Primed for change?

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PRIME Brokerage
Primed
for change?
The earth's surface undergoes constant change as
its tectonic plates continually jostle each other for
position. Change to the prime brokerage landscape is
less gradual but just as relentless, and can still produce shockwaves. And just as an earthquake can
speed the process of geographical upheaval, the
recent financial turmoil has had an impact on prime
brokerage where competition is fiercer than ever.
One aspect of the prime brokerage market that
few thought would change was the historical dominance of three main players: Morgan Stanley,
Goldman Sachs and Bear Stearns. In the relatively
short history of the hedge fund industry these three
institutions have reigned supreme in servicing it better and longer than anyone else. It was a broker
named Furman Selz who coined the term 'prime broker' in the late 1970s to describe a convenient bundle
of services from clearing to securities lending, but it
was some very smart guys at Morgan, Goldman and
Bear who perfected prime brokerage in the 1980s as
hedge funds gathered momentum as an investment
option.
Adam Jones of Scotia Capital says: “By the mid 80s
when there were dozens, rather than the thousands of
hedge funds seen today, the 'big three' had already
begun to recognise the huge revenue potential by
supporting hedge funds. They each invested heavily,
learning the business, developing the risk management expertise and technology required to service a
demanding client base.
“Their early dominance and the speed with which
they were able to capture market share meant it was
hard for others to catch up.”
Jones adds that so dominant were the big three that
a hedge fund was not perceived as credible unless was
connected to one of them.
But times are changing. In March, Bear fell victim
to fate and unforgiving margin calls, and Morgan
Stanley and Goldman Sachs have seen their dominance slowly whittled away in the last five or six years
from an estimated 90% of the market a few years ago
to around 50% between them.
Though the US is still the home of much of the
hedge fund industry, European banks are growing in
prominence. Foremost among these is Deutsche
Bank, recently rated by Global Custodian as the preeminent prime broker in the world. Denise Valentine,
an analyst at independent research
group Aite, says: “Deutsche Bank
was very interesting when they came
on the scene several years ago and
really came out of nowhere, and
have built themselves into an amazingly successful business.
“They've proved themselves on
the basics; it's about trading and execution and inventory, at the core.
They came to the market with a core
offering that was appealing and well
structured. Its like anything else, if
you come out and do something
really well you get attention.”
UBS and Credit Suisse have also
strengthened their prime brokerage offering in the
last few years. Some say that one major advantage a
retail bank has in offering the service is in the perception that they have greater access to their own
capital and are at less risk of failing.
Joseph Corcos
reports on the
new competitors
and changing
realtionships in
prime brokerage
Morgan Stanley and
Goldman Sachs have
seen their dominance
slowly whittled away
in the last five or
six years from an
estimated 90% of the
market a few years
ago to around 50%
between them
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PRIME Brokerage
“Over the last couple of years the main players
increasingly are European banks and I think its
partly because clients feel increasingly it's really a
banking business,” says Roy Martins, managing
director of the investment banking division at
Credit Suisse.
“The [US] Fed[eral Reserve] has for now thrown
an emergency window open, but its suddenly hit
them just how big the lending being done by
investment banks that have very low capital and
deposit basis is.
“For example, at Credit Suisse 32% of our balance sheet is funded by retail and private deposits.
UBS is 25%. Morgan, Goldman, Bear, Lehman are
all nearer 1%. So that is the huge differential
between [retail] banks and broker dealers, and similarly if you look at the credit default spreads, the
main banks are all about half what the broker
dealers are.”
ScotiaBank's Jones agrees that banks which
offer prime brokering services may be set to become
more popular among hedge
funds: “I believe hedge funds
will look more favourably at
prime brokers who are
backed by a highly credit
worthy bank.”
Sean Capstick of
Deutsche Bank says: “The difference for us against our competitors - most of which are
broker dealers - is that we look
at ourselves as a financing
powerhouse, rather than a boutique prime brokerage offering.
“The benefit for us at the moment is those two
[Morgan and Goldman] are broker dealers. We're a
bank - in fact, the number one bank offering brokerage - and in an environment like this, even with the
Morgans and Goldmans, people recognise that there
are big differences in the way a bank funds itself.”
However, Donald Pepper, head of prime brokerage sales for Merrill Lynch in EMEA, thinks that the
greater access that banks have to retail deposits is
misleading as to thier ability to provide financing to
hedge funds.
He says: "Prime brokers do not use unsecured
bank deposits to finance their prime brokerage
clients. Prime brokerage is a self-financing business,
using collateralised borrowing to provide financing.
"Counterparties willing to lend on a secured
basis - with the investment bank/commercial bank
putting up collateral - are more plentiful (and
cheaper) than unsecured bank deposits."
The credit crunch has prompted more investors
to diversify their funds among different prime
brokers. This is also changing the market.
According to Pepper, funds have been spread
"Prime brokers do not use
unsecured bank deposits to
finance
their
prime
brokerage clients. Prime
brokerage is a self-financing
business, using collateralised
borrowing to provide
financing”
Donald Pepper
48 ALTERNATIVES
around several prime brokers for approximately
the last five years in order to get best all-round
service from their investment bank/commercial
bank counterparties. Dealing with just one prime
broker is, as he calls it, 'sub optimal'. Now there is
an element of risk management involved in
appointing a prime broker.
Jones says: “Hedge funds are required to be
more and more cautious about their own counterparty risk. Just over six months ago it would have
sounded ridiculous to be assessing the credit worthiness of a big Wall Street or large European
financial institution, but the shocking events over
recent months have caused people to look far
more closely.
“I believe hedge funds will look more
favourably at prime brokers who are backed by a
highly credit worthy bank and be more willing to
appoint two or more prime brokers so that the
risk is dispersed more evenly.”
Whether this change is fundamental or a symptom of the market is debatable. But lessons have
been learned by hedge funds regarding best practice and prime brokers. Fabio Frontini, chief executive of the hedge fund Abraxas, says:
“After what has happened in the last few months
you definitely have to think twice about having
only one prime broker, especially if you are
someone who uses leverage and needs to borrow
money.
“In the last six months people have realised that
if you put everything in the same pot its not that
good an idea anymore because of counterparty
risk,” he adds.
It is difficult to determine whether the uncertain
times and evolving relationships that hedge funds'
have with prime brokers result in a more even and
competitive prime brokerage market. Yes, competition is increasing, and stakes are higher than they've
ever been, but one shouldn't expect the two top dogs
to go anywhere soon.
“I think it'll take quite some time for the big players to lose their dominance, they have huge
reputations,” says Aite's Valentine. “If you look at
Asia, one of the faster growing markets, who is over
there? Morgan and Goldman. Even as those markets
grow and add new firms - which is what one would
anticipate - they're still the blue-chip names.
“It's taken a handful of years for others to
chisel away,” she continues. “The chiselling began
probably about six years ago give or take. So it
depends how you measure time.”
Meanwhile, the rest of the pack of prime
brokers will be keeping an eye on their
competitors while trying to survive difficult times
that have already claimed the Bear scalp.
Whether they will gain ground depends on many
factors - most importantly, as Valentine says, “they
have to keep doing their job well”.