Big changes are afoot in the prime brokerage world. Once an esoteric business controlled by three playersMorgan Stanley, Bear Stearns and Goldman Sachsit has become a hotbed of competition as rival banks and brokers have sought to profit from the hedge fund explosion.
But it is not merely growth in assets under management and the number of hedge funds that is prompting change. Market maturityspecifically the institutionalization of the investor universe and heightened regulationmeans hedge funds are facing demands for better risk analysis, performance measurement and reporting; more robust operational infrastructures; and greater transparency. And all of this is reflected in the demands placed on prime brokers.
Of particular note is the drive toward more transparency across the brokerage industry as a whole, which is resulting in a new level of openness in the costs associated with the services provided by the prime brokers, says Sang Lee, managing partner with Aite Group, a Boston-based research and advisory firm. With hedge funds under pressure from their clients to optimize their broker relationships, managers increasingly are scrutinizing the services and products they receive from their primes, adds Lee. As they see exactly what they are being charged for, "They will be able to pick on an à la carte basis what services to get from what providers, and that, in turn, can only present more opportunities for entrants to the marketplace."
But it hardly is "game over" for the market leaders. Typically, the strength of prime brokers' services has been their ability to offer all-in-one suites of services that provide funds with all the tools to maintain their operations. While there may be increasing opportunities for componentization, having a proposition that covers the broad scope of a manager's requirements still matters. So given the array of capabilities that the top three offer, their dominance is likely to continue, at least in the short to medium term, Lee predicts.
At the same time that competition in the prime brokerage space is heating up, there is a shift occurring among the larger hedge fund managers toward a consolidation of their multiprime models. Whereas five years ago some funds may have employed eight or 10 primes, a lot of $2 billion, $3 billion and $4 billion firms now are picking the two or three that strategically add value and solutions to their business, according to Ron Suber, senior managing director, manager of global clearing sales, Bear Stearns (New York). The reason is that "It is more expensive and more complicated to interface with 10 prime brokers," he says. "At the same time, because of more cross-selling by the prime brokers, hedge funds don't need as many multiple relationships because the larger primes are delivering the full resources of their global franchise."
Demand and Supply
So what do hedge funds want? According to Suber, globalization is an increasingly prominent issue among hedge funds, so Bear Stearns is expanding its presence in Europe and Asia. Other business issues on the rise include the increasing use of algorithmic trading and quantitative strategies, and a requirement for better data, Suber relates.
To this end, Bear Stearns has rolled out an algorithmic solution called EAST (Equity Analytics and Systematic Trading), as well as its Client Electronic Access (CEA) application, a Web site through which hedge funds can access data from across Bear Stearnswhen they want it and how they want it, according to Suber. "More big hedge funds are using proprietary applications, and they really just want the data," he says. "And with the increase in regulation, hedge funds are being asked for data for compliance, for accounting, and this helps them meet those needs," Suber adds, noting that Bear Stearns also will roll out a new trading application at the end of the second quarter.
Another prominent theme in the hedge fund industry is asset diversification, which, with geographic diversification, is having two parallel effects on prime brokerage. The first is in the broadening use of multiple primes and the potential to split that along asset class lines. For instance, the long/short community, which historically has not used multiple primes as much as relative-value players, is recognizing the value in being able to compare the quality of services, level of pricing and so on across multiple firms, observes Mark Haas, global head of prime brokerage and the Americas regional head of prime services for Deutsche Bank (Frankfurt). For brokers, this provides opportunities to win business by leveraging strengths they may possess in specific product areas and thereby differentiate themselves, Haas points out.
The second impact of diversification is the focus it puts on the breadth of prime brokers' offerings. Credit Suisse (Zurich), for example, moved a few years ago to create an asset class-neutral platform across equities, fixed income and foreign exchange (FX), relates Philip Vasan, managing director and head of prime services with the firm. "This has given us the framework to roll out newer, less-traditional asset types in response to our clients' needs," he says. Credit Suisse since has taken integration a step further, combining investment banking, private banking and asset management into one suite of services as of Jan. 1, 2006.
Within prime brokerage, Credit Suisse's approach is to provide the core operating and financing services that hedge funds count on, while being able to handle more-complex client needs, Vasan continues. "This has helped us gain share at about triple the rate of growth in the overall hedge fund market in the last few years," he asserts.
Indeed, outside the Bear-Morgan-Goldman circle, Credit Suisse and Lehman Brothers (New York) are making the greatest effort to grow market share, according to Josh Galper, managing principal of Concord, Mass.-based consulting firm Vodia Group and author of a report on the prime brokerage shake-up that was distributed in October in cooperation with Aite Group. "Both these firms have more smaller clientsas opposed to Bear's or Goldman's large client basebut have been building their teams and offerings to compete more effectively," says Galper.