According to industry data provider Coalition, the world’s 12 largest investment banks produced USD18.3 billion in prime services revenue last year, up 8.3 per cent on 2017 but despite this the PB arena remains as gladiatorial as ever.
On 7 July, Deutsche Bank announced that it was selling its PB business to BNP Paribas. This has led to a period of uncertainty, during which other bank-owned primes have sought to capitalise; most notably Barclays, which has reportedly attracted USD20 billion of hedge fund assets over to its balance sheet.
As hedge funds continue to deal with their own margin constraints, they remain largely focused on maintaining a core number of PB relationships to achieve best outcomes. Managers have increasingly come to understand that this key counterparty relationship has to be economically viable for both parties, and as such can ill afford to spread their wallets too thin. Rather, they want the best level of client experience possible from two or three PBs, with each receiving sufficient trading volume to justify giving up their respective balance sheet.
It has, in many ways, become a juggling act and as the Deutsche Bank announcement illustrates, European banks are still having to work hard to make PB a profitable business line.
According to Coalition’s report, Q1 revenues at PB firms declined 22 per cent year-on-year, attributing the fall to core prime and synthetics, “which was due to increased margin pressure in the US”.
One of the risks for any prime broker is ensuring that its pricing models evolve sufficiently in line with market developments. Last year, Citi’s FX prime brokerage business suffered a USD180 million loss, which prompted the US bank to publish a white paper – Collateral Damage? How Uncleared Margin Rules Will Revolutionise the FXPB Business Model – in which it issued a clarion call for banks and executing brokers to share the costs of managing risky derivatives.
FX primes are now being hit harder by uncleared margin rules for non-cleared derivatives and placing even more margin pressure on their balance sheets. Previously, only firms trading an aggregate notional daily amount of USD1.5 trillion of derivatives were subject to UMR, but that threshold dropped to USD750 billion in September 2019 and will drop again to USD8 billion in September 2020. In short, having to post initial margin to both their clients and executing brokers, while also segregating the margin they receive, will place further strain on liquidity and funding costs.
The white paper showed how the cost of handling a non-cleared NDF trade with a notional value of USD10 billion will rise to 31 times prevailing rates in order to cover the bank’s funding costs and regulatory capital requirements.
Asked what he thinks the impact of UMR could be on PB’s pricing models, Mark Aldoroty, head of prime services at BNY Mellon’s Pershing, says “it’s bigger than UMR”.
“Is the product being offered valuable to a client at a price point that works for both counterparts?” says Aldoroty. “UMR is going to create the need for infrastructure around uncleared margin which hasn’t previously existed, starting with the larger players in the market, in terms of the rollout, down to the smaller players. The question will be: what kind of build-out will be needed? What will the cost be? Will it be adding value to clients and help them to be more efficient with their collateral?
“To be honest, those questions apply to all products. If it makes sense, then what should the right price point be for everybody?”
At the outset, before bringing a hedge fund client onto their book, PBs are spending even more time understanding how the strategy works, what the risks might be, how much leverage the manager will look to use, the liquidity profile of the instruments he plans on trading and so on. Drawing up this roadmap gives the PB the ability to set the appropriate price model, such that it doesn’t need to be constantly tweaked year after year. Fact is, the more esoteric or illiquid the instrument being traded, the more expensive it’s going to be for the bank to fund.
“Pricing needs to be a quid pro quo,” comments Alex South, Director, Saxo Capital Markets. “That is, set at an appropriate level that enables a manager to build their business and at the same time enables us to make money. In a post-MiFID II environment, pricing has become a lot more transparent than it has been at any stage and pricing has now become a very open and honest discussion. If you start off on the right foot having that conversation you’re setting the foundations for a good relationship.”
Pershing prime brokerage business is a wholly owned subsidiary of BNY Mellon and one of the most well-established clearing firms on the Street, allowing it to finance hedge fund portfolios, covering shorts. This is an important revenue driver for Pershing.
“It is slightly different to other PBs on the Street as it is less of a capital markets firm and more a traditional clearing firm,” explains Aldoroty. “That said, because we clear for three distinct areas – prime brokerage, broker/dealers and investment advisors – it creates a securities basket of USD1.7 trillion; not all of that is available to lend but it does create a robust securities lending product for those who want to short.”
