There's no question that regulation is causing prime brokers to reassess, and, where necessary, evolve their business model. Much is made of the fact that prime brokers are ruthlessly culling hedge funds, banishing them to hinterland. Hedge funds that aren't generating revenues for their primes have become the vampires of high finance, sucking the lifeblood out of banks' balance sheets.
Speak to any prime broker and the stock response is: `We need to improve our return on assets'.
This is completely understandable; necessary even. But it is equally incumbent upon hedge funds to assess, and, if necessary, cull their prime brokers if they are not delivering better efficiencies and transparency that can support their long-term business objectives.
"I completely agree," says Gildas Le Treut, Global Head of Prime Services, ABN AMRO Clearing. "There is still a tendency to gravitate towards the same big names and whilst it's important for primes to do deeper analysis on their clients, it's also important that the fund manager fully understands the revenue items from the prime broker.
"They need to understand what the prime broker's strategy is. It's not a pure service provider relationship anymore, it really is moving more towards a partnership arrangement. Both sides need to decide whether it's a good fit to enter into a business relationship – managers are becoming more selective, just as much as the primes are."
Steve Sanders, EVP, Marketing and Product Development, Interactive Brokers, who this year joined the list of top 10 largest prime brokers – the only specialist prime broker to do so – says that the industry has changed. Everybody is looking for greater cost efficiencies: "Traders don't call their brokers over the phone, everything is shifting towards electronic platforms. That is making everything more transparent, particularly costs."
A recent EY survey – The evolving dynamics of the hedge fund industry – found that 30 per cent of managers have experienced price increases. Some 41 per cent of managers running distressed strategies, and 32 per cent of fixed income/credit managers had experienced increased fees, compared to 13 per cent for relative value strategies and just 4 per cent of those running quantitative long/short strategies.
John Laub, Co-Head of Global Prime Services at Jefferies Group LLC, believes that the industry is still in the "early innings" of price change.
"I think a manager's AUM is much less of a focus now," says Laub. "It's more a case of primes determining whether the manager has a balanced book. Are they running a large tail on shorts? Are they running a large debit with no short book? Do they trade infrequently and hold cash in their margin account? Clients have been educated over the last 12 months on ROA and what it means and how their ROA is thought through. On the margins, I think there are going to be some fund types that are going to be much less attractive but the market will recalibrate."
"We all watched what happened through the financial crisis to convertible arbitrage," recalls Sean Capstick, Head of Prime Brokerage at European boutique prime broker, Global Prime Partners. "A lot of these strategies are not what they once were, the amount of leverage just isn't available today. People are definitely shying away from more difficult to finance strategies."
One prime that is cognisant of the need for greater transparency is Barclays. Its Quantitative Prime Services division analyses trends in PB financing models. "We then share that information with our clients to assist them in identifying what they should be thinking about when engaging with different primes," explains Rahul Jaising, Director, Quantitative Prime Services.
Jaising notes that the prime brokerage business has become more returns-focused (as opposed to revenues-focused) as balance sheet becomes more precious under Basel III.
"Our quant business is accretive to the prime business because a lot of our clients who trade in the quant space run market neutral statistical arbitrage strategies. We are trying to bring in more of these clients as these strategies have a higher efficiency, in the mix of the prime brokerage business; and that is a key driver of returns. Also, because we intimately understand the clients we deal with, we can help them optimise their allocations to PBs to generate the right return profile," says Jaising.
Bank-owned primes are creating new value propositions for their top clients, ensuring that they get access to different parts of a bank's product suite to address their business needs. Within Barclays' Quantitative Prime Services division, for example, it offers two flavours of products for clients who require direct market access: a global low latency product called SubM and another ultra-low latency product called Native, which works in select markets.
"We try to use these products as a point of differentiation for clients who want low latency direct access to the market," says Joe Mecane (pictured), Managing Director, Electronic Equities and Credit Products at Barclays.
Some bank-owned primes continue to struggle to understand precisely what revenues a hedge fund client generates in isolation. Often, they need to look across different revenue buckets: comparing revenues in the prime brokerage division (financing, stock lending) to what the client is generating in the cash channel (trading revenues, research and so forth) and also in the derivatives channel.
As a result, it's getting increasingly difficult for hedge funds to pay the big banks in one channel. This is not a problem for large billion dollar hedge funds, but it is a problem for smaller and mid-sized managers if they are falling below the banks' desired thresholds; and that's where the boutique prime broker has a role to play.
"A lot of the larger banking primes can't always provide their smaller clients the client service attention, the trading desk attention, the technology attention that we can to our clients," says Capstick. "We give a high touch service to smaller hedge funds. We have an 18-person client service team. We have a trading desk, and our own proprietary technology supported by a 30-person team in Cape Town. There are a lot of managers looking for a suitable home beyond the tier one primes and that's where we are concentrating our efforts."
