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US prime brokers move ahead of European peers

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US prime brokers are stealing a march on their European peers as European banks grapple with the demands of shoring up their balance sheets to comply with Basel III rules. As Reuters reported 7th October 2015, Goldman Sachs and Morgan Stanley have a 37 per cent market share, up 6 per cent from the end of 2014 (according to data from Preqin). Goldman was servicing 2,240 hedge funds through May 2015, followed by Morgan Stanley with 1,693. JP Morgan rounds out the top three with 1,462 hedge funds. 

Credit Suisse Prime Fund Services is the highest ranked European PB, with 1,214 hedge funds but as recent newspaper reports have suggested, the Swiss bank's new chief executive, Tidjane Thiam, is planning to split the bank into three businesses – an investment banking business, a Swiss business and an international business – and scale back its prime brokerage activities to free up capital. 

With Deutsche Bank having also lost ground, the situation has enabled US primes to ramp up their activities, leading to higher revenues. According to data compiled by research firm Coalition, the prime brokerage business accounted for 35 per cent of total equity trading revenues in 2014, up from 25 per cent in 2009. This is helping the big tier one US primes to increase their revenues, partly by increasing trading costs, but also by simply doing a high volume of trading business. As Preqin data reveals, 54 per cent of hedge funds only use one prime broker, with a further 26 per cent using two prime brokers. 

This is something that the US primes have been pushing for, and they are reaping the rewards as a result. Europe, it seems, is proving to be a bit slower in adapting to Basel III. One can see this by referring to leverage ratios. Goldman and Morgan Stanley must have a 5 per cent minimum leverage ratio for their holding companies under US rules. As of 30th June 2015, they had a 9.6 per cent and 7.9 per cent ratio, respectively. Compare that to Europe, and Credit Suisse has a 3.7 per cent ratio, while Deutsche Bank's leverage ratio is 3.6 per cent under Basel rules. 

"In the post-2010 era, it has become a much clearer regulatory environment and a much tougher capital situation, particularly for European banks. I think US banks, with liquidity stress testing, etc, have been a bit ahead of the curve and have got their balance sheets in better shape versus the European banks," says John Laub, Co-Head of Global Prime Services at Jefferies Group LLC. 

That's not to suggest that all European banks are in a weaker position, and all US banks are in a stronger position. Bank of America Merrill Lynch, for example, is looking to right size. But it does appear as though US banks have, for the time being, an opportunity to out-flank European bank-owned primes.

"During the credit crisis, a number of European banks were net beneficiaries. They were seen as safer ports in the storm relative to some of the other banks, including US banks. There was a clear market shift towards these European banks during the crisis. Some of those European banks are now having to re-evaluate their books of business," observes Sean Capstick, Head of Prime Brokerage at European boutique prime broker, Global Prime Partners. 

The likes of Jefferies, Global Prime Partners, and many others, are actively looking to compete with the bigger primes in the US and Europe. Even though the US is in a stronger position, Goldmans, Morgan Stanley and others have, for quite some time, been culling hedge funds that are simply not profitable enough as they take a more forensic approach to understanding the return of assets (ROA) when committing precious balance sheet. 

"If a manager is looking for competitive rates and supply on securities lending, whether they are USD100million or USD10billion, Jefferies is a good choice. Our approach is, `How can we help you make money, raise money and build an institutional business?' Today's regulatory landscape gives us the opportunity to compete more readily with the big primes," comments Laub.

"When I look at the differences (between US and European primes), there were some firms that grew very quickly. Then the rules changed. All of sudden, ROA is a factor that previously hadn't been. We paid a lot of attention to these changes. We have always focused on our ROA thanks to the slow and steady approach we've taken to growing the business. We didn't have to take a huge sidestep in our business post-crisis and scramble to ensure our business model fits the new regulatory environment. Trading and financing has always been integrated holistically for Jefferies and this has helped maintain a good ROA."

If European primes continue downsizing it will likely present opportunities for US primes to win lucrative client business and not have to rely on more capital intensive hedge funds. If you can remove USD1billion of AUM that uses USD300million of balance sheet, for example, and replace it with USD1billion of AUM that only uses USD100million of balance sheet, the chances are that is something US banks will look at.

"I think that's the process that is going on right now, generally speaking, in US banks," says Jack Seibald, Global Co-Head of Prime Brokerage at Cowen Prime Services. He is in no doubt that European banks were slower to recapitalise and as a consequence have found themselves at a competitive disadvantage. "They are having to address the issue. One way is to shrink the balance sheet. The second is to rebuild capital. They are at a stage where it appears that the easiest thing to do is to shrink the balance sheet; i.e. show clients the door. It's hard in that environment to win new client mandates when you're going through this period of restructuring."

One of the negative developments in recent years, before Basel III took meaningful effect, was the perverse desire among prime brokers to engage in a race to zero with respect to spreads on financing rates, execution costs, securities lending etc. Some US primes have been quick to act on this and have raised their rates necessarily. It needed to happen and it is something that hedge funds have to accept when operating in today's regulatory environment. 

