In the pre crash world, when markets were booming, hedge funds surged to USD2 trillion in assets under management and the prime broking community, led by the specialist prime brokers, Goldman Sachs and Morgan Stanley, grew symbiotically. Then Lehman’s folded, liquidity froze and the model of prime broking that had seemed to have such potential basically curled up its toes and died.

The changes that have resulted have been many and various, and as Alex Ehrlich, Global Head of Prime Brokerage Services at UBS, puts it: “The marbles are still rolling and anyone who thinks they know what the final shape of the new model for prime broking is going to be is probably deluding themselves.”

Ehrlich argues that we are currently in a period of relative calm, with a huge amount of analysis and deep thinking going on at a subterranean level, out of sight, as various players seek for ways to  position themselves to win market share in what everyone agrees will be a very different world.  

There are at least two huge factors that everyone agrees on as determining characteristic of the new dispensation. First, with Lehman administrator PricewaterhouseCoopers (PWC) refusing as yet to release both cash and fully paid for assets of some Lehman hedge fund clients, segregation of fully paid for client assets from the fund’s prime broker assets is now a huge concern for hedge funds.

Second, the old model, which saw prime brokers able to massively leverage client assets to generate funds to lend on to hedge fund clients, is now impossible to operate. In the first place, segregation of client assets limits the use of rehypothecation by the broker. In the second place, there is still not sufficient liquidity in the market to enable that kind of leveraged model to work. This second point, of course, could change as and when markets take on more of a positive tinge, but the segregation point looks to be settling in as a permanent feature of the landscape.

Roy Martins, Head of International Prime Services at Credit Suisse argues that this new landscape plays extremely well to well-capitalised banks. "The bank model has proved successful in this space. We were also very selective about the hedge funds we took on as clients and that strategy has worked well. These funds are well positioned as investors look to recycle cash back into alternatives," Martins says.

Credit Suisse continues to see significant flows of new business and now sits on a par in Europe with Goldman Sachs and ahead of Morgan Stanley – a significant change from before the crash. "If you look at the latest surveys, last year we had four times less client assets than the number one prime broker. Now we are on a par, which shows our positive momentum" he comments.

For Martins, the secret is the ability to give hedge funds the kind of in-depth funding that only a bank can provide. "Today there are no real broker-dealers left. That model relied to an extent on using client cash to fund the business." The way forward suggests that well-capitalised banks will succeed.

Going forward, he suggests, the debate will also be focused on the value-added that the bank can provide to its hedge fund clients. "There are two over-riding concerns here for hedge funds. One is the quality of capital available to them. The second is securities lending/synthetics," he says.

Martins points out that key industry surveys put Credit Suisse at the head of the pack on this issue. "If you look at securities lending or swaps, we rank number one. These are the strengths that attract the big hedge funds," he says.

Martins says that Credit Suisse recognises that post-Lehmans many of the larger hedge funds are going to want to implement a multiple prime broker, multi-asset class strategy. To facilitate this Credit Suisse has what it terms "advanced prime services". A strong element, he says, is its operating platform, which is highly scalable in terms of asset classes and products, with a strong futures capability.

Additionally, securities lending continues to be a key part of a prime broker’s revenue stream, with margin lending being the other big revenue driver. "With synthetic products, execution flow goes with the financing provider so you need a very strong execution team," he comments.

Andrea Angelone, Global Co-head of Prime Brokerage at JP Morgan, points out that HMT is currently circulating a paper (“Investment Bank Insolvency Arrangements; A Discussion Paper”) for discussion among the financial community with the aim of understanding, among other things, why “the UK insolvency regime applied in the Lehman Brothers International Europe failure did not allow the return of cash and fully paid up assets to clients”.

There is general acceptance that the US model is much better at ensuring segregation of client assets in a way that prevents the liquidator from holding on to those assets in the event of the PB defaulting. “Some of the key differences in the US model over the UK model have to do with the fact that the US model tends to prioritise the customers in a liquidation of a broker dealer even if it limits the re-hypothecation rights or imposes stricter segregation requirements of customer accounts,” he explains.

The next stage in this discussion, after the Treasury has absorbed the industry feedback, will be a  consultation document. “What is clear is that the administrators are required to distribute client assets promptly, but they have to go into the full complexity of the cross liens in the various Lehman subsidiaries. What we are seeing coming out of the present discussion is a requirement for more transparency and more up to date information about identification of client assets, assets re-hypothecation, assets used as collateral, client money held by affiliates, and close out procedures” he says.

Angelone points out that although the major banks with an interest in prime broking are now jocking to gain market share on the basis of both providing safe custody for client assets, and on the back of their ability to provide at least a modicum of liquidity to some hedge fund clients, there is as yet no clear leadership on the future of investment banking.

