Post-Crisis: Hedge Funds, Custodial Risk and Prime Brokers

March 27th, 2010
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Contributed by: Merlin Securities
Prior to the most recent financial crisis, money managers had an awareness of counterparty and custodial risk in concept, but it wasn’t a priority. We were coming off a 25-year bull-run in the financial markets during which the industry did not experience the failure of a single significant custodial bank. In addition, the broker-dealers that failed (e.g., Drexel) were handled in such a way that custodial risk remained a non-issue. So, while the awareness was there, the reality of custodial risk was not entirely appreciated by the majority of hedge funds and their investors.

The financial crisis and the associated global securities firm failures caused a dramatic shift in the way managers select and work with their prime brokers. Custodial risk quickly rose to the forefront as an issue for hedge fund investors. It naturally follows that hedge fund managers would respond, and today multi-prime and multi-custodian relationships are considered best practice in the industry.

This shift is all the more significant when one considers that for 20 years the prime brokers operated more or less as an oligarchy, dominated by a few bulge bracket firms. During that time hedge funds, even large ones, typically maintained only one or two prime brokerage relationships that provided custody, clearance, stock loan, technology and a host of other services.

The largest hedge funds have always been the most attractive segment of the market to the major prime brokers. They borrow large amounts of money and generate significant trading commissions and securities lending revenue. In addition they generate sizeable revenue for the various profit centers of the global firm, including derivatives, research and capital markets, and they generally provide for their own operations and infrastructure. After the crisis, the big banks intensified their focus on the top 250 or so managers at the expense of the smaller hedge funds. The past 18 months has been an unprecedented period of custody change as funds switched their primary prime brokerage relationships and went multi-prime. The oligopoly of the last 20 years was broken as the global players (Deutsche Bank, Credit Suisse) penetrated the market with the strength of their balance sheets and as the dominant U.S. broker-dealers retrenched. Across Wall Street, services for smaller funds were pared back; customer service staffs were reduced, capital introductions and hedge fund consulting groups were decimated and, at most firms, investment in technology for hedge fund reporting came to a halt. Funds with less than $1 billion in assets under management found themselves without the support, technology and service that they relied on and had come to expect from the large providers.

A new wave of players has emerged in the prime brokerage services market to fill the gap, and what was a market of roughly 20 providers circa 2007 has more than doubled. The landscape today consists of four tiers, as represented in the chart below:

The increased competition in the prime brokerage market has brought a number of benefits to managers, who now have more options and can select the optimal mix of providers to suit their specific needs. With each of the four tiers comes a distinct set of advantages and disadvantages:

The Major Primes
This group represents the major global banks who have committed significant capital and full firm resources to building out and maintaining robust global prime brokerage businesses. While these firms handle a portion of most of the largest funds in the world, they are also highly selective, working primarily with the top 250 high-profile funds generating very significant fees across their franchise. The challenge and opportunity for the Major Primes now is how to protect their market share while deepening their relationships with their large fund clients. This is complicated by large funds and institutional investors requiring custodial diversification for their assets. The Major Primes remain interested in smaller funds with good pedigrees and those deemed as high-probability growth opportunities. However, smaller funds run the risk of not getting the attention they need and possibly facing higher fees if their growth lags.

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