Equity trading had a booming start to 2018. Across many of the big Wall Street banks, revenues from their markets business achieved substantial growth, largely driven by improvements in equities sales and trading.
JP Morgan posted record equities revenues of $2 billion in the first quarter of 2018, while revenues from Citi’s equities desk skyrocketed 38% to $1.1 billion, its best ever quarter.
Meanwhile, Morgan Stanley topped the equities ranks, with its revenues beating analyst expectations by $400 million to reach $2.6 billion, up 30% year-on-year. This was followed by Goldman Sachs where equities revenues also jumped by 38% to $2.3 billion.
Elsewhere, British bank Barclays now has one of the fastest growing equities franchises, after seeing revenues rebound 43% to $827 million. So, what are their secrets? The answer: winning business from hedge funds. This has become a key battleground for the big banks, in which many have invested significantly into their prime brokerage capabilities. And now, their investments are paying off.
According to investment banking research firm, Coalition, revenues for the largest investment banks providing hedge fund services increased 20% in the first quarter of 2018.
In the short-term, the big banks benefited from a volatile first quarter in the stock market, sparked by the first hints from US President Donald Trump of a trade war, prompting hedge fund investors to trade more and increase their short selling activity.
However, the jump in revenues also show the results of a longer-term programme in improving prime brokerage capabilities. Prime brokerage is being increasingly tied to electronic execution, and is often the pathway to other products within the equities franchise such as research, equity derivatives, as well as financing.
“Prime brokerage and financing has been a driving force for the industry’s equities wallet, and financing continues to be a catalyst in our growth story,” says Betty Gee, head of prime sales, Americas, Barclays. “Financing often acts as the bridge between businesses. We have seen the prime brokerage business moving from a one-size-fits-all approach to a more tailored model accommodating more bespoke solutions.”
The surge of investment into prime brokerage largely reflects the growth in the hedge fund industry since the financial crisis. Hedge funds have grown every year for the past few years, most recently reaching a record $3.2 trillion in assets under management, up by 6.4% according to Deutsche Bank’s annual Alternative Investment Survey.
Furthermore, in an environment of asset manager consolidation and the growth of passive investing over active investing, traditional long-only managers have been launching hedging strategies that require services from prime brokers, according to Ermanno Dal Pont, global head of strategic consulting at Barclays.
Particularly in Europe, some asset managers expanding under the UCITS banner, enabling them to go short. All of this means a wider client base for prime brokers.
Prime on par with cash
The prime brokerage business has also greatly evolved since the financial crisis. Prior to 2007, the cash equities business was the leading revenue-earner for the industry, followed by derivatives and then prime brokerage.
Fast forward today, cash equities account for around 18% of industry equities revenues at $2.5 billion, while prime services represents 35% of revenues at $4.9 billion with equity derivatives at 38%, or $5.3 billion.
According to Paul Galietto, head of equities, Americas at Credit Suisse, the economics of “cash has changed” as the cost of transacting has fallen, coupled with the transition towards electronic execution. And now, financing is a central element to that electronic piece. “The equation has resettled in that it is possible for the size of the execution and the financing business to be on par. The clear picture is financing, as opposed to being a distant but rapidly growing piece of the equities puzzle, now sits on par with the cash and execution business,” says Galietto.
Many primes are leveraging the business for different parts of their equities franchise. In addition, the transition to electronic execution has encouraged many to focus on synthetic equity financing and synthetic prime brokerage. These services provide clients with access to total return swaps on single stocks, equity baskets and indexes. Banks such as ING and UBS have launched new synthetic prime brokerage services over the years to meet this trend, as well as some of the larger primes like JP Morgan, which see the electrification of equities and equity derivatives tied to prime brokerage.
“There has been a lot of focus on synthetic prime brokerage over the last three years, as well as DMA (direct market access) and execution into prime, which has been a forerunner of MiFID II and electronic execution services. Going forward, the market will continue to look at ways to innovate and continue to offer efficiencies and/or pricing that prime clients can consume. Our aim is to see how best we can leverage prime across other products of the bank,” says Jonathan Cossey, global co-head of prime brokerage, JP Morgan.
