Prime brokerage returns to life

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By the beginning of December 2009, the prime brokerage industry was in a state of disrepair: Bear Stearns had been removed from the picture and Lehman Brothers was gone for good. Fund managers, spooked by the sinking of Lehman, rounded on the remaining industry behemoths, Morgan Stanley and Goldman Sachs, relocating large chunks of cash and securities at smaller rivals. Buffeted by redemptions and the obliteration of portfolios industry-wide, meanwhile, the hedge fund market was entering a period of prolonged evisceration.

But this was not all. As the administration of Lehman's European subsidiary, Lehman Brothers International Europe (LBIE), began to unfold, further cause for concern emerged. As The Banker reported in December 2008, nerve-wracking uncertainty surrounded the fate of LBIE's client assets, in particular assets that had been transferred into the LBIE estate under an arcane, but vital, funding practice known as rehypothecation (rehypo). Months later, the cost of this practice had become clearer: their assets sucked into the sunken LBIE wreck, a number of hedge funds were forced into liquidation and restructurings.

For some time it seemed that the client base, funding model and unquestioning counter-party trust upon which the entire prime brokerage business grew so successful may have been irretrievably damaged. Nearly 18 months on, however, and the industry has not only manfully clung to survival but is beginning to regroup.

Buoyancy not exuberance

Indeed, prime brokers are buoyant, if not exuberant. "We're sitting here, in a much recovered 2010 and we see that the prime brokerage world is reverting to normalcy: the competitive landscape that was dramatically turned on its head in 2008 has been flipped back onto its feet," says Alex Ehrlich, the global head of prime brokerage at Morgan Stanley who was poached from UBS in May 2009 in order to restructure Morgan Stanley's prime brokerage business.

Mr Ehrlich has good reason to be upbeat. Despite the traumas of late 2008, Morgan Stanley and Goldman Sachs remain the industry behemoths, together accounting for 37% of the industry by number of clients. But the likes of JPMorgan, Credit Suisse and Deutsche Bank are also on the rise: all three firms have been beefing up their prime brokerage businesses and have enjoyed major inflows of clients during the past 18 months. According to a report by Wall Street analyst TABB Group, these three companies were most frequently cited as new providers of choice during 2009. Pumped-up by legacy Bear Stearns, the ascendant JPMorgan proved the most popular of the four, according to TABB.

The market remains highly concentrated, with Morgan Stanley, Goldman Sachs, JPMorgan, Deutsche Bank, Credit Suisse and Citigroup accounting for some 76% of the market by assets under service, according to data from Hedge Fund Research. Data from the third quarter of 2009 shows JPMorgan in the top spot with 28.4% of the market, followed by Goldman Sachs with 18.9% and Morgan Stanley with 15.4%. Credit Suisse and Deutsche Bank, meanwhile, account for 5.4% and 4.9%, respectively, according to Hedge Fund Research, with Citi trailing behind at 3.1%.

Prime broker rankings, however, are notoriously tricky and a matter of some dispute in what is still a highly fluid and increasingly competitive environment. Armed with strong and stable balance sheets, both Deutsche Bank and Credit Suisse, for example, have been competing vigorously during the past 18 months: both are setting their sights on the top spot.

"Investors and managers still feel that we're in a volatile period from a counterparty risk perspective: this is not a situation where a bank lacking funding is going to give an investor comfort," says Roy Martins, head of international prime services at Credit Suisse. "As a consequence of that our market share has grown."

Deutsche Bank, meanwhile, is in expansionary mode, having boosted its pan-Asian prime services staff base by more than 20% with a view to targeting a surge of Asian start-up funds. "During the past two years, we've seen an emphasis on financial and operational risk management, and we've benefited from that: we came out of the crisis better than we went in," says Barry Bausano, co-head of global prime finance at Deutsche Bank.

