US bank-owned prime brokerages are reasserting their influence and stealing a march on their European competitors as the financial industry adjusts to regulatory demands; in particular Basel 3 regulation, which introduces rules on capital ratios and is scheduled to come into effect in 2019.
Basel 3 will require banks to progressively reach a minimum Tier 1 capital ratio of 7 per cent by 2019. But whilst US banks appear well positioned – Goldman Sachs now has a 9.6 per cent leverage ratio – European banks such as Credit Suisse and Deutsche Bank still only have leverage ratios of 3.7 per cent and 3.6 per cent respectively.
At a time when European primes like Credit Suisse are scaling back their PB activities and losing market share, Goldman and Morgan Stanley are reaping the benefits, adding some 6 per cent market share since the end of 2014 to 37 per cent.
According to research by Preqin, Goldman Sachs and Morgan Stanley are the two largest prime brokers, servicing 2,240 hedge funds (19 per cent market share) and 1,693 hedge funds respectively. Another US bank, JP Morgan, rounds out the top three, servicing 1,462 funds.
“I think it’s evident that the US banks went through the post-financial crisis balance sheet rebuilding process more quickly, and deeply, than European banks,” says Jack Seibald (pictured), Global Co-Head of Prime Brokerage Services, Cowen Prime Services. “As a result, with their shored up balance sheets, they are in better shape to compete. They’ve been subject to increased scrutiny and regulation by the Federal Reserve with respect to Liquidity Coverage Ratios (LCRs) and scrutiny over their capital plans; forward dividends etc. They’ve been going through stress tests regularly to get their capital programmes approved.”
That the European banks were slower to recapitalise has put them at a competitive disadvantage in the fiercely cutthroat world of prime brokerage. There are two ways to address the issue. The first is to shrink the balance sheet being used to support hedge funds, the second is to rebuild capital and change the cost structure (in terms of financing costs, lending costs) to make the PB business more profitable.
In Europe, it would appear that the first option is being pursued, as hedge funds are being shown the door. Credit Suisse is talking about selling its private banking business and some parts of its prime brokerage business. The easiest option to improve balance sheet is to downsize the scale of PB activities. Not only is this proving worrisome for hedge funds, it is also increasingly hard for some European primes to win new client mandates as they engage in a period of restructuring.
“We are seeing the real life evidence of this with the number of hedge fund managers looking for alternative PB solutions because they’re being jettisoned, or because they are wary of the long-term commitment of some of the European primes,” says Seibald.
Hence why the likes of Goldman and Morgan Stanley are building market share.
That is not to suggest, however, that US banks aren’t also re-assessing the profitability of prime brokerage activities. Even though they rebuilt they balance sheets sooner, they are still going through a process of dealing with the ‘New Normal’ of regulatory requirements on capital and are reassessing all of their business divisions; especially those that are balance sheet intensive.
“What we’ve been hearing for some time from US banks is the transition away from reviewing a piece of business purely on profitability (or revenues) and being far more focused on return on asset (ROA) related to the amount of balance sheet required.
“For prime brokerage, it’s been very evident that US banks have been culling hedge fund clients and requiring more revenue of those they retain, it’s just that they started that process a lot sooner than European banks,” comments Seibald.
Seibald saw this first hand earlier this year when JP Morgan took the decision to exit the introducing brokerage space to support smaller and emerging hedge funds. Concept Capital Markets LLC was acquired by Cowen Group to become Cowen Prime Services. It runs a multi-clearing IB model. Prior to the JP Morgan decision in February, it had five clearing agreements in place: the others include Pershing, Merrill Lynch, Merrill Lynch Professional and ICBC, a major Chinese banking group.
So the ripples of regulation are affecting all banking groups. The US is not immune. Rather, it has acted faster, and whilst bank-owned primes are in a stronger position to put more balance sheet to work to support risky assets, the overall mindset has changed. Ten years ago, hedge funds of all shapes and sizes were welcomed through the door. Now, there has to be a hard-edged focus on working with hedge funds that are able to justify using up a bank’s balance sheet.
“For now, the US banks are probably in a better position. The likes of Goldman, Morgan Stanley are winning market share from the European banks, as is Pershing, through the client wins by its introducing prime brokers. It’s evident that the pendulum is swinging back to the US banks,” says Seibald.
This raises a lot of questions regarding the cost of running a hedge fund. Spreads on financing rates, execution costs etc., have been in a race to zero in recent years. In Seibald’s view, they will start widening again. “The retrenchment in the prime brokerage space will give banks the opportunity to move the needle, and managers should start getting used to the notion of wider spreads over the Fed Funds rate on debit balances.
The US:Europe dynamic could end up playing into the hands of Cowen Prime Services as European hedge fund managers start looking around for alternative PB solutions. The fully disclosed introducing prime broker model doesn’t exist in Europe.
According to Michael Rosen, Global Co-Head of Prime Brokerage Services, Cowen Prime Services, there are only a few mini-primes that provide PB services to smaller and mid-sized hedge funds, “the current structure in Europe is usually in the form of an omnibus relationship whereby the introducing firm faces off against one of the large banks as a single account instead of the fully disclosed relationships that are typical in the U.S.
“A potential issue in this structure at least from a hedge fund manager’s perspective, is that they don’t have any legal standing with the larger, well capitalised institution and are facing off against a smaller firm with limited capital. . From a risk and compliance standpoint, this structure could become more problematic. if institutions don’t know who the underlying customer is that is transacting business that their balance sheet is ultimately guaranteeing via the swap.”
This could lead to more US introducing brokers entering Europe over time, especially as the tier one primes will increasingly look to focus on the biggest, most profitable hedge fund clients. If, for example, Goldman has the opportunity to service USD1billion of hedge fund assets with USD100million as opposed to USD300million of balance sheet assets, they are going to do so. There are many factors involved, not least of which is the type of strategy employed by the manager (the higher the leverage used the more costly the client), but all things being equal, more efficient balance sheet will come from servicing the biggest funds.
“Because there’s a minimum level of personnel that is required to comply with all the new rules and regulations, the costs end up being disproportionate relative to the size of the assets or the capital base.
“As a result, securing the services of a prime broker is becoming increasingly difficult for start-ups and emerging managers as the larger primes focus on higher quality (and higher AUM) managers. If recent regulations have helped to create an environment where the largest banks have no choice but to service fewer customers, this means a meaningful number of managers are going to need to find solutions other than the traditional solutions they are accustomed to. .
“As permitted balance sheet usage has decreased markedly for many prime brokers, the threshold for meeting the ROA requirements at the large Global PBs has increased and will likely continue to do so. The need to generate better returns on a reduced capital base will also mean that the human resources being allocated to support hedge funds will have to be reduced” comments Rosen.
In conclusion, Seibald says that he is actually quite surprised by the lack of a meaningful increase in the costs imposed on hedge funds by the prime brokers. He would have guessed by now that pricing would have been addressed more readily.
“Honestly, I believe it is still to come.
“When we look at the pricing coming out of some of the European banks when speaking to prospective clients we scratch our heads and can’t believe it. I don’t understand why the banks are more comfortable saying they are going to restructure and can’t offer a home for certain hedge funds as opposed to telling clients, ‘We value your business, but in order for you to stay here your rates need to increase from X to Y’.
“My bet is that some of the US banks are doing that now because they are seeing the opportunity. In Europe, the default stance still seems to be one of shrinking the balance sheet and asking hedge funds to find a new home.
