In prime brokerage there always seems to be two enthralling sides to the story: what’s going on with the client and what’s going on with the providers, and each continue to deliver unrivalled levels of drama-filled storylines in the post-2020 era.
Following the height of Covid, we’ve had the memestock saga, the collapse of Archegos Capital and the war in Ukraine impacting the space in concurrent years as unprecedented events seem to have become the norm, driving market volatility in each of the post-pandemic years.
It was probably fair to say that 2023’s own watershed moment had a high bar to reach when it came to impact levels, but the crisis of the year did end up delivering an equally reverberating effect on the markets and prime brokerage space through the failure of three regional banks in the US – Silicon Valley Bank (SVB), First Republic Bank (FRB) and Signature Bank.
SVB was the catalyst for a bank run that led to the collapse of FRB and Signature Bank as the latest iteration of March madness led to market volatility, credit contraction and negative investor sentiment, which very much defined the first half of the year.
But unlike incidents of the past, the market mayhem of 2023 has not been confined to one event. Instead, a combination of rising interest rates, inflation, soaring energy prices and geopolitical tensions have hit hedge funds, and subsequently the risk management practices of prime brokers.
“During periods of high market volatility and uncertainty, investors tend to seek more counterparty credit risk mitigation and may change their trading activity,” noted ABN Amro in this year’s provider questionnaire for Global Custodian’s Prime Brokerage survey. “Additionally, heightened market uncertainty may lead to increased counterparty risk.
“The last 12 months have provided more market turbulence, in large part due to the Russia-Ukraine conflict, continued soaring energy costs and surging inflation. These forces have rumbled markets and led to heightened volatility. This has forced prime brokers to focus more on risk management and diversification of their client portfolios with increased regulatory pressures.”
The market volatility has certainly been a defining feature of the year, for both clients and providers, and gave rise to opportunities for certain strategies, while costing others dearly. Among hedge funds there have been winners and losers, and primes will have needed to both watch their books carefully and make themselves available to assist clients with their evolving needs.
“In today’s environment, managers are placing greater value on diversification of risk, of securities lending access, of financing and balance sheet,” Pershing told Global Custodian. “They’re looking closely at providers’ overall value propositions and core services and how to benefit from a financially secure prime broker who can help them prepare for the unexpected and can give them a competitive edge.”
The expected versus the unexpected
Many of the aforementioned crises may have been impossible to see coming; however, there are a slew of changes on the horizon in both the form of market structure and regulation, which will impact prime brokerage.
As one PB noted to us earlier this year “it would seem reasonable to expect that banking regulators will look to shore up liquidity in the banking system…greater capital requirements and tighter leverage ratios could be coming to the prime broker in your neighborhood”.
Among the major changes is the Basel III ‘endgame’ update, the widely anticipated capital requirements hike for Global Systemically Important Banks (G-SIBs). In July, US regulators unveiled the major new capital rules for lenders with G-SIBs seeing an increase by 19%.
The requirements align the US with Basel III standards which were agreed following the 2008 crisis with capital, leverage and liquidity requirements rolled out in the ensuing years, as the latest reforms look to end the reliance on internal models in the US for estimating risk and introduce standardised frameworks.
The knock-on effect will certainly be felt across trading and lending activities for prime brokers, with the rules applying to lenders with $100 billion or more in assets and other organisations with “significant trading activity” as regulators continue their mission of reducing systemic risk and enhancing resilience following the financial crisis of 2008.
Elsewhere, other local regulatory changes and benchmark replacements continue to impact prime brokers. CIBC Mellon gives an example: “One imminent change to the prime brokerage business is the discontinued use of LIBOR in the US and CDOR in Canada. Canadian regulatory authorities have announced their support for a replacement rate (CORRA), which is based on overnight repo transactions on government bonds, while the US regulators have proposed SOFR as a replacement. This has caused prime brokers to revisit pricing with all of their clients not currently on one of the replacement benchmarks.”
Elsewhere in the US, the SEC remains on an unrelenting path of regulation, transparency and efficiencies with a slew of new proposals and rules that will potentially create noteworthy changes in the trading of securities and escalate the responsibilities of hedge funds and other market participants in 2023.
Interactive Brokers points out that the SEC’s proposed new Rule 10 around cyber security, if implemented, would require all broker-dealers – as well as other financial service providers – to adopt comprehensive policies and procedures to address their cybersecurity risks.
“Firms would also have to give the SEC immediate written electronic notice of a significant cybersecurity incident, as well as annually publicly disclose their cybersecurity risks and the significant cybersecurity incidents they experienced during the current or previous calendar year. While these regulations may reduce cybersecurity risks across the financial services industry, the costs of implementation may be significant and some of the filing requirements may distract entities when they are dealing with cybersecurity incidents,” the firm explained.
The SEC’s fellow domestic regulator, the Commodity Futures Trading Commission, also let the market know this summer through an advisory that some prime brokers may have to register as derivatives clearing organisations (DCOs), in what could be a burdensome process.
Settlement overhaul
The SEC also greenlit the shift to T+1 settlement earlier this year, as Global Custodian has well-documented. The bulk of the cost introduced by the move to T+1 will be felt by broker-dealers, clearing firms, and prime brokers, but there is also a huge operational and process shift for hedge funds.
