Prior to COVID-19, the hedge fund industry was already facing dual challenges of rising costs and compromised profitability. However, prime brokerages have to a large extent passed the first tests posed by the pandemic relating to volumes and credit risks.
Future disruption will need to be managed in tandem with catering to shifting client activity. These challenges come against the backdrop of an uncertain – yet still pressing – regulatory timetable. Preparedness, bandwidth and flexibility will be key to adjusting to this new environment.
- Primes have learned lessons well… to date
The major market shocks that prime brokerage firms have witnessed have provided valuable lessons, such as managing hedge fund collapses and liquidity squeezes in 2008, or volumes spikes during the Brexit referendum result and Trump election. Primes have weathered the initial storm of volatility, de-risking and volumes, achieving this owing to previous investment in platform maintenance, automation of tasks and close management of client exposure. Whilst we have seen Q1 equity trading revenues take a hit, notably at Société Générale and BNP Paribas, due the dislocation of hedges, the classic prime business throughput has seen record volumes and ticket fees bolster Q1.
- The rebirth of equity long-short strategies with signs of ‘peak equity quant’ allocations
As redemptions and asset rotations begin to impact their hedge fund clients, primes are now beginning to look at how they can service the next fund manager trends. Most notably an investment in supporting portfolio margining move for credit and fixed income high volume trading strategies. This requires a focus on automating margin offsets and managing client risk. Value-based stock picking equity long-short is also back in favour, with many capital introduction teams within prime brokers reporting huge demand.
- When it comes to regulation, it is business as usual
The regulatory agenda marches on. While there are some delays mandated by regulators, primes still need to focus on the target operating model impacts of SFTR and CSDR, which have an impact on a prime brokerage’s transactional engine. The level of data lineage, transaction reporting and complexity as it moves through the prime value chain requires careful assessment. Operational resilience, as defined by the SM&CR regime is understandably also a focus given the challenges provided by the recent shift in working practices caused by the pandemic. Meeting these demands was already a challenge for primes, alongside the ongoing adherence to complex rules, such as the FCA’s CASS. Many primes are casting an eye towards year-end, with the impact of a potential Hard Brexit contingency plan needing to be put in place to adjust for business flows.
- Diversification reigns
The most diverse businesses have proven to be the stronger primes, able to withstand any trading risk losses by benefitting from greater ticket fee revenues. Not only this, but the most mature primes have fared well, as recent Morgan Stanley and Goldman Sachs results demonstrate. There needs to be continued focus on client needs across the franchise for research, inventory and financing.
- An acceleration of the future of prime
The COVID-19 period has redoubled the focus on cost reduction. New prime target operating models are being deployed that merge their platforms with those of other global markets businesses, whilst also signalling a renewed demand for better cloud-based data driven decision making.
Looking forward, prime brokers will continue to focus on reducing costs through implementing API and data-driven, cloud-based platforms, and on the implementation of regulations and managing other facets of technological change. In the longer-term, prime brokerage is gravitating towards a prime-as-a-service model, which benefits from greater adoption of common API platform standards, disintermediation and aggregation whilst leveraging a shared services post trade environment. This will allow primes to provide data and services, whilst retaining the commercial advantages of their platform that support their client’s strategies.