Reflecting on 2019, he adds: “In some respects this year has been a tale of two cities. Some managers have de-risked, while we’ve seen other managers increase their leverage, more so in Q4 than they did at the start of the year. Speaking to others on the Street, this is a fairly consistent theme.”
Looking for ways to maximise returns on capital when hedge fund performance has been patchy over recent years takes discipline but it also requires a large dose of faith and optimism. One US bank that has motored to the top end of the PB charts is JP Morgan, lying just behind Goldman Sachs in terms of the size of its book, which last year totalled USD288 billion in AUM. As reported by The Trade News this September, JP Morgan has continued to grow in 2019 and extend its PB balances to beyond USD500 billion, with Troy Rohrbaugh, head of global markets for JP Morgan, pointing out that the bank would continue to focus on synthetics and the Asia-Pacific market, “where client balances have increased by 36 per cent over four years”.
Speaking to the Financial Times recently, the bank’s head of global equities and prime services, Jason Sippel, said that even if market conditions for hedge funds worsened, the bank still wanted to grow in the space; underscoring its commitment to this unforgiving area of finance.
“Our management team has given us marching orders to take market share in equities, that is mission one,” Sippel told the Financial Times. “Scale is critically important.”
“We like having a mix of business,” Pershing’s Aldoroty says. “Sometimes equities are hot, sometimes credit is hot and sometimes sub-sectors within those asset classes are hot. We consider this to be a long-term marriage and we want to make sure up-front what each partner is delivering. It’s important to understand whether the strategy makes sense from a return on capital perspective. We do well with managers who short specials, because of the depth of our securities inventory, and size-wise we have clients that are running billions in AUM through to clients who run USD100 million in AUM.”
The suite of services offered by primes can vary in scale and depth of quality but those who can give managers more of a high-touch solution are faring well, especially in the mini prime space.
At the vanguard of this is Cowen Prime Services, whose outsourced trading solution continues to be a key attractor among hedge funds of all sizes; not all of whom, necessarily, choose to avail of Cowen’s introducing broker model on day one.
“In the past 18 months we’ve hired nine or 10 outsourced traders,” confirms Jack Seibald, Managing Director, Global Co-Head of Prime Brokerage and Outsourced Trading at Cowen.
Cowen’s outsourced trading desk is already connected to more than 100 executing brokers and more than twenty-five prime brokers and custodian banks on behalf of its clients. High quality reporting is a key aspect of the relationship. Mangers receive a suite of daily profit and loss, portfolio appraisal, activity and MTD and YTD commission reports.
The view taken by Cowen when rolling out the Global Outsourced Trading Group was to bring all of the prime brokerage solutions it had developed at Cowen Prime Services to the table to benefit its outsourced trading clients.
“We have also effectively put together a new capital introduction team over the past 18 months,” adds Seibald. “We now have a seven-person team and five of them were hired since the summer of 2018. The team in place is now very seasoned. Most of the new hires are people who have worked on the buyside in prior roles; family offices, endowments, consultancies, etc. They bring a different perspective and their reach into the allocator space is deeper and stronger.”
In order to remain competitive in this gladiatorial arena, Cowen’s Prime Services division is looking beyond traditional asset classes and provide financing to less obvious, more niche strategies, including Special Purpose Acquisition Company (SPAC) funds: SPACs are publicly-traded investment vehicles that raise funds via an IPO to complete a targeted acquisition within a limited time frame (18 to 24 months).
“SPAC funds are one area of revenue for us,” states Seibald, “aside from the usual long/short equity and fixed income fund strategies. Cowen is, from a market share perspective, among the largest actors in the marketplace trading SPACs. Anytime somebody is looking to start a SPAC fund, we’re getting a call. We’re using our ability on the PB side to perhaps provide financing to those managers, who might otherwise not get access to SPAC financing.
“Certain segments in the FX and Futures markets are also being explored based on the enquiries we are receiving from clients, and thinking about where we can match them with the business lines for which Cowen has proven expertise on the research side, the trading side, or both.”