Even the beleaguered Citigroup is making a forceful push into the business, recently adding 13 new hires in its Global Prime Finance Group in London and New York. "For a bank such as Citi, with a global network, prime brokerage is a natural business to be in because it is about core banking services, financing and custody," says Mark Harrison, head of prime finance for Europe, the Middle East and Africa at Citi. Meanwhile, Bank of America Merrill Lynch recently hired a Morgan Stanley sales executive in a bid to bolster its prime brokerage business in Japan.

But the well-recognised brands have competition. Japan's ever-ambitious Nomura has announced plans to double its start-up US-based prime brokerage team this year while, in early April, Scotia Capital nabbed the former head of Barclays Capital's hedge fund services business to boost its expansion efforts. Newedge is another large brokerage on the rise. According to Philippe Teilhard de Chardin, global head of prime brokerage at the firm, Newedge's prime brokerage business has grown some 50% during the past two years and will be expanding in the US.

Rampant head-hunting, new entrants, expansion and a little chest-beating: prime brokerage is hardly an industry in its death throes. So what accounts for this apparently remarkable recovery?

Back from the brink

To a very large extent, the resurgence of the prime brokerage business reflects the astounding renaissance experienced by the hedge fund market: battered, bruised and widely abused, the unpopular hedge fund industry has dragged itself back from the brink.

Although the industry has yet to recover the swathe of assets obliterated by the crisis, money is steadily flowing back in. Projections vary, but TABB Group predicts that assets under management (AUM) will reach 2006 levels by the end of this year, growing from $1300bn to $1500bn, with a 9% return forecast for 2010. Prime brokers are also hotly anticipating a rash of hopeful start-ups - particularly in Asia's resurgent economies - and are building out their capital introduction capabilities accordingly.

But the surprising boom in prime brokerage activity and offerings does not merely reflect the renewed health of its client base: it also indicates just how critical the prime brokerage business has become to the bulge-bracket broker-dealer model at large. Prime brokers generate the bulk of their revenues on client loans, deposits, the financing of synthetic products and, as the row regarding rehypo underlines, on the cash and securities of which they take custody and reuse elsewhere. But The Banker understands from well-placed sources that for every dollar generated in the prime brokerage business, another three dollars are generated elsewhere in the investment bank as a result of follow-on transaction flow.

"Every other business benefits from prime brokerage," says a senior investment banker at one of the top banks. "If you start up a fund and help build it, that relationship will last a long time." This makes rebuilding the prime brokerage franchise such a critical strategic investment for brands badly dented by the crisis such as Citigroup and Bank of America Merrill Lynch: to be a credible player in the securities industry you have to be serious about prime brokerage, say bankers.

Not all client relationships are equal, however, and many did not withstand the liquidity constraints brought about by the crisis. As industry AUM nosedived, the major prime brokers, under severe balance sheet stress, were forced to trim their client lists in order to improve the return on investment per client - a process Denise Valentine, a senior analyst at Aite Group, refers to as the profitability test. "That's when the industry started seeing massive purges," she says. "The [bulge-bracket prime brokers] have been doing this for the past two years and are pretty much done now."

This will allow the big boys to achieve greater economies of scale. But it has also created major opportunities elsewhere in the market for smaller firms keen to capitalise upon the benefits associated with the prime services business. Indeed, beyond the shadow of the Wall Street powerhouses lies a swollen layer of some 45 so-called 'mini-prime' firms offering high-touch prime services to the niche and small end of the hedge fund market. These firms are primarily found in the US and offer trade execution, clearing, trading technology and direct market access, capital introduction, research and operational support.

Boasting healthy margins averaging between 16% and 20%, according to Aite, the mini-prime market has matured substantially during the past 12 months, tempting several established firms to grab a piece of the action. Cantor Fitzgerald launched its own prime services offering in 2009, while ConvergEX Group, a major US-based agency broker and execution technology provider, also entered the market in November last year with the acquisition of Atlanta-based fund services provider NorthPoint Trading Partners. While NorthPoint has targeted the small end of the hedge fund market since its inception in 2006, the bulge-bracket purges have boosted the firm's potential client base, says Michael DeJarnette, president of NorthPoint Trading Partners. "That was always our niche from the beginning - to fill a void in the marketplace for the hedge funds who were not big enough to be great clients for the bulge-brackets," he says.

