The prime brokerage industry has been subject to margin pressure on services such as margin lending, sourcing stocks for short-sellers, and total-return swaps since 2008. Meanwhile, changes in market structure, regulatory environment, and technology have commoditised banks’ offerings, pushing them to undercut one another on fees and risk tolerance.
Increased competition may tempt banks into more aggressive positions to sustain their revenues. Credit Suisse reportedly generated a meaningful $17.5 million in fees from Archegos in the preceding year, but ultimately suffered a $5 billion write-down. It is now reportedly planning a $35 billion reduction in its lending to hedge funds.
Other banks still see an attractive risk-reward trade-off in prime brokerage, with global revenues growing 8% annually since 2015 to over $30 billion last year, according to Aite Group research. These banks need to understand whether Archegos was an aberration or the product of market conditions.
Placing Archegos in context
Many aspects of the Archegos implosion were exceptional. The success of the firm’s initial bets on a concentrated stock portfolio should have de-risked its margin loans, but Archegos used rising share prices to collateralise new loans, creating a virtuous cycle. Other investors were unaware of this ‘whale’ investor, because the use of total-return swaps obscured ultimate economic ownership. The cycle turned vicious when the companies’ share prices started falling, forcing Archegos to liquidate positions to meet margin calls, driving prices down further.
However, certain risk factors originated in the same structural changes that have made prime brokerage a more competitive industry.
That Archegos could access margin loans on accommodating terms is partly a function of a crowded market conducive to banks taking on more risk.
Another factor was the rise of the ‘multi-prime’ model. Lehman Brothers’ collapse in 2008 illustrated the dangers of concentrating counterparty risk in one prime broker, encouraging a shift to multiple providers. Hedge funds with AUM over $5 billion now have over five prime brokers on average, per Aite Group. Combined with the anonymity afforded by total-return swaps, each of Archegos’s prime brokers suffered a critical lack of information on their client’s other levered bets, causing them to underprice the risk of their own loans.
The pace of technological change posed the same challenge within banks. Unwieldy, legacy-based technology estates obstruct a consolidated global view of client risk across different platforms. Credit Suisse’s risk management systems reportedly struggled to keep pace with its growing exposure to Archegos because of an incomplete roll-out of dynamic margining.
Not every aspect of the Archegos situation was prefigured by changes in prime brokerage. Regulatory scrutiny has been increasing since 2008, but this situation is being cast as evidence of insufficient regulation.
Critics have pointed to Dodd-Frank requirements for prime brokers’ institutional clients to post initial margin which have not yet been fully implemented. The SEC has not mandated the same reporting requirements for security-based total-return swaps as exist for swaps regulated by the CFTC. Dan Berkovitz, a CFTC commissioner, called the situation a “vivid demonstration of the havoc that… family offices can wreak”, suggesting impending regulation of a growth client segment.
We therefore expect further regulation around ownership, control, record-keeping, and capital. The SEC may extend regulations around security-based swaps, mandating disclosures at certain indirect ownership or voting right thresholds.
While the Archegos collapse was symptomatic of some recent challenges within prime brokerage, where that wasn’t the case, it will only serve to compound them.
Despite these pressures, we expect a consolidation of the prime brokerage market, rather than widespread retreat. It remains fast-growing and potentially lucrative. A reduction in the number of players might also reduce competitive pressures and reverse the multi-prime trend.
The biggest firms with the best risk-management software, and the ability to respond to regulatory change, will be optimally placed to enhance their position. Archegos demonstrated the risk that large defaults can deal to an otherwise profitable business and has triggered further oversight. Prime brokers need to understand whether and why their existing controls would not have caught these risks, while preparing to remodel their systems for new regulations.