“The banks may have a certain amount of liquidity to offer to the right customers now, but there are a lot of other things going on, including bad assets on bank balance sheets and the de-leverage of them. What is clear is that banks that have access to the central banks facilities now need to comply with the rules laid down by the central banks, including the need to be within defined regulatory risk capital ratios” he says. That of itself suggests a different kind of prime broker model, one that is going to be a lot more cautious than the old, now defunct, model.

There are other issues for the prime brokerage community, he suggests, not least of them being that the kinds of investment models that are likely to work over the next year or so do not play well for prime brokerage revenue streams. “We expect the distressed fund strategy to see a lot of play. There is a great deal of investor interest in this area, but distressed funds do not need leverage. It is a pure investment play and as such there is not much for a prime broker to do for the client,” he notes.

Further, the balance of power has shifted from hedge fund managers to investors and many larger investors are now pushing hedge funds to provide them with segregated, managed accounts. The advantage for the user is that it means that if they want to redeem their money, there are no other investors in the queue before them. From the manager’s point of view, however, it means a lot more investor communication and possible investor interference in the fund’s investment strategy.

Moreover, as Angelone explains, the access to leverage via the hedge funds’ prime broker is limited. “The segregated managed accounts approach (as stand alone legal entities) imposes limitations because you can not pool the accounts for leveraged purposes. Moreover, it is the investor, in specific types of managed accounts, that owns the fund assets, not the hedge fund, and that too imposes restrictions on the hedge fund manager when it comes to running its strategy ,” he points out.

Another factor implementing the hedge fund/prime brokerage relationship today is the way some hedge fund managers are using the Ucits III framework. The idea is that investors feel safer with the Ucits framework and the Ucits market, after all, is worth some USD5.3 trillion, around five times the size of the reduced 2009 hedge fund market.

“From the prime broker point of view, the structure has a lot of parallels to custody plus prime broker-type arrangement, so PBs can have a role in this space. However, Ucits does not allow re-hypothecation, and there is limited scope for leverage as well as very limited scope for short selling (only via synthetics), both of which limit the appeal of the UCITS structure for prime brokers,” he comments. Prime brokers want the relationship with the larger hedge funds that are setting out to win big institutional UCITS mandates, but they’d appreciate those hedge funds to also win more traditional hedge fund leveraged long short mandates.

UBS’s Ehrlich says that the overriding factor in the current hedge fund/prime broker relationship has to do with counterparty risk. “A year or two ago people thought that the financing component of the prime broker service was the commodity part. Now the only thing that matters is counter-party credit worthiness,” he comments. The ability of banks to be the primary financing counterparties in a hedge fund environment of growth and leverage remains slight, so that kind of environment is being stifled at present. “We may have retreated 25 % from the precipice that the major banks were staring over six months ago, but that doesn’t mean that anyone can say that liquidity is not a problem any more. I expect this to create an environment in which alternative financing mechanisms will take root,” he says. The share of financing  that belonged unreservedly to PBs two years ago can only go down, going forward.

David Aldrich, Managing Director, Alternative Investment Services at Bank of New York Mellon says the bank conducted a survey recently which showed that the industry expects hedge funds to shrink from around USD2.3 trillion in 2007 to just over USD1 trillion in 2009, but that the expectation is that new money flowing into funds will push it past the 2007/2008 high water mark by 2013.

“The bottom line is that institutional investors want hedge fund, or absolute return, exposure and they are going to increase their mandates to the sector. So prime brokers are going to be setting out their stall to win that business,” he says. Aldrich too, believes that the new winners in this space will be the big banks, who are best placed to provide credit and securities lending. However, BNY Mellon believes that having turned themselves into banks in their turn, the big broker dealers, particularly the prime brokerage giants, Goldman Sachs and Morgan Stanley, will come back fighting for market share very aggressively.

He points out that BNY Mellon services both hedge funds and prime brokers. “When we work with prime brokers now, we are working with them to help them redesign the structure of prime brokerage, with the main change being the need to create segregation of client assets,” he comments.” BNY Mellon also acts as an intermediary for the Investment Banks and their hedge fund clients in two key areas, “Margin Direct”, which is the servicing of the independent amounts for ISDA CSAs to reduce counterparty risk, and triparty collateral management, which is the collateralisation of the financing relationship between the parties to cover any net exposure.

The custody and collateral management of prime brokers’ assets reinforces the roles of the custodians and international central securities depositaries, as Frank Reiss Director at Euroclear and Head of Equities Product Management, recognises. The segregation of assets is key to protecting investor rights. And the use of triparty agents, such as Euroclear, is an excellent way to ensure the proper segregation and monitoring of the assets under custody.

“Prime brokers are looking for ways of monitoring the assets they have under management much more closely, and in talking to us, they realise that they can very easily partition off proprietary assets from clients’ assets and keep these assets in a fully secure environment,” he says.