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Mini-Primes Offer Hedge Funds Turnkey Service to Diversify Counterparty Risk

In response to counterparty risk concerns, mini-prime brokers are offering smaller hedge funds the hosted technology to manage multiple prime relationships.

Following last year's market turmoil, which made it abundantly clear that even the largest brokers are vulnerable to risk, a new prime brokerage model is emerging to help small and midsize hedge funds diversify their counterparty risk through multiple prime relationships. Institutional agency brokers are offering the smaller hedge funds a way to diversify their trading exposure by linking up with multiple prime brokers.

Historically, small hedge funds -- those with less than $250 million in assets -- could not support multiple prime brokers because they lacked the internal IT staff to deal with the operational complexity. In addition large prime brokers have turned away some of these smaller hedge funds that don't meet the primes' asset-size or product-mix requirements. But now so-called mini-primes are hooking up with larger prime brokers and technology vendors to bridge this gap in the hedge fund servicing segment.

Managing multiple prime relationships "certainly is more complex than dealing with a single prime broker," comments Keith Bliss, SVP and director of sales and marketing at Cuttone & Co., an institutional agency broker that has become an introducing prime broker to Goldman Sachs Execution and Clearing (GSEC). According to Bliss, Cuttone & Co. manages that complexity for clients that can't do it in-house.

"We do all client-facing services, but we introduce the assets to Goldman Sachs," Bliss explains. While GSEC provides its balance sheet to facilitate the clearing and settlement, and also offers access to its stock loan department for short sales, Cuttone's role is to provide the trading platforms, the human-based traders, and the portfolio and risk reporting mechanisms, he adds.

"If people don't have the technology and the apparatus in place to manage the multi-prime relationships, it's going to be a headache," says Bliss, pointing to operational complexities such as rolling all positions into a single book, checking balances at the end of the day, tracking money transfers and dealing with leverage issues. "You have to assemble all of that information together and put that in a spreadsheet to know where you stand from a margin perspective."

In mid-December Cuttone announced the launch of Compass, a hosted trading platform for the multi-prime hedge fund model, in partnership with San Francisco-based Nirvana Solutions. Compass is a portfolio management platform that provides an aggregate view of assets, risk exposure and P&L across multiple prime brokerage accounts, according to the announcement. As an application service provider (ASP) solution, Compass interacts with the prime brokerage systems to aggregate and consolidate all the information onto a single interface, relates Bliss. With the turnkey service, he notes, Cuttone is prepared to handle even smaller hedge funds, in the $15 million to $20 million range, that are seeking a multi-prime solution.

Multiple Relationships, One Contact

Eyeing the same opportunity, NorthPoint Trading Partners in Atlanta integrated its trading platform with two clearing brokers -- GSEC three years ago and Jefferies & Co. about a year ago, and recently added a third clearing firm, J.P. Morgan Clearing Corp. "NorthPoint is the prime broker and GSEC is the clearing firm and the custodian of our client assets," explains Doug Nelson, cofounder and CEO of NorthPoint, which is targeting midsize hedge funds with less than $300 million in assets.

"We have a couple of clearing relationships, and we're about to add another one," relates Michael DeJarnette, NorthPoint's president. "[Clients] have the benefit of more than one clearing relationship to mitigate what they see as potential counterparty risk. But the phone number they're going to call for any trade breaks or anything else is the NorthPoint phone number." DeJarnette says NorthPoint aggregates technology from third-party vendors such as REDIPlus, Bloomberg, Lava and Derivix for risk management.

He adds that NorthPoint provides brokerage and trading services in equities, futures and options to more than 75 mutual funds and hedge funds. "They're able to use a broker-neutral DMA and direct each of the trades to the clearing firms," DeJarnette says, stressing that the mini-prime brokerage model is the future of the business. "That is the way prime brokerage is headed."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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