Hedge funds are cutting back on the brokerage accounts they hold as the prime brokerage industry begins to consolidate more than four years after the Lehman Brothers bankruptcy blew the sector wide open.
The shift comes as prime brokerages are facing increasing challenges. New capital regulations are raising costs, while low interest rates, reduced use of leverage and less hedge fund activity pressure revenues.
That shift is likely to hurt the smaller primes that flourished after the crisis and are now seeing their offerings increasingly commoditized, while entrenching the leadership of the top-tier players such as Morgan Stanley, Goldman Sachs Group Inc and JPMorgan Chase & Co.
It is also likely to lead to a rise in funding costs for the hedge fund industry, particularly when certain shorting strategies are less lucrative for the broker.
"What it's doing is segmenting the industry and making an industry where the top-tier players again are controlling the big market share and the industry is going back to having few providers in the prime brokerage space," said Matt Simon, a senior analyst at Tabb Group, who monitors prime brokerages.
After Lehman went under in 2007, "counterparty risk" became a key watchword for hedge funds, which faced the very real possibility of their assets being caught up in lengthy bankruptcy proceedings. As a result, they diversified.
In 2009, hedge funds with over $3 billion in assets had an average of 4.8 prime brokers, according to Tabb Group. Funds typically had just one broker before the crisis.
But that disaggregation is reversing, falling to 3.9 in 2010 and to 2.9 brokers in 2011.
After the financial crisis, lower-tier players such as Deutsche Bank AG and Citigroup Inc tried - and succeeded - to take market share from the traditional duopoly of Morgan Stanley and Goldman Sachs, while a number of smaller primes ramped up their operations.
That jockeying for position came ahead of an expected renaissance that has so far had mixed blessings for the industry.
Hedge fund assets, which peaked at $2.2 trillion in 2007, rebounded dramatically after the financial crisis. They fell to $1.4 trillion in 2008, but are now around $2 trillion.
But successive crises and volatile, correlated markets have sapped investor confidence, hitting trading, which in turn is hurting prime brokerages. Average daily U.S. trading volume so far in 2012 is 6.83 billion shares, down from 7.84 billion in 2011.
"The internal cost of funding is really quite high," said Robert Lyons, the former chief operating officer at Bear Stearns Global Equities, a post that had the prime brokerage business under its purvey.
Lyons describes a recent conversation he had with a head of prime brokerages at major firm: "I talked to the head of PB and he said 'we're barely breaking even.'"
Total revenue for prime brokers is hard to establish. Lyons estimates it has fallen to around $12 billion a year from $15 billion in 2008.
Revenue for Goldman Sachs' prime brokerage have fallen a whopping 53 percent to $1.6 billion in 2011 from $3.4 billion in 2008, according to data tracked by Global Custodian. Although some of that is due to falling market share, it also tells a story about declining revenues across the industry.
"With the volume of trading so low and the volatility so low there really isn't enough to feed everybody at the table right now," said Ron Suber, a senior partner at Merlin Securities, a New York-based prime broker that aims to attract hedge funds in the $100 million to $1 billion range.
That will also mean that funding costs for hedge funds are likely to increase, says Suber.
"With Basel III coming, the expenses to run a prime brokerage business and do financing on certain asset classes are increasing," he said. "So we are seeing as an industry where many prime brokers are calling hedge funds and increasing rates on margin financing on less liquid securities, anywhere from 2 to 7 basis points."
Basel III will impose stricter regulations on reserve capital requirements for banks. This means prime brokerages are less willing to finance clients if the returns are not big enough. That has even led to primes politely showing smaller clients the door.
Under those conditions, prime brokerages are telling clients that the relationship is not going to work unless they start executing all their trading business through them. Prime brokerages can be attractive to parent banks if they pull in other, more lucrative business.
"With the new regulation, balance sheets become a bit more precious," said Lou Lebedin, global head of prime brokerage at JP Morgan. "In those situations, where clients have a very tight spread and are using a lot of the balance sheet, it is not uncommon for us to go back to them and explain to them how the economics look from our perspective."
JP Morgan became a major prime broker in 2008 when in bought the failed Bear Stearns. It is attractive to clients because of its "fortress" balance sheet.
Lebedin says clients who are only shorting and not using leverage on the long side are most often a cause for concern because the bank's balance sheet is absorbing more short exposure.
In addition, many of the shorted stocks are cheaply borrowed 'general collateral' securities that might be used in vanilla arbitrage strategies rather than more lucrative 'hard-to-borrow' stocks. That makes the return for the broker far less attractive.
The lack of hard-to-borrow stocks or 'specials', in-demand stocks that command a greater premium for lenders and brokers, is due to a number of factors.
Fewer mergers and acquisitions and a tendency for deals to be carried out in cash by cash-rich companies reduce opportunities for arbitrage in the shares of the acquirer and the target company, a source of borrower demand.
In addition, there are also fewer initial public offerings that create a market in hard-to-borrow stocks for short sellers.
Less M&A and IPO activity is largely the result of the same market and economic conditions that have driven correlation in markets and have kept hedge funds cautious. Global M&A fell to its lowest in seven years in the first quarter, according to Thomson Reuters.
"The hedge fund market has improved, but the activity levels haven't picked up as much as what one would expect," said Brad Hintz, an analyst at Bernstein. "There is just too much collateral chasing way too few people that are shorting."
Hintz says that for lending revenues for prime brokers to increase interest rates need to rise. In the United States, borrowers typically post cash collateral for borrowed stock, which is reinvested by lenders. While interest rates are ultra-low the return will be much less.
"Everyone in the industry is waiting for the recovery," said Hintz. "Waiting for securities lending to rebound; for cautious clients to come back to the market and for rates to rise." (Editing by Andre Grenon)
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