To meet the demands of hedge funds for over-the-counter instruments, a new and hugely lucrative prime brokerage service has emerged. Natasha de Teran examines OTC intermediation.

Just under two years ago, The Banker looked at how prime brokers would cope with the fast-growing competition within their ranks and the escalating demands of hedge funds. One of the areas that looked ripe for prime brokers to develop was some kind of conduit-like facility for the over-the-counter (OTC) derivatives market.

Lou McCrimlisk, head of fixed income prime brokerage in London at Citigroup, told The Banker back then that the growth in OTC activity would probably lead funds to seek out some kind of cash, collateral and operational optimisation service.

“Because funds are trading with a number of counter-parties, they have collateral obligations to different banks that all need managing on a daily basis,” he said. “As this activity grows, hedge funds will want to optimise their collateral, using their prime brokers like conduits to mark trades to market, to margin across products, and to re-link trades between different counter-parties, thereby gaining capital efficiencies.”

Mr McCrimlisk, as it turns out, was correct. Since The Banker spoke to him in mid-2004, just such a service has emerged. It is called OTC intermediation and most of the large prime brokers are understood to be offering or developing such a service.

Service development

Andy Mack, managing director and head of multi-asset-class prime brokerage for Europe and Asia at Morgan Stanley in London, explains how it arose: “One of the challenges the prime brokerage business had been facing was how it could get more involved in the OTC derivatives business.

“Traditionally prime brokers have not played much of a role on the OTC side, which did not really matter while hedge funds’ activity remained relatively limited or until their use of credit derivatives and other OTC products became quite mainstream.

“One of the benefits that prime brokers typically offer their clients is the ability to cross-margin their positions, and we soon realised that by stepping into these normally bilateral OTC derivative transactions we could offer them the same cross-margining by consolidating all their OTC positions and margining across their total portfolios.”

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Deutsche Bank began incubating its OTC intermediation capability around the same period The Banker first wrote about it, and Mark Haas, global head of prime brokerage and Americas regional head of prime services, says the bank has since completed “several thousand” transactions this way.

 

However, because of the operationally intensive nature of the business, he admits his bank is still investing heavily to create a fully scalable platform that it can roll out to cover a wider range of asset classes and a broader range of clients.

His bank is not alone. “We believe that a number of prime brokers are offering OTC derivative intermediation for selected funds – but any suggestion that it is being offered by prime brokerage firms across the board is a significant overstatement,” says Mr McCrimlisk.

Banks are understandably keen to gain an edge in the prime brokerage sector. According to research published by Morgan Stanley, investment banks’ prime brokerage operations generated revenues of more than $5bn last year, a 28% increase from 2004.

Huw Van Steenis, head of asset management, brokerage and diversified financials at Morgan Stanley, estimates revenue growth will continue this year at a more steady but still respectable 11%.

But the development of OTC intermediation is not just the latest add-on gizmo dreamed up by brokers keen to offer something different in a bid to attract new business. The service is based on a real demand from hedge funds.

The principal demand, according to Mr Haas, arises from hedge funds’ longstanding close focus on administrative efficiencies and cash and liquidity management. Mr McCrimlisk agrees: “There are number of reasons why this service is very useful to hedge funds – it centralises confirmations and money flows and offers capital conservation and operational ease.”

Streamlining process

By centralising their transactions with a single counterpart, the funds are able to extract valuable cash and collateral efficiencies as the prime broker will realise margin offsets for them on counterbalancing trades that would otherwise be spread out between different counterparts and require separate margining. A single trade venue also means the hedge fund’s back office needs only to interact with a single point of contact.

The concerns surrounding the documentation and operational processes supporting credit derivatives and other OTC derivative transactions have also served to underscore the desirability of the service for hedge funds.

The UK’s Financial Services Authority (FSA), which was the first regulator to warn about the risks arising from backlogs of unconfirmed credit derivatives trades, noted in its recent Hedge Fund Consultation Paper that operational issues related to credit derivatives continued to be among the key risks it was monitoring in the hedge fund sector.

In particular, the FSA noted how hedge funds’ growing use of increasingly complex instruments, such as synthetic and structured products, credit default swaps and collateralised debt obligations (CDOs) were “adding significantly” to market-wide operational risk levels. And while the FSA has made it clear – along with other banking regulators – that it will continue to monitor these risks closely, Morgan Stanley’s Mr Van Steenis believes that funds are set to increase their use of such instruments.

In his recent report he said: “In the quest for higher returns, groups are going off-piste down the liquidity spectrum or ‘freestyle’.”

Among the off-piste products he cited were structured credit and CDO-type products.

Although the prime brokers have tapped into some real demand with the OTC intermediation service, it is still only in its formative stages, and there are still many uncertainties that have yet to be ironed out. Among these, the all-important question: how banks will charge for the facility?

Mr McCrimlisk says he is unsure whether the prime brokers have really tackled how the pricing will work for the service over the long term. He adds: “Some pricing models are based on a small service charge, others combine this with giving the prime brokers a last-look on the trades; in others the funds are only charged when they trade away from the house.”

Income potential

Mr Haas admits that though there is some money to be made from the fee-based charges that prime brokers are levelling on OTC intermediation, the facilities will not necessarily appear economically attractive – especially when compared with the income potential associated with the provision of their traditional services.

Instead, he says the real recompense for prime brokers will be less direct. “The real and broader benefit sought is the likelihood that clients will conduct not only more traditional financing activities but also more trading activity generally in the underlying contracts, including, in some cases, that the dealer will get a last-look on trades.”

If that latter idea is appealing to the prime brokers, who will at once get an accurate view of a hedge funds’ total exposure and a grab at all its trading activity, it may be less so to the funds themselves – as the two bankers readily agree.

Mr McCrimlisk says: “One downside to this is that there is a danger, over the long term, that the funds will find themselves important to one counterparty but less important to all others.”

There are two other potential or theoretical dangers for any fund concentrating its business with a single prime broker. One lies on the credit side and the possibility that any prime broker offering OTC intermediation may be obliged by its credit department to decline a fund’s trade with another counterparty because there are concerns about the extent of the fund’s leverage or risk concentration.

As Mr McCrimlisk points out, when proposed trade counterparties hear that trades have been declined, that fund could very quickly find itself the victim of dangerous rumours: “And, as we know, rumours can precipitate terminal runs on funds in a very short time frame, so it is a risk that prime brokers have to be very cognisant of.”

Mr Haas suggests a second potential disadvantage for a fund consolidating all its OTC activities with one firm. He says: “There is clearly a consolidation of counterparty credit risk and, of course, the dependence on one firm’s infrastructure.”

For smaller funds Mr Haas believes this may not be perceived as that great a problem, but like Mr McCrimlisk he believes the larger funds will want to avoid taking this risk.

Instead the two believe the funds will address this issue by using two or more OTC prime brokerage service providers. In itself that will provide a further challenge for the prime brokers offering OTC intermediation, as by sharing the OTC business, they will not have the holistic view of a funds’ exposure that they would otherwise get.

The future of OTC intermediation

How these uncertainties and difficulties will be resolved and overcome remains to be seen, but the prime brokers are sure to do so, given their strong interest in servicing the vastly lucrative OTC sector. Mr Haas, for instance, says OTC intermediation presents a “very material opportunity” for prime brokers. Such is the opportunity, in fact, that it may well extend well beyond the hedge fund sphere.

Mr McCrimlisk says there has been no interest as yet in the service from the traditional long-only funds – but as OTC intermediation is virtually unheard of outside the prime brokerage and hedge fund realm, that is not surprising. In the future that may well change and they too may become interested in the service.

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