The New Face Of Prime Brokerage

The prime brokerage landscape has changed dramatically since the Lehman’s  collapse in 2008.

A couple of years ago both Goldman Sachs and Morgan Stanley had 2/3rds of the Prime Brokerage Market.

Today, the top 4 brokers now control 68% of the prime market, representing a significant redistribution of power within the prime brokerage industry.

Evolution
Historically, hedge funds and institutional investors would use a prime broker to provide :

•    Centralised Clearing
•    Single Set of Books and Records
•    Consolidated Position Keeping
•    Efficient Cross Margining

During the credit crisis, the amount of leverage available to hedge funds drastically reduced from 30 to 16  times against a prediction that 30% of hedge funds would go bust. At the same time, prime brokerage profit and revenues plunged.

Multi Prime Relationships
Counterparty risk and the fall out Lehman’s proved to be the final nail in coffin for the single prime brokerage model.

Market participants became only too aware that no prime broker (PB) was too big to fail. There was a need to spread their counterparty risk across several prime brokerages introducing the arrival of the multi prime relationships.

Hedge funds of all size now demand multi custodial relationships, which introduce additional complexity  such as increased reconciliation, margining and asset servicing across several custodians and ultimately prime brokers.

Market Structure
Without a captive single prime model, the high cost structure that leading prime brokerage firms now face is no longer viable to service small hedge funds based on pure economics. This has been seen with PBs  being more selective on what type and size of funds they manage.

Conversely, funds in less liquid or highly leveraged assets are finding is a lot harder to attract and maintain a top tier prime relationship.

Smaller hedge fund (HF) have historically been serviced by the midi and mini primes who are now expanding their offerings to attract new funds. The mini primes, such as Merlin, still use the clearing and financing services from the large primes and have ultimately developed a cost structure to allow a profitable PB service to be developed for the smaller tier HFs.

The major players are now sharing the prime landscape with both the midi and mini primes, who  are proliferating fast with a number of new entrants coming to market.  To date, there are 3 mid sized operators and about 20 minis with 10 more planning to enter the market  soon.

Commoditisation of Prime
As the market matures along with a high level of competition across the sector, the commoditisation of prime brokerage has started.

Profit margins are lower for the mini and midis which only provide basic services and will struggle against the majors who make most of their money from complex strategies and the financing of large portfolios.

The conventional business lines between prime brokers and hedge funds are starting to blur with many  Prime Brokers now acting as business partners. As part of this service, PBs  provide business plans to the HF community, publish white papers, arrange office space leasing  and advise on risk management services and strategies.

Winners
The clear winners in the prime brokerage race will be the players who can differentiate their service offering.

Key to this is being able to leverage technology to deliver a new Prime Brokerage infrastructure that can support aggregate multi prime relationship along with real time reporting of critical data such as PnL, risk and margining.

The ultimate challenge is to become the provider of choice with a true cross product capability across FX, equities and fixed income.

The winners will be the prime brokers who understand and act on the new economies of the market.

IAN ALDERTON
Email : ian@IanAlderton.com
Tel : +44 (0) 7702 777770

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