Prime brokerage is a gateway to a suite of products and services offered by a bank to hedge funds, allowing them to operate. These days many see the term prime broker as a misnomer, as hedge funds may use more than one prime broker -- or even, although not a common practice, choose to operate without a prime broker at all.
The explosion of new hedge funds, particularly in Europe, has prompted many US-based prime brokers to establish or boost international prime brokerage platforms.
According to EuroHedge, a trade publication for European hedge funds, the number of new start-ups in 2001 was 149, compared to 104 the previous year and 55 in 1999. European hedge fund start-up raised USD6.6bn in 2001, slightly lower than the USD7.3bn raised in 2000, says EuroHedge.
Bank of America is the latest to announce its intentions to build an international platform, while Citigroup -- which owns the former Salomon Smith Barney prime brokerage business -- and Dresdner Kleinwort Wasserstein -- who lured Martin Keller and his team --are among those who have recently gone live with their international platforms.
Bear Stearns, which has a long established US prime brokerage business, is beefing up its platform in Europe. The firm, which hired Thomas Colucci to focus on prime brokerage sales to European hedge funds last year, has been winning mandates in Europe, particularly France, Benelux, and Scandinavia. While Bear Stearns has numerous UK hedge fund clients, it is the larger UK-based hedge funds that the firm will aggressively target in 2002.
Charles Stopford Sackville, managing partner at Securities Finance International, says that there are some 20 services that prime brokers are meant to offer in different forms, at different stages of a hedge fund's life-cycle. Among the basics are custody, clearing, reporting, securities lending, cash lending, execution, leverage and pricing.
Capital introduction, start-up services, credit intermediation, risk management, straight through processing, futures and options clearing, research, initial public offerings, and contracts for difference and swaps, are among the more sophisticated services some prime brokers are adding to the package.
But despite the plethora of services on offer, prime brokers only really make money on lending stock or lending cash; everything else on offer is essentially a cost to the bank. But prime brokers are racing to offer these additional services to ensure a hedge funds puts all, or at least a majority, of its business through a single prime broker.
With many of the large hedge funds, such as Citadel Investment Group and HBK Investment Group, building internal financing desks, hedge funds are now able to pick each product from the best provider, rather than depending on one or two prime brokers for all their services. Internal financing desks are not usually designed to replace the role of the prime broker, just to allow the hedge fund to source financing more effectively.
A few funds operate without prime brokers, for example, preferring to execute deals via contracts for difference, bought from a broker. But many believe that if a hedge fund disintermediates all the prime broker functions it will have an effect on the intangible services such as research, first-calls, sell-side ideas and structuring.
The way a hedge fund behaves is largely determined by the strategy it runs. Some strategies are heavily dependent on leverage, while others depend on ability to access stock and some, which run pure derivative-based strategies, need product-structuring expertise from the bank they use as prime broker.
Morgan Stanley was the first to set up an international prime brokerage platform in London in 1989. It has always come top of the rankings as the favoured prime broker. In Europe it has always seen itself at the forefront of innovation and this is among the reasons clients continue to flock to it. Egerton, GLG Partners and Marshall Wace are among its blue-chip European clients.
But now Morgan Stanley shares the European hedge fund market space with Goldman Sachs, which set up its international platform in London in 1996. Goldman Sachs' European business employs well over 100 people. An important part of Goldman's structure is the fact that it sits alongside offshore fund administration, stock lending and equity finance, all housed in the equities division.
Another prime broker raking in new business is Deutsche Bank. It started its prime brokerage business in 1999, and in the first year alone, it secured more than 60 new mandates. Big wins included Jupiter Asset Management's Hyde Park Hedge Fund and New Star Asset Management's UK equity long/short fund.
Deutsche's integrated global equity finance business -- which houses stock lending, prime brokerage, structured finance and the value added services such as capital introduction -- is now called 'prime services', reinforcing the idea that prime brokerage is the wrong name for the vast product range.
