Saturday, 25 February 2017
Last updated 21 hours ago
Dec 22 2009 | 8:25am ET
The past 18 months has been tumultuous for the prime brokerage industry. On Sept. 15, 2008, the day Lehman Brothers filed for bankruptcy, hedge funds woke up to the fact that their assets could actually be frozen if a large bank failed. The practice of using multiple prime brokers and having several custody relationships took on new urgency. Hedge funds began to reevaluate their existing prime brokerage relationships en masse.
“There has been a whole upheaval over the past year where managers have asked themselves who they want to prime with and what their reasons are for going with them,” said Matt Simon, an analyst at TABB Group.
With two of the big boys—Lehman and Bear Stearns—gone for good and hedge fund managers reevaluating their relationships with their service providers, primes took a good, hard look at their own businesses. Some acquired new talent (plentiful in a year that saw record unemployment), added research and risk management services, and generally tried to differentiate themselves from their peers. Others courted—and were courted by—large financial services firms with strong balance sheets. And smaller primes that rely heavily on high trading volume were forced to tighten their belts. What used to be a two-tier system—the bulge-bracket primes that catered to the $1 billion-plus hedge funds and the mini-primes that worked with smaller shops—gave rise to a third category: the mid-tier primes.
The Emergence Of The Mid-Tier
A recent TABB report, Prime Brokerage 2009: The Hedge Fund Perspectives, co-authored by Simon, found that among hedge funds that have switched primes in the past year, 64% cited counterparty-risk as the prime reason for the move. This proved a boon for firms that already had multiple counterparty relationships in place.
“Merlin, given its unique position and differentiated offering, was able to add 192 new hedge fund clients in the calendar year 2009,” said Ron Suber, head of global sales and marketing and a senior partner at Merlin Securities. The firm “has the solutions that investors require, like multi-prime, aggregation of assets, advanced analytics and risk… A lot of these other firms did not invest in technology, and they only offer one trading system, whereas Merlin offers six.”
Merlin is one of three firms—BTIG and Jeffries are the others—that fall into the new, middle-rung on the prime brokerage ladder. Mid-tier primes are categorized as such because they have substantial capital, a differentiated product and more than 250 hedge fund clients.
“The mid-primes have an edge, and the market is rewarding them for the edge,” explained Suber. That edge includes services once only offered by the bulge bracket primes, such as access to research and 24-hour international trading desks. Indeed, in a year that has seen nearly 900 hedge funds close their doors while just 550 have debuted, Merlin, BTIG and Jefferies have all managed to pick up new clients while their peers struggle to hang on to existing ones.
Mini-Primes, New Deals and New Entrants
As the mid-tier primes gained market share, the approximately 36 mini-primes—which had thrived by offering smaller hedge funds personalized service—saw their profits fall as trading volume diminished. The economic crisis has pushed some to the brink, while others are using the upheaval in the financial marketplace to strike new deals and beef up their product offerings.
“Given where interest rates are, it makes it very difficult for every prime broker to generate revenue as they historically did,” explained Suber. “And with the VIX declining in the last month or so, there is in aggregate less trading happening, and there is less leverage in the market…. Some of these mini-primes that have solely depended on the trading have seen their revenue streams evaporate and they won’t be able to survive or thrive if they don’t succeed in attracting a lot of new financing and commission business.”
But despite increasingly demanding clients, lower trading volumes and an already crowded landscape, a handful of new players have recently entered the prime brokerage space, and they’ve chosen to do so as mini-prime players.
One of these recent entrants is the ConvergEx Group. But while the firm is new to prime brokerage, its recent acquisition, NorthPoint Trading Partners, is well established in the space.
In November, ConvergEx, which already owned a number of hedge fund-related technology and trading businesses, acquired NorthPoint for an undisclosed sum. Douglas Nelson, co-founder and chief executive officer of NorthPoint, explained that there would be no major changes to the firm. Its name, staff, locations, services and custody relationships—which include JPMorgan Chase, Goldman Sachs, and Jefferies—would all remain intact.
“This is going to put us in the unique position of being the only mini-prime with a large firm behind us,” said Nelson. “The resources and other products that [ConvergEx] has will now be available to our clients, which will give us a good competitive advantage.”
And Nelson admits that in the rapidly changing prime brokerage space, firms—even successful ones—must keep one step ahead of their customers’ needs.
“There is always a level of innovation and a curve that we need to stay ahead of. Since we started the firm our goal has been to act as an aggregator and bring things to our clients that they could not get on their own because it was prohibitively expensive,” said Nelson. “This deal with ConvergEx is going to bring another level of depth to what we can bring to the table in that aggregator model.”
Those new services include access to ConvergEx’s research, LiquidPoint’s derivatives technology and trading software, a 24-hour global trading desk and the Eze OMS technology platform, all standalone entities owned by ConvergEx.
One reason firms like ConvergEx may be inclined to buy an existing prime brokerage rather than starting their own is a simple matter of supply and demand. TABB Group’s Simon, for one, isn’t expecting to see many more prime brokerages launched from the ground up.
“It will be difficult for more players to enter the space,” said Simon. “Startup [hedge funds] are not occurring as frequently… and at the end of the day, how many are you going to able to work with?” Simon asked of hedge funds that utilize more than one prime.
Yet that isn’t stopping another new entrant. In October, investment banking firm FBR Capital Markets hired Shoreline Trading Group’s core four-man team to launch a new unit. It is the first time the publicly-listed company has offered prime brokerage services.
“When you look at the portfolio of products and services that FBR Capital Markets is able to deliver its clients, it changes the entire introducing prime brokerage space,” said Mike Murray, managing director and head of prime brokerage services at FBR, pointing to firm's extensive research department as well as its large balance sheet, a comfort to anyone stung by Lehman and Bear.
In fact, in the TABB study, when hedge funds were asked to rank what was most important when it came to selecting a prime broker, 32% said that it was a firm’s balance sheet.
“Of course, that goes hand in hand with counterparty risk,” explained Simon.
Other newcomers to the prime brokerage landscape include Cantor Fitzgerald, which formed a prime brokerage unit in July, TradeStation Securities, which launched a prime services division in September, and Lazard Capital Markets, which unveiled its new prime unit the same month.
But more prime players means more competition—though after a year of few hedge fund launches, there may be good news ahead.
“We are seeing a tremendous group of new hedge funds spinning out of some of the bigger, multi-strategy platforms in the January/February period,” said Suber, adding that he expects new launches to continue to pick up in the second and third quarters.
And when all is said and done, if TABB’s Simon is right—he forecasts prime brokers’ revenues will top $10 billion next year—even a small slice of that pie can be a lucrative one.
THE PRIME LIST*
Dominant Top-Tier Primes
‘Big’ Top-Tier Primes
Bank of America/Merrill Lynch
Citi Prime Finance
Fidelity Prime Services
Alaris Trading Partners
BMO Capital Markets
Celadon Financial Group
Cuttone & Company
Direct Access Partners
FBR Capital Markets
Gar Wood Securities
Grace Financial Group
Interactive Brokers Group
Lazard Capital Markets
Meridian Equity Partners
MS Howells & Co.
NorthPoint Trading Partners
PCS Dunbar Securities
Saratoga Prime Services
Shoreline Trading Group
Silver Leaf Partners
Terra Nova Financial
*Firms are categorized by size/market share. Firms in each category are then listed alphabetically.