Furthermore, the emphasis on execution capabilities has mirrored the rapid rise of quantitative hedge fund strategies. According to the Deutsche Bank survey, over three-quarters of respondents said they allocate to systematic hedge funds, and of those investors, over half plan to add at least one quantitative strategy in 2018. It is because of this that prime brokers are invested heavily in technology, developing new execution techniques, and then linking quantitative fund clients to other areas of the franchise.
“It is increasingly about coordination across the equities, futures and fixed income, which are linked via financing, clearing and execution across the ecosystem,” explains Barclays’ Gee. “For example, we are investing in our smart order router and algo platforms, which will further enhance our execution offering.”
In addition, financing, much like clearing and settlement, is increasingly being seen as a commoditised function among prime brokers. As a result, banks have had to think more laterally about how prime brokerage can bring the hedge fund closer through value-added services.
“Prime brings the client relationship for the firm together and allows you to think about that client more laterally across products and regions. When you are offering balance sheet you need to think about how you can use it to enhance the client’s footprint with, and maximise the return for the firm. For the client prime is a commodity business to a certain extent so it is about the identifying the unique value a firm can offer and using the prime wallet to enhance the relationship and access to limited resources,” explains Dougal Brech, global head of prime finance, Nomura.
MiFID II impacts
While the onset of Europe’s MiFID II has had a clear impact on the equities departments at the all of the big banks, it is having its own effect on prime brokerage.
The unbundling rules meant prime brokers would have to disaggregate their service in terms of the fees they charge. This means prime brokerage charges to hedge funds will be itemised and managers will have greater transparency over their service provider fees.
The rules were intended to open up competition, providing hedge funds with greater information about the fees charged for certain prime brokerage services and spread out their providers.
However, the intended impact is having quite the opposite effect, with prime brokerage concentrated among the biggest players.
“In a post-MiFID II world where institutional wallets are unbundled for research and execution, it’s observed that clients are increasingly concentrating volumes with the few providers where they can aggregate everything into one,” says JP Morgan’s Cossey. “We are seeing those wallets concentrating with the full-service providers that also offer post-trade services. The big prime brokers have seen the biggest benefits, and the smaller brokers are now focused on this strategy as they want the same holistic revenue stream.
“The more MiFID II becomes entrenched in equities divisions, the more important prime services are becoming. Prime will soon become the heart in the middle of the equities wheel, with all of the other trading products around it.”
The extra transparency requirements MiFID II has enforced on the industry is also having a noticeable effect on prime brokerage operations. Barclays’ Gee believes a more transparent prime brokerage offering will resonate with clients, with new technologies and ‘best execution’ policies helping to create deeper client mandates.
“We’re focused on building partnerships with our clients. One of the key principles behind this is the idea that transparency will lead to better and stronger client relationships. The industry is moving towards best execution within financing,” adds Gee. “You are now seeing more prime brokers, hedge funds and securities stock lenders building out their technological capabilities, moving from iterative, manual, ad hoc processes to real-time processes with improved precision and the ability to optimise financing decisions based on commercial attributes. We are investing in this shift toward transparency and best execution, and which we think will help us create deeper and stronger relationships with our clients.”
A break in the duopoly
With the importance of prime services increasing and banks investing significant amounts to propel the business, what does this mean for the competitive landscape? Historically, the prime brokerage market has been a duopoly, dominated by Goldman Sachs and Morgan Stanley.
Since the financial crisis however, the popular narrative has been that this duopoly has been disbanded, replaced by a new order of half a dozen or so providers and a growing breed of mini primes and prime-of-prime brokers. In reality, however, the two banks still have a significant lead over the rest of Wall Street. But that lead is closing.
