A survey of the prime brokering industry by Ernst & Young throws up new insights into the challenges it faces due to the changing dynamics in the hedge fund industry and regulatory changes.
Tougher market conditions
The industry is facing headwinds from the increasing tendency of clients to diversify their prime brokers from one to many (‘multi-prime’), as well as a pressure on fee levels.
The headache of counter-party risk has led most hedge funds to distribute their exposure among a larger number of prime brokers. The report says that in 2009, hedge funds with assets over $3B had an average of 4.8 brokers, up from just one broker pre-crisis.
The advent of foreign players such as Deutsche and Credit Suisse has also led to fierce competition.
Capital requirements promoting multi-prime
Increasing capital adequacy levels for conducting business in OTC derivatives is creating the need for multi-prime, because a single broker may not have the capital required to take on all of the hedge fund’s business.
Multi-strategy funds becoming popular
Multi-strategy funds are rising in popularity, and these funds typically require a wide range of broking services and multi-market access, leading to the adoption of multi-prime.
Prime brokering industry still struggling
Prime brokers are unable to “integrate all their systems with clients’ information and unique business requirements,” resulting in confusion over the computation of operational costs per client. This is a bottleneck in boosting profitability.
Prime brokering survey specifics
Client acceptance – about 70 percent of brokers took on new clients after the approval of a committee. 57 percent of brokers insisted on a minimum annual revenue threshold from the client starting from $250K. No broker was able to fully automate a new client set up.
Client monitoring – All prime brokers monitor their clients for risk and profitability on a daily basis, and 75 percent have meetings pre-fixed at regular intervals.
Organization – EY found only one broker organized as a stand-alone, self-sufficient business unit. Other brokers operated functionally, such as FX, securities lending and OTC Clearing, with these operations providing service to both prime brokering as well as other departments. The back office, support (IT) and risk functions were organized centrally in some brokers and served both prime brokering as well as other disciplines. In some cases, prime brokering had a dedicated set up all to themselves.
Liquidity management – 71 percent of the prime brokers surveyed do not have a method for notifying their treasury group of large cash inflows and outflows. The 29 percent that do, use email and phone calls to inform treasury.
Lockup agreements – More than 70 percent of the firms surveyed offer lockup agreements. The most popular terms are 30, 60 and 90 days. About 30 percent of the survey respondents provide lockups as long as 365 days, depending on the client and relationship.
Leverage – Three-quarters of the survey respondents offer margin relief to their clients beyond the Federal Reserve’s Regulation T margin limit of 50 percent.
Conclusion
Prime brokers need to strike a balance between conflicting push-and-pull factors such as cost cutting, regulatory demands on capital and leverage, client service levels and risk control.
