s portfolio. “You don’t want to pay for more than you need or leave yourself too short either. We’re having constructive discussions with clients on the term structure of that pricing. Most managers have the foresight in an environment of increasing capital requirements and shrinking balance sheets to understand that not having these kinds of discussions might actually be cause for concern,” she says.

De Gentile-Williams adds: “The growth and ‘market share at all costs’ approach has been replaced by a more forensic approach to the bottom line.”
With AIFMD, Basel III and a raft of other regulation in the pipeline, the next challenge for prime brokers will be how they adapt to these conditions, whilst at the same time ensuring margins remain strong and quality of service remains first-rate.

“There may be more partnering between prime brokers and the big custodians,” suggests Frase. “Smaller players are always moving in and out of the market but I imagine the AIFMD will discourage them from moving in.” The potential liability costs simply won’t be worth it.

“Regulation is definitely a challenge moving forward. It’s something we spend a long time on, understanding it and making sure we’re aligning our business correctly with it,” concludes Harrison.

Please click here to download a copy of the Hedgeweek special report: The Evolution of the prime brokerage model – Challenges & opportunities 2011

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