“We know where our strengths lie: supporting start-up and emerging managers, and managers who are focused on FX strategies, or whose strategies require FX hedging. In that context, we are extremely relevant,” adds South.
He points out that China will be a key growth market for Saxo over the coming years, just as it was referenced earlier that JP Morgan views APAC, more broadly, in similar terms.
“Being acquired by Zhejiang Geely Holding a couple of years ago gives us access to China that a lot of our competitors do not have. It’s going to be a significant area of focus for us, going forward, not only in terms of providing our clients with access to products in China (Stock Connect and Bond Connect), and equally to provide Chinese investors with access to global markets. We think this will ultimately be beneficial for Saxo’s hedge fund clients from a product perspective, a jurisdiction perspective and from an exchange perspective,” says South.
Back over at Pershing, it is leveraging its relationship with BNY Mellon to help introduce hedge fund clients to registered investment advisors, as they look to introduce their end investors to the virtues of hedge funds as part of a diversified portfolio. This ability to connect to hedge funds to a potentially new set of investors – beyond the usual institutional investor community of family offices, endowments and pension funds – is proving to be a key part of Pershing’s long-term growth strategy.
“It’s really an education process on both sides, between RIAs and hedge funds, in terms of how they can add value to each other and how the investment vehicle can fit well into their client portfolios.
“It’s a way of broadening the investment horizon for RIAs in the hedge fund space – beyond just looking at liquid alternatives for instance,” he says.
Each year, Pershing hosts an industry conference called Insite, which brings together investment consultants, RIAs, as well as prime brokerage clients – be they hedge fund or liquid alternative fund managers. Over the last few years, Aldoroty says there has been an uptick in interest in the advisor and consultant community sitting in on panel sessions on alternative funds. Although he adds that this is an ongoing process of engagement.
“Where a hedge fund fits into an advisor’s client portfolio varies, case by case. But I can say the level of interest has gone up although finding access points is one of the things that people have found challenging; in certain cases, the investment minimum may be too large but the RIA may have other ways of accessing a hedge fund to meet the minimum subscription,” he says.
At Societe Generale Prime Services, the capital consulting team takes a data-driven approach to supporting its hedge fund clients, to augment what is a key part of the PB service offering.
“From our standpoint, we’ve always tried to be very data-driven in how we capture information and it is a key part of our capital introduction process,” explains Alex Hill, Director of Alternative Investments Consulting at Societe Generale Prime Services.
“We use that information both to help on the traditional cap intro side, helping to get managers in front of the right investors, and we also use it to help investors. We produce a suite of investor reports, which we send out regularly, to give an investor a view into what hedge fund strategies are out there. We also use the data to create benchmarks and performance on different hedge funds and feed that back to our clients to show how they are performing relative to their peers.”
These benchmarks include the SG CTA Index, which provides daily performance benchmark data on some of the industry’s leading CTAs.
“Our hedge fund clients really value that information and the feedback we can offer in that process. By better understanding the competitive environment, managers can formulate their marketing and business development strategy. We combine that with knowledge on the investor side to create more meaningful introductions,” states Hill.
He goes on to say that “you have to have both the personal relationships as well as to provide data-driven intelligence; bringing both together can be very effective. Our ability to support hedge funds at both ends of the size spectrum is well proven and it’s why we can add value.”
Technology will arguably continue to play a key role in the PB arms race to win market share, as hedge funds continue to squeeze as much juice out of their counterparty relationships as possible. Those with the most agile technology frameworks to support hedge funds as they adapt and evolve to changing market conditions, and the most elastic pricing models, will likely be in the strongest position.
“Technology is a core component of Saxo’s DNA, as a whole, and indeed in terms of the PB offering to deliver cost efficiencies to our clients,” explains South. “The strength of our FX offering is really appealing to both emerging and established hedge funds. We have established relationships with larger PBs and can intermediate that to help them gain access to liquidity pools they couldn’t otherwise access. We also have a bond trading solution where we’ve established relationships with 40 or so market makers, we take feeds from them, and create a dedicated order book for our clients to trade against.”
Technology not only applies to better understanding the needs of hedge fund managers but also how technology is changing the world we live in, and the way investors think about the markets.
