Global Custodian Prime Brokerage Survey 2011 Published

The 18th annual Global Custodian survey of the clients of prime brokers, published today, finds the global hedge fund industry in a cautiously optimistic condition. Assets under management have risen substantially in the last year, yet both investment returns and the appetite for risk – as measured by leverage and appetite to borrow stock to cover short sales – remain suppressed by comparison with the years prior to the financial crisis of 2007-09.

This combination is depressing the revenues of prime brokers, whose chief sources of income remain margin finance and stock loan. The estimated $10 billion of revenue generated by hedge funds for investment banks and broker-dealers is at least a third below historical norms. Yet there is no shortage of firms ready to compete for a slice of the revenue. No less than 29 firms received responses from clients in the 2011 Global Custodian Prime Brokerage Survey.

That said, neither client numbers nor revenues are distributed evenly. Estimates of market share made by Global Custodian (see Table 1) suggest that, just as nine-tenths of AuM in the hedge fund industry are managed by a sixth of hedge funds, the top six prime brokers – namely, Bank of America Merrill Lynch, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan and Morgan Stanley – control up to two-thirds of the market. The top nine, when the group is enlarged to include Barclays Capital, Citi and UBS, controls four-fifths.

Table 1: Proxies for Market Share of Prime Brokers

Source: Global Custodian Prime Brokerage Survey 2011

In other words, the prime brokerage industry presents a paradox: an oligopolistic structure that is, nevertheless, characterized by a large number of competitors and a high degree of fragmentation. Competition for business is especially evident this year in the scoring of financing and margining, where respondents reward prime brokers that are willing to deal with them on financing terms and punish those that remain cautious, though in some cases this is because they lack access to cheap sources of finance themselves.

This makes the answer to the question which prime brokers are favored for appointment in the coming year more than usually interesting. Bank of America Merrill Lynch – which has not only made a major commitment to the prime brokerage business in the last year, including appointing a new head of prime services, but also has access to the balance sheet of the parent bank – comfortably topped the popularity poll this year (see Table 2). However, with Credit Suisse in second place and J.P. Morgan in fourth, it is clear that the preference for sustainable finance from strong credits that characterized the immediate aftermath of the crisis remains an important factor.

Table 2: Popularity index

Collected from a sample of 620 who answered this question.

To reflect the growing concentration of hedge fund business with larger funds and leading prime brokers, this year Global Custodian has published an analysis of how the major hedge funds have scored the leading prime brokers. Responses from this select group of just 132 hedge funds (out of a total of 3,112 individual funds that responded) are also weighted differently, using a variety of measures (such as balances, financing tools and contractual agreements in place) to test the intensity and value of their relationship with particular prime brokers.

Table 3 sets out how the scores of the top prime brokers vary between these leading hedge funds and scoring by respondents as a whole. To measure the competition for hedge fund balances between the major firms, this year for the first time Global Custodian has also published a table showing how hedge funds that rate more than one prime broker score the various firms they assess. The outcome of this exercise, also shown in Table 3, again shows considerable variation in the scoring by comparison with the scoring by all respondents and leading respondents.

Table 3: How All, Leading and Clients-in-Common Rate the Top Prime Brokers

Despite the different outcome of these three measures, the results offer some clear indications as to what is happening in the marketplace. The investments made by Bank of America Merrill Lynch are paying off, with the firm adding balances as well as improving its scores significantly.

“Bank of America Merrill Lynch continues on its mission to build its prime brokerage business with hedge funds,” says Sylvan Chackman, managing director of global markets financing and futures at BofA Merrill Lynch. “Our global equity reach, combined with our global innovative and integrated finance offering makes us a compelling partner for hedge fund managers of all sizes. Once again, our goal remains to help our clients grow and deliver results to their investors. We are grateful for the feedback and results and we look forward to continuing that work in 2012.”

