Prime Brokers Face New Challenges While Trying to Regain Revenues

While hedge fund assets under management (AUM) are up, prime brokerage revenues are down, and several hurdles have hindered a return to pre-crisis levels.

In a survey of eight prime brokers with a global footprint, Ernst & Young found that in order to reclaim these revenues (down from $15 billion in 2008 to $12 billion in 2012), prime brokers try to stand out from the pack through unique product offerings and the efficiency of the various aspects of their business. And there are several pieces of the puzzle that explain why revenues were lost and what will happen going forward.

“Funds, certainly since before the crisis, have deleveraged their portfolios, so that’s going to account for some of it,” says Gerry Tamburro, managing director of Pershing and co-leader of the company’s prime services division. “There is also simply less trading volume. Those would be the main reasons why we’ve seen that revenue reduction at the prime level.”

Part of the reduction can also be explained by the trend of using multiple prime brokers. Pre-crisis, hedge funds tended to use just one prime broker, but this spiked to an average of nearly five in 2009 for funds with over $3 billion in assets. Since then, this number dropped to an average of 3.9 prime brokers for these funds in 2010 and 2.9 in 2011.

Funds are “eliminating prime brokers for two reasons,” says Tamburro. “One is because [funds] only have so much currency to pay, and they want to make sure they’re paying the primes so that they get the right service and the right borrow. But post-crisis, the funds also realize that they have just as much credit risk and operational risk with their primes. The thinking prior to the crisis was that hedge funds presented risks to the prime brokers and the banks. But some of these hedge funds became better credits than the counterparties that were financing them, and therefore they reduced significantly the number of primes they were dealing with in order to limit their risk.”

Since the breakdown of the single-prime model, there have been more opportunities for medium-sized prime brokers. Ernst & Young’s study cites that in 2006, the top two prime brokers, Morgan Stanley and Goldman Sachs, accounted for over half of all hedge fund assets, but now they account for less than a third.

“Hedge funds have [had] to get to know their PBs better since the crisis,” says Chris Hagstrom, head of prime brokerage in the U.S at UBS. “Pre-crisis it was very much a name game of the brand names that were selected as PBs, without thinking much about how strong balance sheets were, how strong firm liquidity was, and that’s become a big focus [now].”

Tying into these selection factors, Tamburro says the biggest challenge the industry faces is complying with regulation. In particular, he identifies Basel III as an agent of change, as it has led to significant balance sheet reductions. “The prime brokerage firms that will do well in this environment are the ones that can manage their balance sheets prudently and can package a whole host of services to clients,” he says.

The survey notes that one strategy to meet these requirements is to use a broker-dealer structure combined with an offshore entity, which “allows the prime brokers to move their derivatives business offshore, reducing their balance sheet burden and lowering regulatory capital.”

Another significant challenge prime brokers face is the lack of a system to integrate all of a client’s information into a prime broker’s own system, thus making it more difficult to fully understand the client’s profitability potential. Less than half the respondents said they even use a semi-automated system for onboarding and monitoring clients.

This lack of technology also extends to liquidity management, where 71% of respondents said they do not have a system in place to notify their treasury group of large inflows and outflows. Those that do have a system in place use manual processes, so there is space for an automated solution. As prime brokers look for an edge over the competition to regain revenues, liquidity management could be one such differentiator.

“Those firms that can fund the cheapest will certainly have a competitive advantage in this business,” says Tamburro.

Going forward, the winners in the prime brokerage space will be those that can both meet the regulatory challenges while strengthening client relationships and the internal processes to maximize efficiency.