And other firms are waiting in the wings. In late 2009, it was reported that Lazard Capital Markets also plans to launch a prime services business in New York this year.

Roy Martins, head of international prime services at Credit Suisse

Rehypo what?

If the resurgence of the Wall Street majors and the rise of the mini primes underline anything, however, it is the ineluctable reality that hedge funds need prime services just as much as ever.

But this is not to suggest that managers have forgotten about Lehman Brothers: counterparty risk is now a priority, say fund managers. "Our flagship futures fund cleared with Lehman until four days before it collapsed: that has opened our eyes and our collective focus as asset managers has changed," says Troy Buckner, managing principal of NuWave Investment Management, a top 100 US-based hedge fund. "In all cases, we have a much greater focus on balance sheet security," he adds. Balance sheet strength and brand have become the top two criteria when selecting a prime broker, according to TABB's survey.

Market-watchers have made much of the ongoing trend towards multi-prime broker relationships, although this is by no means a new or universal phenomenon. Only 40% of funds surveyed by TABB have added or changed a prime broker. Many respondents say that they do not generate enough business to justify multiple relationships and analysts believe that a fund must have more than $100m in AUM to sustain a multi-prime platform.

Balance sheet strength and diversification, where possible, may represent the first line of defence against counterparty exposure, but neither ensures the security of hedge fund assets in the event of insolvency. This has proved to be the most salutary lesson delivered by the case of LBIE: indeed, such a mess has the LBIE estate proved to be that frequently the administrator, PricewaterhouseCoopers (PwC), has been unable to trace the whereabouts of client assets held by the erstwhile institution let alone ascertain their legal ownership.

Central to the problem surrounding the traceability and ownership of the bank's client assets is the process of rehypo, a widespread prime broker practice of which few fund managers and market-watchers were fully aware prior to September 2008. Rehypo is the process of taking assets that are pledged as collateral by a hedge fund client and reusing that collateral in the money markets to raise secured credit.

In order for rehypo to take place under the UK regulatory regime, the legal ownership of client assets is transferred to the prime broker: the true implications of the practice became painfully clear when PwC announced that it will not be returning any rehypoed assets to their former owners. According to Bob Penn, a partner at Allen & Overy, hedge funds with rehypoed assets merely have a claim on the insolvent estate to the value of the lost assets. Hedge funds are recouping about 20 pence in the pound, The Banker understands.

In contrast to the US regime, the UK regulatory framework imposes no limits on the value of customer assets that may be rehypoed under prime broker agreements (PBAs). This meant that, unless otherwise negotiated, PBAs historically allowed for the blanket transfer of asset title regardless of the indebtedness of the hedge fund to its prime broker. Rehypo sits at the heart of the prime broker funding model, in many cases allowing the business to operate on a self-funded basis. And according to an International Monetary Fund working paper published in March 2009, anecdotal market evidence suggests that rehypo has historically proved a cheaper means of financing than the repo market, as the risk of non-delivery of collateral in a repo transaction incurs a cost.

Beyond the outcry

In the initial shock and confusion following the collapse of LBIE rehypo prompted much outcry among fund managers and market-watchers ignorant of the practice. According to some bankers, however, without the right to rehypo, prime brokers would be forced to draw on unsecured credit lines making it prohibitively costly to finance clients.

"If you do not have rights to rehypo, it is massively balance sheet-intensive," says Deutsche Bank's Mr Bausano. "It is possible but it is very, very expensive as it competes for balance sheet space with higher yield assets. For an investor, not allowing rehypo dramatically changes their cost structure," he adds. Citi's Mr Harrison puts it another way: "Rehypo is the price clients have to pay to finance their assets."