Deutsche Bank, whose scores are quite outstanding across the board, is also adding balances. Indeed, scores and comments and market share data underline the fact that Deutsche is now established as one of the top four prime brokers. Expectations of service quality and flexibility from the bank have risen accordingly, but Barry Bausano, co-head of global prime finance and head of equities for the Americas at Deutsche Bank, is confident the prime brokerage group can meet them. “Each year we evaluate the results of this survey carefully and take client feedback into consideration,” he says. “This year we are pleased our clients cited a broad spectrum of strengths across multiple categories as they voted to name us a top firm for the sixth year running.”

It is also obvious that both Goldman Sachs and Morgan Stanley in particular are rebuilding balances they shed during the crisis, though they are finding it harder to compete with the universal banks on financing rates and terms. Despite that handicap, Morgan Stanley has staged a remarkable comeback from the financial crisis. As one client explains, the firm has “maintained most of their deep bench through the crisis” and will “make a strong return to the front of the line as the industry rebuilds.” The scores suggest that, some comments notwithstanding, Morgan Stanley has re-built the trust of its clients. “Morgan Stanley suffered a reputational hit and a loss of talent in the aftermath of the 2008 market crisis that they are still recovering from,” as a client puts it. “That being said, these issues are being addressed, and clients are seeing the benefit. Overall, Morgan Stanley remains the gold standard in prime brokerage.”

Credit Suisse, which has followed a singular strategy of pursuing profitable business from larger hedge funds for nearly a decade, continues to impress larger clients the most, and does well when compared with peers competing for the same business. “We are grateful to our clients for naming Credit Suisse, along with an American provider, as the first choice among prime brokers that managers have in common, and are cheered that clients whom we do not know yet have also ranked us as their first choice, along with another American provider, as their next prime,” says Philip Vasan, managing director of prime services, at Credit Suisse in New York. “At another moment of hyper-competition among prime brokers, this survey’s identification of what hedge funds do when their providers are in head-to-head competition seems groundbreaking.”

Citi and UBS, on the other hand, both earned their best scores from smaller clients, where both banks lifted scores by wide margins. “We faced considerable challenges during and after the financial crisis, but the strong increase in flows of new business in the last nine months shows that we have now put those decisively behind us,” says Nick Roe, global head of prime finance at Citi. “Since the second half of last year we have experienced a sea change in attitude, and large increases in balances, which are up by a fifth year on year. We are pleased the results of the survey show that our continuing investments in infrastructure and talent are paying off, with increases in every service area bar one. For the rest of this year and into 2012, we are confident that our continued focus on investing in talent and technology, and in the development of cross-asset class product coverage, the placing of all margin-based services on a single platform, and the evolution of a new set of consultancy services will set us apart from other providers across the entire asset management services industry.”

However, the provider that raised its scores the most this year is Barclays Capital, which has earned spectacular returns in every service area and almost every client type where it chooses to compete. “Our clients have clearly recognized the investments we have made in our prime services business,” says Ajay Nagpal, head of prime services at Barclays Capital. “Our materially improved ranking this year across all key categories and strategies shows the consistent growth in our franchise, validates our long-term approach and emphasizes our standing as a leading cross-asset prime services provider. Most importantly, these results confirm our clients’ view of our ability to successfully partner with them for the long term.”

J.P. Morgan, which has faced the additional challenge of retaining and extending the Bear Stearns franchise into Europe and Asia on top of integrating its existing businesses from a client perspective, has held its own in all its traditional areas of strength and made progress in expanding its geographical reach. “These results show that our delivery of exceptional prime brokerage products across all asset classes and to ‘deliver the firm’ is being noticed by clients that do business with us across the entire spectrum of cash and synthetic products in equities and fixed income,” says Neil Sherman, global head of prime brokerage sales at J.P. Morgan. “Our portfolio swap product, which is already available in Europe and Asia as well as North America, is not only recognized as market-leading in this survey but is also one of the products in the forefront of our international expansion. That expansion continues apace, with the launch this month in Europe of our full prime brokerage offering for our international clients based there or operating in the region. We are also experiencing growth in our Asian business that more than justifies our decision to continue to invest in building up our prime brokerage operation in the region.”

