Prime brokerage has been under sustained pressure and activity continues to be constrained by a combination of more stringent capital requirements, lacklustre economic growth and subdued, one-directional trading. But the outlook seems to have stabilised and some new opportunities have also emerged.
“There are now just six major prime brokers in the US – JP Morgan, Wells Fargo, Bank of America, Goldman Sachs, Morgan Stanley and Citi – compared with perhaps 14 around the time of the 2008 crisis,” says Joshua Satten, director at Sapient Global Markets.
“Foreign banks such as Deutsche Bank, Barclays, RBS and the French banks have been pulling out of the US because various regulatory constraints around unencumbered cash and risk ratios are raising their service cost basis to uncompetitive levels, and the scale of their businesses has shrunk generally.”
While the major banks have now implemented the necessary Leverage Ratio and Liquidity Coverage Ratio requirements in accordance with regulations, not all bank prime brokerage groups have the same constraints, and some struggle more than others to meet their required internal hurdles to justify the use of balance sheet capacity for lending activity.
“Standards vary by jurisdiction and some banks charge their business units on an aggregate, rather than individual, basis,” explains Josh Galper, managing principal at Finadium.
“Further, banks might have an end-of-day charge or an end-of-month charge. This means the constraints that banks face can vary widely, and that will impact their pricing.
“The issue for prime brokers is less a reluctance to lend, it is more a question of ‘what is the balance sheet impact?’ We found in a 2015 study that the regulatory cost of an OTC derivatives trade is much less than the regulatory cost of a securities loan.
“As a result, many banks and brokers, depending on their regulatory framework, have an incentive to conduct a swap instead of making a loan. They will still borrow and lend where that makes sense, but it may not be the best choice for low value, general collateral transactions that could otherwise be netted internally.”
Unable to avoid capital charges, the larger primes have been re-evaluating their client relationships, focusing their efforts on supporting more profitable clients, with the dynamic impacting not only lending but other areas such as clearing.
Many primes have ended their relationships with their smaller hedge fund clients, which is partly a function of how the market has changed from the pre-crisis era.
In 2008 many more hedge funds were actively trading, vocal and focused on profitability, but today the market is dominated by the giant asset managers that are still getting comfortable with an extended range of products and, in terms of the investment process, are sometimes less sophisticated.
“Off-boarding has become a much more researched area over the last 12 months,” says Virginie O’Shea, research director at Aite Group. “I have been covering client lifecycle management for a decade and off-boarding has traditionally been at the bottom of most banks’ priority lists.
“It is telling that this has changed and large brokers such as Goldman Sachs, Credit Suisse and numerous others, have announced that they will be actively evaluating their client relationships and ending those that are judged to be too costly to the firm in terms of capital.”
For more lucrative clients, there is a clearer focus on service. The relevant decision-makers are now much more likely to be on the investment side of the business.
Chief investment officers and portfolio managers are getting much more involved and, as the asset management has become much more competitive generally, they have become more focused on using it as an active investment tool.
“Prime Brokers historically looked for clients who had the trading style to make the most money for them, typically hedge funds with proprietary trading styles that are high-frequency or high volume, but now many are pension funds or endowments that trade at a minimal level, generally for hedging,” adds Satten.
“Trading volumes are not exploding, so outsourcing for operational tasks such as reconciliation and administration is the main growth area. Banks are all looking to save money – according to ‘Project Scalpel’, something in the order of $2trn.”
While the large prime brokers are typically constrained by their balance sheets, an opportunity exists for smaller ones and new entrants to fill the gap with hi-touch services, as well as alternative lending models such as enhanced custody, which gives the client greater visibility and control over their assets.
Peer-to-peer lending is an interesting option although lenders have not yet embraced hedge funds as a preferred counterparty on a large-scale basis.
Small prime brokers are particularly picking up traction in vanilla fixed income. However, the rise in opportunities for mini-primes is largely a US phenomenon, and there are differences of opinion as to whether the industry has yet seen the full extent of the off-boarding.
Some argue that the largest primes have little inclination to reduce their client range further as the wider the base, the more insight they have into market activities and portfolio management services while also reducing concentration risk. Some smaller primes say that the flood of new clients is now waning.
Furthermore, many of the largest banks that initially responded by reining in the number of clients they were servicing to focus on the largest funds are returning to the arena, especially those in the US that were forced to clean up their balance sheets at the quickest pace.
Jefferies, the mid-sized self-clearing US broker-dealer that is not subject to Basel III, is often put in as a client’s second prime broker as it is able to offer an all-round high-touch service to smaller clients, according to John Laub, Jefferies’ co-head of global prime services. He adds that the crisis has forced banking arrangements to become much more transparent.
“We are now pretty far along the regulatory process, although there is widespread agreement over the need for several European banks to raise more capital.” he says.
“However, for the most part the repricing of collateral and adjustments to return on balance sheet have played through the system and prime brokers, which have not been the most understandable of businesses to hedge funds, have done a much better job of educating their clients in a two-way process about what works for their model.”
Currently, there is considerable uncertainty about the Trump administration’s commitment to rolling back some of the regulatory burden impacting the market.
A series of new appointments have been made at the SEC and the Commodity Futures Trading Commission (CFTC), some of whom have been vocal against regulations, particularly Dodd-Frank.
To date, only a few banks have priced in the Net Stable Funding Ratio, which may turn out to be unnecessary depending on how national regulations proceed with Basel III.
“The industry is awaiting the full rollout of the Basel III framework across the various global markets – though the Trump presidency has somewhat called into question the US adoption timeframe, and raised questions about a possible full setback,” explains O’Shea.
“In the rest of the world, Basel II was delayed by 11 years, so we have an interesting precedent to follow. Thus far, we’ve had numerous extensions from the original 2015 deadline out to March 31 2019.
The larger investment banks are obviously at the sharper end of the regulatory stick when it comes to capital requirements – but all banking institutions are in the frame.”