Last year, Deutsche Bank and Goldman Sachs shared the spoils of the two largest start-up launches. The two banks are prime brokers to IIU Capital, the global macro hedge fund formerly run by Tiger Management veteran David Morrison, and Sthenos Capital. The latter is a pan European long/short equity fund run by Alan Lewis, who used to work at Louis Bacon's Moore Capital.
Competition among prime brokers is fierce. Some argue that the competitive edge depends on where prime brokerage is positioned within the entire bank. Others see technology as the differentiating factors. Barclays Capital, Lehman Brothers, and Dresdner have all developed online systems they regard crucial for advanced product and service delivery.
Barclays Capital has made a notable entrance into the global arena. It entered the market in 1998, when it bought the equity prime brokerage business of Daiwa, and has been building share both in the US and the rest of the world at the same time rather than leveraging off an existing business. Starting with a clean slate and a lack of legacy systems has allowed the firm to offer a slightly different service. It is understood to have Tudor Corporation, Concordia Advisors and Citadel among its blue-chip clients.
Barclays Capital prides itself in offering four financing activities from the same platform under one management structure. It integrates services for execution, derivatives, and clearing of equities, futures and fixed income products from the platform.
Spared the manacle of old technology, Barclays has built an advanced web-based platform. As part of it, Barclays launched Strax, an Internet-based system that brings together lenders and borrowers of equity securities to its clients, which include custodians, beneficial owners, and hedge funds.
Strax is believed to be the only online service that allows lenders or hedge funds to submit live bids and offers, and get instant fills. Via Strax, a borrower knows where the stocks are coming from, with Barclays acting as a principal intermediary. The borrower looks at the custodial offering via Barclays and pays the spread for the service.
At Dresdner, prime brokerage falls under equity finance, which in turn is part of the equity derivatives umbrella. This way, in addition to equity finance, clients can have access to alternative investments, convertible bonds, structuring and financial engineering, structured products, securitised products, listed and over-the-counter derivatives.
Dresdner's tool to compete with the established prime brokers in Europe is EQ Finance, a web-based equity lending and borrowing and repo/reverse-repo trading and order management platform. EQ Finance provides clients with a platform for processing all equity finance trades from beginning to end.
Dresdner acts as principal between lenders and borrowers, allowing users to benefit from access to more than 300 potential business counterparts. It also offers a real-time mark to market for all open equity-financing positions between clients and Dresdner.
Like Dresdner, Credit Suisse First Boston has also positioned its equity finance business under the equity derivatives umbrella. At CSFB, equity finance is the umbrella for prime brokerage, securities finance, swaps, synthetic prime brokerage and securities lending. All the products are available on a single platform, but the fact that equity finance sits under the equity derivatives and convertibles unit means that CSFB's offering is fully conversant with derivatives.
Lehman Brothers houses its prime brokerage operation on the trading floor, allowing it to bundle borrowing, financing and trade ideas with execution in one package. Prime brokerage is part of equity finance, which also covers securities lending, equity swaps, contracts for difference, and yield enhancement.
Last year, Lehman's equity finance business launched eBorrow, a proprietary online stock lending platform. eBorrow allows hedge fund clients and other institutional borrowers to locate single and multiple stocks and see the fee/rebate that is offered. Clients also have access to prime brokerage services, swaps and CFD reporting online.
Many prime brokers are racing to devise value added products as a way to entice new clients and retain existing ones. Capital introduction is currently in vogue, although many prime brokers no longer see it as an add-on luxury but as a service they need to offer to remain competitive.
Capital introduction is seen as a service to bridge the stringent rules on advertising, particularly in the US. In its simplest form, capital introduction involves prime brokers arranging events for hedge funds to meet potential investors.
Long before the high-profile near collapse of Long Term Capital Management, hedge fund investing has been associated with risk. As institutions enter the hedge fund arena, both as investors and as providers of product, risk management has emerged as a key concern.