"I'm surprised by a lack of a more meaningful increase in the costs imposed on hedge funds by prime brokers. When we look at the pricing coming out of some of the European banks when speaking to prospective clients we scratch our heads. I don't understand why banks are more comfortable saying they are going to restructure and can't offer a home for hedge funds, rather than tell clients, `We value your business but in order for you to stay here your rates need to increase from X to Y,'" opines Seibald.

US banks raised a lot of capital from 2009 onwards. Granted, some have been hit with significant fines by the regulators but despite that they've been able to continue to build their capital structure. That accounts for the significant spread between the leverage ratios in place in the US banks like Goldman's and those in Europe. 

At the same time, there's a need to generate a return on capital because US banks are being continuously assessed based on the capital requirements they have in place for assets held on their balance sheet. 

"I tend to think that the firms who are growing market share are the ones that have the best integrated equities platforms," suggests Laub. "We're starting to field more enquiries from European hedge funds as they start to get culled, just as we did a year ago when US managers noticed that their rates were going up, and were beginning to feel less important. I think in 2016 you'll increasingly hear that European banks are raising their rates and culling managers."

Not that it is all doom and gloom in Europe. One bank that is preparing to build out its prime brokerage offering is Societe Generale Prime Services. In May 2014, the bank chose to buy out Credit Agricole's 50 per cent stake in Newedge, a leading Prime Broker in Equities, Fixed Income, Listed and OTC products. Newedge is now able to leverage the strengths of Societe Generale and operate as a full-scale prime services business. 

"Many of our competitors have had large PB franchises for year. Some of them were perhaps oversized versus the rest of their business, leading them to reduce their clients' portfolio. On our side, we have taken the time to grow our PB franchise steadily and we are committed to keep expanding", says Fred Colette, Deputy Head of Prime Brokerage & Clearing Sales, Societe Generale Prime Services.

"The combination of Newedge's existing PB franchise and infrastructure with Societe Generale Equity footprint (large inventories, execution, derivatives expertise, researchº) enabled Societe Generale Prime Services to build a competitive Equity PB offering for all clients. The integration is now successfully complete and we are continuously winning more mandates as Societe Generale Prime Services."

What gives Societe Generale Prime Services a competitive advantage over its European peers is that its prime brokerage business has been constructed as a single integrated offering that has neither the legacy technology issues nor the silo-based arrangement that is now proving challenging for some banks to gain a full understanding of the revenue capabilities of hedge fund clients.

"Our strength is to offer a truly cross-asset approach. By combining execution services, cross-asset financing and prime brokerage under one umbrella our clients benefit from a global, non-siloed service. We can address all our clients' needs, regardless of the products and services, as one single partner.

"In the current context, hedge funds looking to diversify their source of balance sheet capacity cannot solely rely on US-based prime brokers. Clients are looking to diversify their exposure to regulatory uncertainty and counterparty risk, which is a strong selling point for European Prime Brokers. It goes without saying that the year ahead is critical for the reshuffling of the industry mix," states Colette.

From a regulatory standpoint, a new disclosure requirement is set to come into effect in 2016 that could, potentially, add an unwelcome operational cost to European primes. Known as Securities Financing Transaction Regulation (`SFTR'), it relates to repos, securities lending, margin loans etc. However, SFTR contains a provision that has a broader effect than repos, securities lending and margin loans. It governs any collateral arrangement that carries a right of reuse; i.e. rehypothecation.

"In the early stages of developing the regulation there was talk that rehypothecation might be banned altogether, which would have had a massive impact on European prime brokers," comments Allan Yip, Partner at international law firm Simmons & Simmons LLP. 

"Luckily, it didn't happen. Instead, what we've ended up with are some rules and parameters for any collateral arrangement to carry a right of reuse. One of which is that when a prime broker takes collateral, it has to disclose explicitly to its clients what the arrangements are, what the risks are associated with right of reuse, and some operational requirements such as getting the clients' express consent." 

This disclosure requirement is a European rule. It mirrors what the FCA had put in place in 2011 for prime brokers – this is when the FCA first formally recognised prime brokers and inserted into their rulebook a PB Annex, which included disclosing the risks of rehypothecation of clients' assets. 

Broadly, the SFTR disclosure is similar but it now applies at a European level. Moreover, it's not just geared towards European prime brokers but any counterparties that have a collateral right of reuse arrangement. If a hedge fund has an OTC derivative relationship, and uses separate margining to the prime, to the extent that the fund receives any variation margining from the prime then the fund, too, will have to provide the same disclosure to the prime. All of which seems rather counterproductive.

"I would best describe the disclosure and transparency requirements of SFTR as a pain to prime brokers in relation to collateral reuse. If you've got 10,000 clients, the prime broker now has to face the prospect of reaching out to every one of them and tell them what the risks are. How valuable an exercise is that? Who is going to read those disclosures? They'll end up just getting filed in a drawer," says Yip candidly. 

European primes have a lot of work to do to close the gap on their US counterparts. They've been slower to build out their balance sheets and that is going to leave them at a distinct disadvantage for the foreseeable future. 

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