Privately, practitioners have scant sympathy with clients who claim to have been unaware of the true risks of rehypo, arguing that the rules are straightforward. But not everyone has found this to be the case. Although it has come to light that LBIE was not complying with UK Financial Services Authority (FSA) rules, it has also become clear that the rules themselves are not water-tight: indeed, the FSA was dealt an embarrassing blow in December 2009 when a UK High Court ruling slammed the FSA rules on client asset segregation as "patently inconsistent and flawed in certain significant respects".

According to Todd Groome, chairman of the Alternative Investment Management Association, the industry is responding positively to market, regulatory and investor pressure regarding the use and security of client assets. "Investors want more control and identification of their money inside the hedge funds and the hedge fund managers are asking similar questions of their prime brokers," he says. From a competitive standpoint, prime brokers have had little choice but to assuage client misgivings: "Every prime broker has had to figure out how to provide clients with some form of product enhancement that would address their concern regarding counterparty credit standing," says Morgan Stanley's Mr Ehrlich.

Faced with the full cost of unsecured lending, few hedge funds are willing or able to prohibit the rehypo of their assets, but many are asking awkward questions and revising their PBAs. According to Allen & Overy's Mr Penn, blanket asset title transfer has yet to become a thing of the past but it is being carefully negotiated. Many hedge funds are seeking to define explicit limits on rehypo rights in a trend that will likely bring the UK more in line with the US, where the Securities Act of 1933 stipulates that a broker dealer can only rehypo assets worth up to 140% of the customer's indebtedness.

Improved transparency and reporting on the amount, type, and whereabouts of rehypoed assets is also becoming more prevalent. "Hedge funds are not telling brokers not to rehypo but they are looking for clarity as to the amount of assets being rehypoed and in some cases they are looking for reporting on those assets," says Mr Harrison.

Troy Buckner, managing principal of NuWave Investment Management

A full recovery?

Another key feature of the US regime is the restriction of the rehypo process to margin accounts or leveraged securities, meaning so-called 'unencumbered' or 'fully paid-for' securities are held in a segregated trust account in the name of the client. The majority of prime brokers are developing new custody products based on this division of encumbered and unencumbered assets. "A lot of prime brokers are resistant to the idea of complete segregation of all your assets, but they are prepared to talk about a middle ground," says Andrew Kennedy, the chief operating officer of UK-based hedge fund SAM Capital Partners.

Most commonly, prime brokers will segregate unencumbered assets via one of two custody models: the first involves separating assets via the prime broker into a trust account situated elsewhere within the broader group. Citigroup, JPMorgan and Morgan Stanley have rolled out solutions situated internally. In order to truly diversify the counterparty risk, however, some providers are developing tri-party relationships with external custodians. Deutsche Bank, for example, has entered into an arrangement with Bank of New York Mellon, while Merlin Securities, a leading 'mini-prime', has cut a deal with Northern Trust.

"They are also coming up with alternative solutions," says Mr Kennedy. "Each night, all accounts are swept and they might be deposited with a handful of other commercial banks or put into top-rate money market funds and taken out the next morning," he adds. But safer solutions are likely to be more complex and therefore costlier. "Ultimately you can come up with a solution that's iron-clad, but it will cost a lot of money," says Mr Kennedy.

This additional cost has evidently been a turn-off for many funds: TABB found that only 22% of participants separate their assets from their prime broker account, indicating that fund managers prefer to forego the ongoing costs of segregation in favour of limited rehypo rights and greater visibility on the whereabouts of assets.

But this is by no means the end of the story. Smarting from its December slap-down, the FSA is getting tough on sloppy treatment of client assets, releasing a consultation paper on the subject in March this year in which it outlines several new provisions. Although the FSA will not impose US-style limits on rehypo, prime brokers will be forced to introduce a so-called 'disclosure annex' into their PBAs highlighting the agreed contractual rehypo limits. The FSA will, however, restrict the amount of client money that may be deposited elsewhere within the parent group, such as trust accounts, and it will introduce mandatory reporting.

Prime brokers are downplaying the potential impact of the new FSA rules, but as Mr Harrison concedes: "It will affect the economics of the business." This being the case, it may yet be premature to anticipate the full recovery of the prime brokerage business.