Hedge fund managers are putting their prime brokers under continued pressure to be more transparent and open with respect to how they set their revenue targets and how they determine their costs for stock lending, commission rates, and margin finance.
For the last two decades, the PB operating model has been rather opaque, with very little consistency over how one bank prices its services versus another. It worked perfectly well but as new regulation such as MiFID II in Europe requires fund managers to demonstrate they are delivering best execution for their investors, PBs are having to respond accordingly. This is helping improve the PB/manager relationship simply for the fact that both parties need to have a clear understanding of what they are trying to achieve, and how that plays out in terms of profitability on the one hand, and cost on the other.
“You should work out how much of a purse you have to spend with the PB at different points of your development,” says Phillip Chapple (pictured), COO at Monterone Partners, a European equity long/short hedge fund.
“Also, you need to make sure the PB gets paid what it needs to give you the service that you require.
“For example, if your revenue is going to be X but you know that the PB is going to want 2X, it’s not going to work. It won’t have a chance to become a meaningful long-term relationship so you have to look at revenue carefully. This is where the expertise comes in because some PBs will make money out of fixed income, some second that out (and won’t consider it as part of their revenue stream) so you’ve got to look at your investment strategy, your purse, and think about how that would fit in to the PB’s business model.”
This calls for an open and honest conversation. The more a prime broker understands a manager’s investment strategy, and how it can potentially touch other areas of the bank (from a revenue perspective), the less chance there will be of getting offloaded at a later date. That is far from ideal but it has been happening in earnest over the last couple of years as banks deem smaller clients no longer economically viable.
“I think there is more transparency coming from PBs, especially now that MiFID II has gone live,” says Chapple. “Previously, PB was this large packaged product, some of which you needed, some of which you didn’t. Pricing was opaque, as was the profitability to the PB. Now, I think it is a healthier situation to go through each of the revenue lines and work out what the PB is making. Then the manager has transparency to understand what drives revenue for the PB and it facilitates an easier relationship.”
The COO of a global macro fund who asks to remain anonymous tells Hedgeweek: “We’ve always got transparency on costs. Now we have to pay something for research – which is not ideal. MiFID II has increased our costs, not reduced them.”
He says that they rely on their PBs more for settlement and custody as opposed to funding and that they prefer to avoid multi-netting arrangements, which some in the industry regard as improving cost (margining) efficiency.
“I’m not a big fan of multi-netting agreements. I like to know what the margin costs are for specific asset classes like FX. When we trade swaps, everything is given up to the CCP, which makes things easier. I would estimate that 95 per cent of what we do with swaps is given up to the clearing house, with a single clearing margin.
“There has to be very clear transparency on how margin is being calculated and whether it is reasonable or not,” he says.
Simon Hampshire heads up Investor Relations at Cognition Investment Partners, a London-based macro strategy. For their strategy (and many other macro and CTA strategies), things such as financing and stock lending were not important considerations when selecting their prime brokers at inception as the strategy trades futures. Of much greater importance were commission rates. This is critical for controlling trade costs.
“The costs were quite high early on the relationship as we got to know one another. However, after the first month we re-negotiated our rates substantially. We have to know the full breakdown of all the pricing involved from electronic execution through to clearing costs and exchange fees. Quite a few providers are reluctant to break down the combined figures into the three elements because they see it as part of their competitive edge. For us, we have to tightly manage our budget. It is important we know the figures in order to trade efficiently on exchanges and manage our margin costs in the most optimal way,” explains Hampshire.
He agrees that primes are being pushed more by their clients, especially the younger generation of millennial managers, to be more transparent.
“There are strategies such as ourselves that only need a vanilla product. We don’t need to have a specialist PB relationship in that sense. And that is the case for a lot of managed futures funds. There are very few add-ons that PBs need to offer us – it’s all about execution and STP capabilities,” adds Hampshire.
Where macro strategies like Cognition will hold their PB to account is when the strategy suffers trade breaks. Prime brokers have invested huge sums in technology to support STP and e-trading, such that trade breaks are increasingly rare. “Most primes can offer a process that is 99.9 per cent accurate. Because everything is automated there is no reason for human error.
“As a result, there is very low tolerance among macro managers for trade breaks,” says Hampshire.
Testing the manager relationship and establishing clear terms and expectations at the get-go is something that Societe Generale Prime Services is fully focused on, as it looks to build its market share.
According to Alexia Weiller, Global Head of Prime Solutions, when selling prime brokerage services “you aren’t just selling access to the bank, you are selling access across the whole chain – including operations and IT infrastructure”.
In other words, PB is not just a front-end solution.
“It’s important for us to work with our clients to develop a transparent, long-lasting relationship. Fund Managers are also assessing us on the way we manage incidents; we can’t treat them as any client buying a product.
“When a manager is selecting a PB I think it’s important to try to understand front through back how they work, how integrated their operations are, what IT capabilities they have: all of these should be part of the service offering,” says Weiller.
As with any healthy relationship, communication is key. Fund managers today understand why Basel III is making banks’ balance sheets a more expensive commodity and that margin costs will be higher, depending on how much leverage they are looking to employ.
“We work with our clients from the start to define the capacity they need. We analyse the composition of their portfolio and define the most appropriate business mix for both them and us. Each client will have different needs, depending on their strategy, size and appetite.
“That way, at least at the discovery phase the manager knows what he’s going to get. He will know what impact he is having on our balance sheet,” explains Weiller.
Other primes are adopting a similar mindset to Societe Generale. In that respect, the paradigm has changed.
As one source tells Hedgeweek: “We live in a world where regulations continually change and evolve, putting pressure on the banks. We need to understand the constraints and communicate them clearly to our clients. You can’t expect your clients to give you the right book of business if you don’t explain to them what you need.”
Hedge funds want the ability to reach around the world to access different assets – futures, Forex, options and stocks – from one single platform. “We’ve always had this capability but it is not easy for bank-owned primes to develop such a capability,” remarks Steve Sanders, EVP, Marketing and Product Development, Interactive Brokers.
“We make all of our pricing available to the world. Prime brokers tout transparency but one of the areas they make the most profit is in stock lending and borrowing; and the fact is, there is no transparency on this. They tell you over the phone what rate you can get. We, on the other hand, make those spreads available to any of our clients so that they know, in real time, the cost of borrowing.”
With so much digital technology disruption happening in the market, as the years go by Sanders does not believe that the legacy issues of non-transparency in the bank-owned primes will be as much of an impediment as perhaps they were in the past.
“Everybody has a different way of showing how they give price improvement and depending on the definitions you put into your analysis, you can make them look really good. You could say you only want to include market orders, limit orders, you only want to look at the market over the last 10 days, so it’s not as cut and dried as commissions.
“With commissions, you can easily compare one broker who charges USD1 versus another broker who charges 50 cents. We think our definitions are pretty good.
“We announce our earnings every month, in which we show the total commissions per trade that we charge along with the execution cost of that trade. Very often, it’s negative and we get rebates from the exchanges. We think this is a good measure of how we perform versus everybody else. We know what the intrinsic value is of all our hedge fund clients,” explains Sanders.
Going forward, Weiller says that the strategy at Societe Generale will be to become a prime broker where managers go for quality of service and breadth of product offerings.
“Our clients are constantly looking for innovation and new ways of doing business. You need to be proactive, to respond to your clients very quickly. Prime services is one of the key growth areas over the coming years so it is important to have the full backing of the bank,” concludes Weiller.