Whether it is boutique primes like Global Prime Partners utilising an omnibus account structure to provide a valuable lifeline for smaller hedge funds, or bank-owned primes that are focusing on quantitative solutions to improve revenues, there are many ways to adapt and evolve in today's environment. By leveraging electronic trading expertise in equities, credit, and other asset classes, bank-owned primes have the potential to generate revenues in different pockets that are accretive to the creation of a higher overall ROA.
"Electronic trading, whether it relates to the prime brokerage business or pure cash trading business, allows us to collect commission dollars without consuming significant financial resources. We are able to generate returns across a menu of services, whether it's to support systematic managers requiring low latency direct market access or traditional money managers, long/short managers and so on," says Jaising.
ABN Amro Clearing is a prime broker with a custody DNA. With AIFMD now up and running, this is putting them at a distinct advantage as depositary banks, appointed to safeguard the assets of EU-domiciled Alternative Investment Funds, look far more closely now at which prime brokers hedge funds want to appoint: their financial structure, credit worthiness and operational capacities, etc.
"With our DNA in post-trading, and as a custodian, we understand what is needed in respect to segregation of assets. We definitely have gained momentum under AIFMD, mostly with the depositary banks who understand the importance of operational efficiency and transparency.
"Pre-AIFMD, hedge funds were deciding which prime brokers to use. Post-AIFMD, it has become a combined decision between the fund manager and their appointed depositary. In our business proposition, we offer a true partnership. We are not a depositary bank but we speak the same language, and that is working to our advantage," confirms Le Treut.
Key to this is that a full depositary arrangement under AIFMD means that they are legally responsible for the restitution of an AIF's assets, should anything go awry.
"In the clearing world, providing complete transparency around what and how you charge, is a necessity. In the new regulatory landscape, depositary banks wants to achieve greater transparency in the counterparties they work with, and we are well positioned to offer that," comments Delphine Amzallag, European Head of Relationship Management, ABN AMRO Clearing.
"We've built our franchise over the last 35 years and now the prime brokerage space needs new players with strong balance sheets and a sound financial structure. Nevertheless, you need to be focused on certain strategies, not all strategies, and I think this is where the evolution is heading: a set of prime brokers that specialise in core strategies as opposed to being generalists. We specialise in supporting quantitative strategies, high-frequency trading and arbitrage strategies."
One firm that is pushing the envelope and growing its market share by offering a fully automated low-cost prime brokerage model is Interactive Brokers. The way that market structure is evolving, Interactive Brokers suddenly find themselves in a favourable position. Not that it has been an altogether smooth process.
"When we first got into this business we would get two objections: a) your name is not well-known and b) people would say, `I want capital introduction services so I'd prefer to go to Goldman or JP Morgan who can introduce me to investors and help me raise capital,'" recalls Sanders.
People have found out, however, that actually getting those introductions hasn't been as easy as perhaps they expected.
"We take a different spin on this. Our Investors' Marketplace allows hedge funds to list their services electronically, their performance track record, and we have a very sophisticated client base of individuals who come in and view this through our firm. That has certainly helped overcome the challenges we faced in the early days.
"We do it all, from trade execution to securities lending and financing, but with an automated twist. Indeed, if someone wants to lend out their shares we will borrow them. We post our rates electronically so there's no need to call someone up. We have something called our Stock Yield Enhancement Programme. Provided you're not taking out any financing, we will lend out your shares and whatever revenues we make we share with the beneficial owner on a 50:50 basis," explains Sanders.
There is no doubt that technology is vastly improving the way that both primes and hedge funds can evaluate the `economic value' of their business partnership. Indeed, for specialist prime brokers like Interactive Brokers, the very fact that they have incorporated technology into the heart of the business model is symptomatic of where the industry is headed, and one of the reasons why some bank-owned primes are struggling to improve the ROA that Jaising refers to above.
"A lot of the systems that they've built are still mainframe systems, and over time they've added a new interface. What's really required, however, to bring their systems up-to-date is to apply a whole re-write. They put together these multi-year projects involving lots of personnel, they often then get hit with cost constraints, and it becomes a bureaucratic mess. I tend to view Interactive Brokers as a technology company that operates in the prime brokerage business, and as such we are constantly updating our systems for the future," comments Sanders.
"The thresholds that we look at among clients are much lower because we don't have such entrenched costs," adds Capstick.
Capstick thinks there may well be more entrants into the boutique prime space, moving forward. Global Prime Partners have a competitive advantage, if this were to happen, given that they've been around for eight years, over which time they've put the technology in place, the client service team in place, a stock lending programme in place and so on; this is not, in other words, an easy business to establish overnight.
"It requires a fair amount of capital and technology investment. But I think others will look at this business, given the pressures that the banks are under," says Capstick.
"The nature of the next layer down from tier one primes is changing. Not all banks are now able to provide the same amount of leverage and access to client service that they once could because they don't have the balance sheet and depth of departments any more. That is allowing other entrants to enter the PB space. We want to double the asset base and double the revenue base within the next three years.