In Coalition’s Global Investment Bank League Table for 2017, JP Morgan is now joint second with Goldman in prime services, and potentially establishing a ‘triopoly’. Hedge funds have diversified the types of prime brokers they use, and have already increased the number of prime brokers they partner with.
Nevertheless, brand remains important, and hedge funds of all sizes are keen as ever to ensure they are partnered with a tier one bank. As equities departments at the top banks continue to link execution with prime services, the landscape is more competitive than ever. With hedge funds dramatically increasing in size, the competition to win these clients for all aspects of the equities franchise is more intense.
“That linkage creates one franchise sale to our most important clients and consequently, the wins and losses are magnified across all three products,” says Credit Suisse’s Galietto.
Furthermore, the competition within prime brokerage has been helped by the easing of the Basel III capital rules. Back in 2013 prime brokers began to start shedding clients to free up their balance sheet, but this has now calmed down. Many banks are now having a capital plan in place and have shifted resources to certain products that meet overall strategies.
“The prime brokerage landscape is the most competitive since 2007. Everyone is focused on optimising revenues, and the stability of the prime platforms means for many, getting bigger is a net improvement in return metrics,” explains Cossey. “The industry isn’t constrained by any single constraint such as balance sheet as in 2013, and are now in a better position to manage regulatory impositions and understand the impacts in their business across numerous binding constraints.”
However, the position the top three US investment banks hold in the prime brokerage market is being challenged by other players.
Credit Suisse, which at a time was once the third largest prime broker in the US, is making a number of moves to win clients after significantly scaling back the business. As have Barclays, BNP Paribas, Nomura, and – now to an extent – Deutsche Bank, which has recently voiced its commitment to the US prime brokerage market.
According to Nomura’s Brech, the time for European and Asian banks to take on the US primes globally is fast approaching.
“The US domestic market has been over-brokered over a long period of time, so the margins have gone to the lowest they have ever been,” says Brech. “From a balance sheet perspective, the US is one of the least efficient because the US stock lenders usually only take cash collateral which increases usage. It still remains an attractive business because of the potential scale, but having natural resources of usable and good internalisation rates are vital if you are going to hit firm target returns.”
Subject discussions between prime brokers and hedge funds have largely evolved from matters that were previously taboo, such as fees and revenue targets, to one where both sides look to benefit their own businesses as a whole.
Hedge funds are now a lot savvier when it comes to the prime brokers they select, splitting their mandates between the bulge bracket prime brokers and other emerging banks. Fees are becoming less and less a core selection choice for hedge funds, and rather wanting to partner with a broker that offers the most in the long-run.
“One of the fundamental changes in the industry is that clients are no longer simply looking for the cheapest price, rather that they want their balances to generate the firm target return so they get long term sustainability,” adds Brech. “Clients have become experts in how prime brokers generate revenues and demand transparency to make sure their balances are lucrative and will therefore be valued at the overall bank level.”
In addition, with the level of sophistication growing rapidly when servicing large hedge funds, the level of awareness over efficiency is also increasing within these discussions, resulting in prime brokers looking at their own shop to see how they can improve efficiency ratings.
“Both sides are spending more time and dollars on technology to try to significantly increase the efficiency of financing. This effort has the potential to reduce the cost of financing for hedge funds, while increasing the return on financial resources deployed by prime brokerage businesses,” says Galietto.
There is a clear correlation between the changes within the hedge fund space and the growing importance of prime services for banks. The prime broker-hedge fund relationship is evolving beyond financing to one that includes electronic execution, derivatives clearing, securities lending and algorithmic trading solutions.
As hedge funds clients become even more important to the big banks, and the evolution of electronic trading in the hedge fund space picks up, those primes that are able to invest heavily in technology may be successful in challenging the historic duopoly of Goldman Sachs and Morgan Stanley.
JP Morgan may have the best shot of establishing a new industry hierarchy. Ultimately, prime brokers will become more transparent in their service offerings, which may categorised how deals are made going forward.