The two French investment banks, BNP Paribas and Newedge, are pursuing markedly different strategies, though both have ambitions to expand their geographical coverage. “We continue to pursue a different strategy from other prime brokers, which we believe is better adapted to the changes taking place in the hedge fund industry,” says Philippe Teilhard, global head of prime brokerage at Newedge. “We have worked extremely hard in the last two years to create for hedge funds an agency-only service that is fully integrated across all asset classes and geographies. Our new Ultraedge low-latency execution platform, which we unveiled in Europe this summer and will be rolling out in America and Asia this year, offers hedge funds not only fully automated access to execution, but seamlessly integrates clearing, settlement, reporting, financing, risk management, collateral management and stock loan across equities, fixed income, FX, commodities, futures and options and swaps. We are confident that we now have the tools and the talent in place to show how we can add value for hedge funds and their investors.”

Though Newedge has something of a standstill year as it reinvented its technological platform, BNP Paribas continues to collect good reviews from the clients it has retained since the restructuring of the business during the financial crisis, though these remain for now entirely North American. Another prime broker with ambitions to build on its strength in North America is Fidelity, which continues to add large clients, and to excel in financing, margining, stock loan and operations as well as offering a diversification of counterparty credit risk.

Jefferies & Company also has international ambitions, with plans in hand to add prime services to its established investment banking operations in London and Hong Kong. With the exception of two areas of importance to its mostly smaller-scale hedge fund clientele – consulting and capital introductions – Jefferies again collects exceptional scores from a sizeable group of clients, which is growing fast. It scores best in areas that matter most to smaller funds, notably value, client service, operations and reporting and technology. “We are grateful to our clients for the continued support they have given us in the Global Custodian Survey. The recognition by clients of the hard work of our technology and client service groups is very rewarding and inspires us to continually develop and improve our offering,” says Glen Dailey, managing director and head of prime brokerage at Jefferies & Company. “Our investments in our capital introduction group and the firm’s global expansion in Europe and Asia will allow us to expand our reach and be more competitive on a global basis in the years ahead.”

In Canada, where two of the six banks that compete in the prime brokerage business have rethought their strategies, the strongest performances were delivered by the traditional market leader, TD Securities, and CIBC, which has developed a strong following among high frequency trading funds. Scotia Capital, the most international of the Canadian banks, is also rated in the survey but none of BMO Capital Markets, National Bank Financial Primes Services or RBC Capital Markets received enough responses to be rated.

One reason the relatively small Canadian marketplace sustains so many providers is the absence of so-called mini-primes. Despite the shrinkage of this sector in the United States, the survey continues to attract mostly flattering responses from clients of introducing or execution-only brokers such as Alaris Trading Partners, ConvergExNorth Point Trading Partners, Gar Wood Securities and RCM Prime. However, each of these firms has a distinctive model but none as distinctive as that of either Pershing Prime Services (which can build a prime brokerage business on top of a massive clearing and custody franchise) or Merlin (which has used technology to build a unique set of capabilities).

A rateable number of responses were also received from clients of one firm new to the Global Custodian Prime Brokerage Survey: Cantor Fitzgerald & Co., where Noel Kimmel, global head of prime services, is leading a team of former colleagues and other seasoned prime brokerage executives. Responses were also received from clients of Macquarie, where the former leadership of BNP Paribas in New York is now in charge, and RBS, neither of which have previously featured in the survey.

For full details of the scores, ratings and best in class awards collected by the prime brokers that took part in the survey, members of the press can contact Surveys Editor Allison Cayse directly. The average and weighted average scores are based on 4,026 authenticated responses received on behalf of 29 prime brokers. The number of responses was up 25% by comparison with 2010 (3,215).

The full results of the Prime Brokerage survey, and a full explanatory methodology, are available for GC subscribers here

Contacts:Dominic Hobson, Editor in Chief, at dhobson@www.globalcustodian.com or +44 (0) 207 228 3013Allison Cayse, Surveys Editor, at acayse@www.globalcustodian.com or +1 513 574 0220Muzaffar Karabaev, Survey Reprints/Research Enquiries, at mkarabaev@www.globalcustodian.com or +44 (0) 207 148 4289