By Sundhanshu Bahadur, Vishal Bakshi, and Valcony Sun, Sapient Global Markets
While the industry’s migration from a single-prime to multi-prime broker model has benefited Fund Managers, it has also increased complexity in their operations. As Fund Managers demand more transparency from their Prime Brokers (PBs) and adjust their business models to diversify counterparty risk, PBs also face new operational challenges around middle/back-office functions as they try to accommodate clients’ needs and remain competitive. This has inevitably led to a reorganization of the business model and competitive landscape of the Prime Brokerage industry.
In either case, reviewing the operating model is the key to flexibility, business agility, scalability and minimum operational risk, which all contributes to future growth.
As the operating structure becomes complex, one area requires increasing attention: operations and IT. This has been largely bypassed by Fund Managers who usually focus on other corporate and front-office functions. Efficiency in these areas was never aggressively pursued because they are considered business support functions rather than profit-generating functions. Recent years, however, have proved that this uneven focus is a costly lapse, strategically as well as financially.
By defining a mature Target Operating Model (TOM), both PBs and Fund Managers will be able to transition to the next-generation business model and more effectively address the challenges of today’s brokerage market.
Target Operating Model considerations
A TOM is the idealized business vision of how an organization will operate, including the principles that will be used to guide the organization’s behavior.
The key areas of focus in operating strategy in the multi-prime world include:
• Effective Counterparty Risk and Collateral Management
The counterparty risk in a single prime model is overbearing, a fact confirmed by the resulting turmoil following the fall of Lehman Brothers as Fund Managers lost their collateralized assets. In the multi-prime model, there is a need for stringent collateral administration and counterparty monitoring to efficiently manage collateral across various PBs. The focus areas to ensure effective collateral management processes include accurate valuation of assets, collateral allocation and optimization.
• Standardized Trade Allocation Process
The multi-prime broker model necessitates an approach for trade allocation across the primes. Depending upon the fund size, Fund Managers have to define an allocation methodology, such as static allocation that can be by Fund, by market or by strategy; dynamic allocation that distributes by security, at a pro-rata basis or arbitrarily; or opportunistic allocation by borrow availability or by executing broker. Each option has its pros and cons and the final approach may vary from Fund to Fund. Based upon resource availability, Fund Managers may opt to add staff or leverage outsourced organizations to assist with allocation. Having a structured and effective allocation process ensures that the output data can be sliced and diced in meaningful ways to suit data consumers’ needs.
• Structured Reconciliation Process
Standardized processes are required to manage cash and position reconciliation with multiple parties—and to resolve exceptions/breaks in a timely manner. This requires an investment in processes and technologies that can reconcile and report, minimizing breaks between counterparties.
When using a single PB, the entire Fund Manager’s book is managed through a single counterparty, thus enabling easier access to positions, balances and risk reports. With multiple primes, one of the biggest challenges is to set up a process for the daily aggregation of data across multiple primes in order to track the entire portfolio risk, performance metrics, etc. This also requires consideration by Fund Managers to build infrastructures or outsource services to a third party. The infrastructure has to be efficient to consume inputs from numerous primes that may be using different systems and various protocols, such as flat-file, XML, SWIFT and FIX. It may also require customized integration with other existing systems within the Fund. The in-house option can be complex and involves significant cost, but it also offers complete control over the data and required reports. It has the added benefit of giving each Prime Broker access to only their portion of the portfolio. Additionally, there is a tradeoff in the form of risk—distracting the fund from its central purpose of alpha generation. Other options that can be considered are hearsay reporting using a selected Prime Broker and using a Fund Administrator for aggregating and reporting across PBs.
• Sound Data Architecture
An operating strategy typically drives data aggregation requirements. If a fund is split between many PBs to acquire better financing and also to spread risk, it becomes necessary to aggregate data from multiple primes in order to generate consolidated reports. Hence, Fund Managers need to acquire technology to achieve the same level of service and transparency as a single prime environment. This requires the creation of a data architecture that allows for the consolidation of data ingested through various mechanisms (ESBs, queues, messages, files, etc.), collection into usable packages (ABOR, IBOR, etc.) and storage in an easily reportable format (data warehouses, dimensional data marts, etc.).
By establishing a TOM that addresses these focus areas in the multi-prime world, Fund Managers and Asset Managers can increase their competitive advantage. Opportunities that could potentially set them apart include looking into fast-growing solutions and technology that enable the firm to move with the market, increase alpha, improve operational agility, reduce expenses and expand into innovative products.