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Riding Hedge Fund’s Coattails

As hedge funds experience explosive growth, prime brokers aim to become their one-stop shop for clearing and execution.

Advanced Trading Spring 2005Last year, the Securities and Exchange Commission revealed that, beginning Feb. 1, 2006, it would require hedge fund managers that handle more than $25 million to register under the Investment Advisors Act of 1904. With registration removing the veil of secrecy that had surrounded hedge funds, many believe hedge funds will find themselves awash with pension and mutual fund cash that had previously been reserved for more conservative investments.

As hedge funds prepare for the influx of newfound cash, many are shoring up their technology and operations. That could mean a serious boom to the hedge fund's traditional service providers: prime brokers, third-party administrators, executing brokers and vendors.

At the top of the hedge fund's partner list is the prime broker - an indispensable ally in hedge fund's quest for success. Prime brokers traditionally provide hedge funds with the financing they need to execute esoteric trading strategies, clear trades, custody securities, provide margin financing, lend stocks to cover short sales, and provide cash and position reports.

With their foot already in the door, prime brokers have been steadily inching into the front office, and today they offer hedge funds a smorgasbord of technologies and services. Among the largest prime brokers are Bear Stearns, Morgan Stanley and Goldman Sachs.

Get Connected

Bear Stearns recently partnered with FutureTrade, a Lake Forest, Calif.-based provider of electronic trading tools and services to institutional traders and hedge fund managers. The deal allows Bear Stearns to offer FutureTrade's electronic-trading platform to its hedge fund clients, facilitating connection to exchanges, electronic communications networks (ECNs), alternative trading systems (ATSs), market makers, DOT and options exchanges.

And connections are the key for hedge funds, according to Tim Lind, a senior analyst with Needham, Mass.-based TowerGroup. "That is the real value that a prime broker can bring, where the hedge fund can say, 'I don't have to buy servers or software - I can lease from my prime broker, and they can administer telecom and connections. I just look at the Web-based user interface and all the integration work and support is hidden from me,'" he says.

Not to be left out of the hunt, Morgan Stanley touts its Prime Brokerage Execution Desk (PBX) as a full-service, fully independent trading desk that assumes a hedge fund's trading functions. PBX offers a FIX-enabled order-entry system as the hedge fund's trade blotter.

For its part, Goldman Sachs Prime Brokerage features its GS Financial Workbench, which offers Web-based access to trade entry, online queries and report retrieval via a direct phone line or secure Internet connection.

Unified Services

But not every hedge fund sees a need to have its execution and prime-brokerage services consolidated under one roof. Karen Paine, vice president and head of operations for Mosaic Capital, a New York-based hedge fund with $25 million under management, has decided to keep those two services separate. Though Mosaic uses Bank of America as its prime broker for both its offshore (started in July 1999) and onshore (launched in January) funds, Paine says the hedge fund uses New York-based Electronic Global Securities (EGS) and, occasionally, William Blair as its executing brokers.

The main reason? Price.

"We used Bank of America a few times as an executing broker, but I think they were rather expensive compared to Electronic Global Securities," Paine says.

That is not to say BofA didn't want the execution portion of Mosaic's business. Paine says the prime broker offered a 1-cent commission discount if Mosaic would use its executing broker capabilities. But Paine says that still wasn't enough to make it worthwhile.

Mosaic was extended technology from EGS' sister company, Advanced Financial Applications (AFA). Specifically, Mosaic began using AFA's Impact Pro platform, which enables hedge funds to access multiple pools of liquidity (including ECNs, market makers and soft-dollar brokers) on a neutral basis for execution, allocate trades across multiple accounts, generate compliance and middle-office reports, connect to multiple prime brokers, and export data to prime brokers at the market close.

Every business day at 4 p.m. - after she has executed trades with EGS throughout the day using Impact Pro - Paine clicks a button in the application, creating a trade file that is saved to her desktop. From there, she clicks on BofA's trade interface and imports the file into the prime broker's system. "I check the information and hit transmit, and off it goes to Bank of America," Paine says.

All for One?

For Mosaic, using Bank of America as its sole prime broker works just fine. That is not true in all cases, however. Many larger hedge funds maintain multiple prime relationships. When that is the case, a third-party administrator like Spectrum Global Fund Administration can come in handy.

"We are a global fund administrator, but we also provide a level of outsourcing that distinguishes us from other administration organizations in the sense that we will do data reconciliations to the prime broker - we will do same-day reporting of positions, holdings, P&L, etc.," says Spectrum's CEO, Michael Griffin. Griffin adds that Spectrum often can provide a more granular level of reconciliation, reporting and accounting than most primes are willing to do - going down to the investor level as opposed to the fund level.

Spectrum also looks to differentiate itself by providing aggregation services to hedge funds operating in a multiprime environment. "So we pull the information not only from the manager but from all the different primes, and then we reconcile to the primes and provide [the hedge fund] with a consolidated report that includes their holdings across all their different prime brokers and custodians," Griffin says.

But, just like primes, Spectrum is looking into offering front-office platforms for its hedge fund clients. Specifically, Spectrum CIO Mark Seaman says the company is in talks with Wolverine Trading, "which has a tremendous execution platform, and they are looking at trying to wrap their service inside our administrative offering."

When it comes to selecting a prime broker that can do it all, TowerGroup's Lind says funds should take a look at features like direct-market-access capabilities, best-execution methods and the availability of multiple trading algorithms. He also suggests finding out whether the prime offers only agency or agency and principal trading, how many markets it makes and how effectively it can work an order to prevent market movement.

Mosaic's Paine says it's important to look at what the prime broker can offer in terms of custody services, along with report accessibility and quality. "Ask if they do domestic and international with the ability to settle in different markets," she advises. "And, most importantly, what are their fees for executions and borrowing?"

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10 Questions to Ask When Selecting a Prime Broker

1. What are its direct-market-access capabilities?

2. What are its best execution methods?

3. Are multiple trading algorithms available?

4. Does it offer agency-only or agency and principal trading?

5. How many markets does it make?

6. How effectively can it work an order to prevent market movement?

7. What custody services does it provide?

8. In terms of reporting, how accessible are reports and what is their level of quality?

9. Can it handle domestic and international execution and settlement?

10. What are the fees for executions and borrowing?

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