In that regard, developing appropriate high-impact research is a key metric for measuring the efficacy of prime services to hedge funds, just as much as trade execution, transparent pricing and so on.
Shannon Murphy is Managing Director, Jefferies Prime Services Strategic Content. Murphy runs the strategic content initiative at Jefferies, focusing on strategic and thematic research in equities; essentially anything that impacts the way its hedge fund clients do business but which doesn’t fall into the single stock FAANG world (Facebook, Apple, Amazon, Netflix, Google). This year, in addition to producing its State of Our Union report, the first of which was published in February 2018, Jefferies produced its inaugural Millennial Survey.
As millennials represent the next emerging generation of investors and fund managers, Murphy says they wanted to find out how they are changing the way in which they source, digest and value information.
“As information has become ubiquitous, what is the next level of intelligence separating the have’s from the have not’s? Who are the ones thriving in this new environment and what have they been doing?” says Murphy.
She says that differentiated insights “will always play a role in how providers can assist clients in managing their businesses and portfolios. In a world where you can Google anything yourself, thoughtful analysis and views are even more valued when delivered in a clear, succinct and thorough manner.”
Allocators are increasingly asking about hedge fund firms’ internal “R&D” efforts, working to understand research efforts to ensure that managers maintain an edge in today’s market. As the Jefferies report states:
We are witnessing funds devote resources to building out internal R&D projects that source, collect, and analyse big data with fast-growing sophistication. At the same time, managers are repurposing broker votes to best capture expenditures and measurement of the inputs they receive, and better align needs with counterparty core competencies.
Jefferies suggest that multiple factors are driving firms to revisit their own research processes and inputs from front-to-back, including:
• Growth of data and anticipated acceleration of available data;
• Increasing cross-asset correlation;
• Shift in invisible forces impacting and creating new investment opportunities;
• Crossover and convergence of themes across sectors impacting business models, and;
• Revisiting alignment with (and core competencies of) counterparties.
To respond to this evolving research trend, Jefferies Prime Services is building on its core competencies and expanding its research group.
“For example, we have a data science working group that works closely with our corporate access team. Corporate access has done a good job of serving as matchmaker between company management teams and our clients. The next iteration and version of that is not just management teams and experts but heads of data in different business verticals such as healthcare, energy companies: the aim being to broaden and deepen our offering.”
In terms of key themes for 2020 and beyond, Murphy cites three key areas: market structure, climate and carbon-related topics, and what generational/social shifts might mean for the global economy.
This is one example of how PB firms are focusing their efforts to remain as relevant to hedge funds as possible.
When asked if Jefferies is having to think differently as to how it produces and disseminates its research to younger hedge fund managers, who increasingly seek inspiration from social media platforms, podcasts, YouTube interviews and so on, Murphy responds: “We are constantly evolving our approach to connecting with clients. We have found success in delivering insights across diverse platforms – whether audio, visual or more traditional written mediums. Clients choose to access and digest information in all different manners at different times of the day, and we strive to meet those needs.
“Managers’ interest in differentiated delivery of their insights is growing considerably – with many actively exploring and piloting video and audio strategies to better connect with their current and prospective partners.
“This year, we launched Invisible Forces, the first franchise wide narrative podcast, two new video series (“Quick Takes on Big Ideas” and “Views from Capital Intelligence”), and a dedicated website to better distribute and engage around this content.
“Going forward, Jefferies will continue to broaden and deepen its commitment to partnering with clients to help them more effectively share their expertise and insights with the market.”
The quality of prime brokerage services will always be constantly evaluated by hedge funds. And as managers seek to minimise the number of counterparty relationships, knowing that their PBs understand their own particular idiosyncratic needs, and will be there in a mutually beneficial capacity, will become ever more important.
Pershing’s Aldoroty offers the following concluding remark: “We did a recent ad campaign where the slogan was: Strength, Supply, Service. Strength meaning strong balance sheet, supply in terms of securities lending with the depth of our box, and service, meaning the focus we put on servicing every client well. If a manager is looking for a well-rounded PB that can offer leverage, short coverage and a stable team, we think we can excel.”