For this reason, most prime brokers offer proprietary risk management analytical tools and services to the hedge funds. Morgan Stanley formed a joint venture with Algorithmics, a risk management tool provider. Through the alliance known as AlgoLink, fund managers and other investors have a way to measure and report the risk of complex equity portfolios.
Competing with the prime brokers for this space, Reech Capital, an online derivatives and securities financing specialist, has launched RiskHedge, a risk management engine for the hedge fund market.
RiskHedge, which is being used by Martin Currie Investment Management's hedge funds, will give hedge fund managers access to sophisticated risk technology, previously only available to the larger investment banks, at a cost specifically tailored to hedge funds.
The product is capable of handling all asset classes and trade structures and offers reporting flexibility and customisation. This flexibility makes RiskHedge suitable for all types of fund, regardless of trading style and size.
The application service provider (ASP) delivery method of RiskHedge enables hedge funds to access the service directly with minimal entry costs and on a pay-per-use pricing structure.
In addition, RiskHedge can be white-labelled and co-branded by both prime brokers and hedge funds, allowing the service to be offered to underlying clients and investors.
An estimated 15-20% of all transactions on the New York Stock Exchange are now hedge-fund-related, while 50% of all equity finance trades at Morgan Stanley in the US are made on behalf of hedge funds. More than USD550bn is invested in hedge funds globally, with some USD39bn invested in European hedge funds in March 2001.
All of this supports the exponential growth in prime brokerage products and services. But despite the rosy picture, a recent report, conducted by TCA Consulting in London, concluded that prime brokers in the US and Europe are failing to maximise the huge commercial opportunities in the hedge funds industry because of poor levels of operational efficiency.
For the report, based on a survey conducted at the Economist Conferences' Third Annual Investment Forum: Hedge Funds, TCA interviewed four prime brokers and 24 hedge funds in the US and Europe. Securities lending books and the relationship with the prime broker were among the top requirements by hedge funds, which on the whole were largely satisfied.
But where prime brokers seemed to be stumbling was in the accuracy and timeliness of reporting. Fewer than 20% of hedge fund respondents were completely satisfied with the accuracy of their reports.
According to TCA, in order to compete, prime brokers need to make sure that their reporting is more comprehensive, flexible and accurate, as well as to improve the corporate action information provided.
Sandra Williams, principal consultant at TCA and author of the report, said:
"A lack of integration means that prime brokers spend a great deal of their time collating and processing data -- time that could be more profitably spent selling their services. One of the hedge fund respondents surveyed actually complained of a lack of sales calls from his prime broker."
Nearly half of all the hedge funds interviewed regarded operational efficiency to be key in their selection of prime brokerage services. The research found that prime brokers are currently working with poorly integrated systems, with slightly over 30% of hedge funds having global straight-through processing (STP) between themselves and their prime brokers in some key areas such as trade confirmations, trading and execution.
According to Williams, prime brokers should not underestimate the importance of STP. Without it, prime brokers are missing opportunities to reduce both their costs and their level of operational inefficiency, and so are unable to provide their hedge fund clients with the accurate information they need.
The lack of properly integrated systems also has significant consequences for operational risk. Hedge fund clients rely on their prime brokers to facilitate settlements and process corporate actions, both of which carry high levels of operational risk.
Prime brokers are therefore on the front-line when it comes to absorbing the operational risk associated with the failure of these processes. TCA believes that a more advanced level of IT systems integration would allow prime brokers to reduce operational risk and make them more attractive to potential hedge fund clients.
In addition to the technology investment, the prime broker of tomorrow will be able to give a hedge fund an integrated package of products. In an ideal world, all the services used should be accounted for in one statement, posting margin once for all transactions.
It will be the prime broker that can offer the hedge fund error-free access to everything it needs, with the required level of personal relationship, that will be the victor in the competition to win business in an increasingly crowded market.
