The financial crisis of 2008 has changed forever the relationship between hedge funds and prime brokers.
A prime broker may best be viewed as a bridge between hedge funds and their investors on the one side, and institutional investors on the other side who may be lenders of stocks or funds. More important, at the hedge fund end, we see a symbiotic relationship with the prime broker as the source for custodial services, funding requirement, leveraging transactions and consultation on regulations. In return the hedge funds generate lucrative commissions for the prime broker.
The so far cosy relationship between the prime broker and his hedge fund client is under severe strain post the 2008 crisis.
This is because hedge funds have perforce had to reduce their leveraged transactions activity in view of the increased risk in global markets. The declining volumes have resulted in reduced commission earnings for the banks at a time when they are facing regulatory challenges, higher costs and increased capital requirements to comply with Basel III standards.
In addition, the new risk environment has also changed the investor attitude towards hedge funds with more demands for better risk management and faster and transparent reporting. The average hedge fund may not be capable of catering to these new challenges and would need to look towards the prime broker to provide support wherever possible. In many cases these demands have taken the shape of new and improved technology investments by the prime brokers.
In the net result, prime brokerages are seeing a diminishing revenue stream from hedge funds on the one hand, and an increased customer support demand on the other. It does not help that regulators have added to the pressure. New and threatening legislation across both sides of the Atlantic proposes to do away with traditional comfort zones for banks and their prime broking outfits.
In the circumstances, it comes as no surprise that prime brokers are trying to make a trade off in the number of hedge fund clients they service and the potential for revenue from these clients. The modus operandi is to remove unprofitable or low-revenue clients and to focus on the larger, more active hedge fund accounts, according to CNBC.
The article quotes an industry source as saying: “A number of prime brokers have told me the same story — they’re focusing on key accounts to increase their share of wallet. If you grow from 4 percent to 10 percent of a big fund’s trading flow (then that’s worth a lot). Goldman Sachs Group, Inc. (NYSE:GS), Morgan Stanley (NYSE:MS), and UBS AG (NYSE:UBS) have all told me they’re focusing.”
In the current scenario a prime broker may be looking for an average of $250,000 business annually, but this may be a big ticket for the smaller or less active funds, which may still require the whole range of services from the prime broker.
The trend is being exacerbated by the increasing tendency of investors to park funds with the larger and safer funds in their opinion.
These developments could lead to a consolidation within the prime brokerage industry as the smaller players may get squeezed out.