“One of the most significant benefits is that it will align the settlement date for options and equity traders, helping everything from treasury financing to margin funding,” noted Clear Street. “This has the potential to lower margin requirements and benefit the buy-side by shortening the time frame between execution and settlement. It will certainly reduce the level of margin market participants must post to offset the settlement risk, particularly during periods of heightened market volatility.”
Technology vendor Broadridge also explains the change in procedures for asset managers delivering trade details to prime brokers and coordinating information among the asset manager, executing brokers and PBs.
“Currently, buy-side firms deliver trade data to executing brokers and prime brokers separately. The trade and allocations details are sent to the prime broker before the trades are matched with the executing broker,” the vendor detailed in a report. “This is a timing problem which causes issues on T+1 if there are any trade discrepancies between the asset manager and the executing broker. When the asset manager and executing broker identify and resolve an exception, the prime broker is out of the loop. That disconnect introduces timing and market risk, not to mention a delay that often stretches for a full day. Obviously, that process won’t cut it in a T+1 environment. Buy-side firms must implement solutions that supply prime brokers with trade details in real time as trades are matched between the asset manager and the executing broker or send the trade details to the prime brokers after the trades are matched.”
Interactive Brokers said it believes the reduction in the settlement cycle from T+2 to T+1 should impact prime brokers positively, as the shift will reduce credit, market and liquidity risks arising from unsettled securities trades, along with a drop in fail rates.
“Following implementation, which may require significant resources, this change may increase efficiency and reduce costs to prime brokers,” the firm said.
In Europe there are also a range of changes in market structure and regulation, ranging from EMIR to Mifid, while a reduction in its own settlement times could be on the horizon in the coming years.
The continually shifting provider landscape
Over the past 12 months we have continued to see the ripple effect of a shift in the provider landscape which very much began taking its form in previous years. The sale of Credit Suisse to UBS was relatively undramatic, given the former had already pulled out of the PB space, but the overall consolidation seen in recent years has certainly reshuffled the pack. Household names Deutsche Bank and Nomura all but departed the scene – joining Credit Suisse – while some remaining bank primes are seeking a diversification of clients, with widespread talk of offboarding or limiting access for numerous funds.
Many mid-tier PBs continue to look upstream and ambitiously add clients who have either fallen foul of exiting primes or been offboarded.
“Where once an asset manager had a litany of prime brokers to choose from, they now are knocked back on various grounds – whether it be due to their size, revenue, or legal structure,” noted challenger prime Lazarus, which adds that “gone are the days of pure-play execution and financing” as prime brokers are evolving to provide day-to-day operations, like clearing and settlements, to market insights and connectivity through research and capital introduction.
As we noted in last year’s Fund Services annual, if the trends around top tier banks cherry picking clients and offboarding are as true as many make out, then a chasing pack of primes are aggressively trying to make their move. The likes of TD Cowen, Cantor Fitzgerald and Jefferies have all looked to capitalise, though without being “ambulance chasers”, as one source highlighted. This section of the market is fierce in competition, with specialities and areas of focus differing between the aforementioned trio and the likes of Fidelity, Interactive Brokers, BTIG and TD Bank – the latter, which announced its acquisition of Cowen, only for the two to be seemingly going different ways at the time of publication.
“The impact of several major players leaving the market has resulted in a shake up in the prime brokerage sector, with a number of prime brokers emerging stronger and having an even sharper focus on what their clients need in challenging circumstances,” said TD Cowen. “Fund managers have also had to adapt, with many re-thinking their approach to prime broking; becoming more selective, working with multiple prime brokers to help manage and grow their business.”
Targeting emerging managers
One of the consequences of this great reshuffle may be the trend towards partnering with several prime brokers, especially those offering the full spectrum of services, and including mid-tier firms in the mix to avail themselves of some of the value-added solutions they can offer.
With the larger banks focusing on larger AUMs and higher revenue clients, there is a battle for new launches and emerging managers.
“Dependency on highly manual processes means that these firms cannot operate profitably with smaller funds, or with funds that have more sophisticated risk profiles or demanding trading strategies,” said Clear Street. “Rather than service these clients properly, the dominant philosophy seems to be that the needs of the prime broker outweigh the needs of their small- and mid-size clients.”
Many of the firms competing for this business are touting the high-touch, technologically innovative approaches they are taking.
“An updated technology stack allows for automation, data insight, and scale in a variety of market conditions, driving efficiency and reducing operational frictions,” Clear Street added. “In turn, high-tech firms can provide funds with front-, middle-, and back-office tools – like order management, risk management, and portfolio management systems – that improve automation and efficiency in their own operations.”
At the top end of the market, the trio of Goldman Sachs, JP Morgan and Morgan Stanley still sit unrivalled and undeterred, despite facing their own regulatory and capital requirement challenges. While a group of banks with different geographical profiles and offerings exists in the likes of Bank of America, UBS, Barclays, Citi and Wells Fargo – to name a few. But for the rest of the market, the space is an entertaining and competitive landscape as hedge funds are looking ever more closely at providers’ overall value propositions and core services, along with commitment to the sector in order to help them prepare for the unexpected and can give them a competitive edge. And in their own world, an arduous journey of navigating challenging markets, shifting regulatory regimes, and ever-increasing data requirements lies ahead. Picking the right partner, or partners (plural) is critical.