Convergex: Innovation in Prime Brokerage and Clearing

Jun 1 2016 | 10:19am ET

Editor’s note: The prime brokerage business continues to evolve, with newer entrants relying on technology and innovative partnerships to address the increasingly complex needs of their clients – particularly around risk mitigation and hedging. In the case of New York-based Convergex, this innovation has led to an expansion into broader derivatives clearing and a new securities lending service, whereby clients are compensated to loan out fully-paid-for long positions. FINalternatives managing editor Steven Lord caught up with Doug Nelson, head of global clearing and prime services for Convergex, to explain.

FINalternatives: Convergex has debuted two new capabilities in recent months, a clearing agreement with futures specialist INTL FC Stone Financial and the rollout of a fully-paid for securities lending service. How do these steps relate to trends you are seeing in the prime brokerage business, and where do you want to take Convergex Prime?  

Doug Nelson: Our clients are always evolving and we are always listening to our clients to help address their needs and solve their problems.  We view these new additional product offerings as value added not just to our Prime clients, but also to the wider Convergex client base that may not be maximizing the value of their long positions and whose existing prime brokerage or custody relationships may not offer a robust futures platform.

The trading environment of the last 12 months has again illustrated the value of understanding portfolio risk at a macro, instead of positional, asset or market level. Accordingly, are you seeing traditional long/short hedge fund managers using futures/derivatives more as a hedge mechanism these days, or as a potential source of alpha?  

The simple answer is both.  The more sophisticated portfolio management and risk technology gets, the more interest we have seen in the derivatives markets.  With better tools, our clients are better able to understand the risk/reward and value-add of these types of products.  We expect this trend to continue. 

Does the FCStone arrangement mean Convergex Prime is aiming more at the CTA/CPO marketplace? How does the integration of the new arrangement improve on what Convergex already offered its futures-trading clients?  

We have always had a futures offering, but the new FCStone relationship greatly expands our capabilities and allows us to cater more to CTA/CPO clients. We also see this as a big growth market for more traditional portfolio managers. Many people assume that since the derivatives marketplace is more sophisticated, it is also more institutional. That has historically not been the case. If you think of the pension, trust, and 40-Act fund world, these are entities that have not been very involved in the futures markets in the past.  With the proliferation of liquid alternatives and better risk and collateral tools available today, we expect a much bigger institutional footprint in futures and derivatives products going forward.

Take us through the new securities-lending enhancements to your platform. How do you handle the collateral and mark-to-market requirements of this kind of activity? Was it done through a collaboration with your clearing division? And was this step driven by an increased interest in short-side trading since last fall or was the timing unrelated to market events?  

Yes, this was in collaboration with our clearing division.  Convergex clears for more than 50 broker/dealer clients worldwide, and has an independent stock loan team as part of our clearing offering. We found that many Convergex clients are either not maximizing the income they can receive, or don’t even realize that they can be compensated for their fully-paid, long positions, so last year we decided to begin the integration for this offering.  

Essentially, clients can open an account with Convergex Prime that will be custodied at Convergex Clearing, and deliver in any long positions that they want to lend out. We will lend out those securities at the best rates we can, utilizing our international network that has been in place for years. Our goal is to not only maximize the rate paid, but also to maximize utilization and lend those shares as much as possible.  This is an activity on which many of our clients don’t focus, and thus don’t realize the amount of money they are leaving on the table.  We have integrated all the daily data into our portfolio management system and are able to provide daily reports or data to our clients to minimize the impact on their daily workflow.  A main differentiator of the Convergex fully-paid for lending program is that we strive to be proactive instead of reactive.  Our team aggressively seeks to place a client’s stock with institutions that want to hold the position for a significant amount of time instead of waiting for requests to cover short- term deficits in the security.

Much has been written about the changes in the hedge fund industry over the last few years. From the prime brokerage point of view, how would you describe the state of the alternative investment industry now compared to five years ago? How about compared to pre-crisis?  

Despite many of the negative headlines and increased regulatory burden placed on the hedge fund world in the last several years, we continue to see growth in the space. Last year was the best in our history in terms of new client asset growth. As the space has matured, there has been a dramatic increase in the number of cost-effective service providers (attorneys, administration firms, accounting firms, software/technology providers, etc.) that make it far more affordable to launch and run a small fund than five years ago. This has helped to counteract the increased cost of regulation. It is also easy to forget that not every hedge fund is trying to reach a billion dollars in assets under management – we have many clients that manage small-midsized funds that do a great job for their clients and run great businesses.  Not everyone needs to “rule the world”.

Relatedly, post-crisis regulation has altered much of what goes on in the alternative investment space. What have been the largest impacts from Basel III, Dodd-Frank, ESMA, AIFMD, etc. on what you do? Will these changes lead to continued consolidation in the industry? 

These changes have had a large impact on the clearing space, as evidenced by JPM exiting the business last year.  JPM was probably the largest custodian of small-midsized hedged funds, so this was a large shake-up in our industry.

Other clearing firms have limited certain types of activity that were causing larger balance sheet usage than previously, which has in turn caused more limited choices for some strategies. In some cases, these change have made them not economically viable.  We have found that different clearing firms with different mixes of business have different views of what types of strategies they want, so our model of offering multiple clearing options has been even more attractive to these clients.  We view this industry consolidation as a positive for a firm with our position in the market.

Liquidity, or lack thereof, has become a hot topic since last fall. Was your recent launch of multi-leg capital commitment crossing algos to facilitate liquidity sourcing a step in addressing this problem? How else are prime brokers adapting to the lack of dealer/bank balance sheet capability?  

Yes. The ability for Convergex to offer its own world-class algorithms has been a big positive for our prime clients.  We continue to listen to their needs, and innovate to create new offerings to meet them.

Liquid alternatives were all the rage until late last year, when they suffered from global market volatility and investors learned that while their liquid alternative fund might be liquid, the securities it owns may not be at all. What do you think the future holds for liquid alternatives?

I think we are in the early innings of the liquid alternative game.  We have been in the liquid alt space since very early on, bringing our first clients aboard in 2007.  While I do not think you will see the same pace of launches as in the last few years, I am convinced that the liquid alt space is here to stay, and will continue to gather assets.  It really makes no sense that average mutual fund/retail investors should not be able to access more sophisticated, and in many cases lower risk, strategies just because they are not qualified to invest in an LP.  Also, contrary to what some believe, the vast majority of the liquid alternative world is comprised of relatively straightforward strategies that use some directionality or derivative exposure to gain alpha and manage risk.  While it's true that some of these strategies may hold less liquid securities, and they could be a negative in some market conditions, I don’t think this is any different than we see with some strategies the long-only, or ETF world.


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