Buy-Side Technology - Concept Capital signs with Paladyne
October 1st 2007

Features

Multiple choices – Not all prime brokers are created equal: Joel Clark investigates the criteria employed by hedge funds to differentiate one prime broker from another, and concludes that the multi-broker model is the most feasible and flexible approach for most buy-side players.

The relationship between hedge funds and prime brokers has always been complex, but as alpha remains the objective for fund managers and as markets remain volatile, that relationship is changing. Joel Clark investigates the criteria funds employ to distinguish prime brokers

Selecting a broker is a difficult choice for any institution in the financial markets, but for hedge funds that move in the shadows and are cautious of revealing even a hint of their alpha-generating strategies, that selection is even more complex. As the majority of prime brokers act within the walls of investment banks that trade in the same markets, hedge funds have to be sure they have found a worthy, trusted bank to take them to market.

For the investment banks, prime brokerage has become one of the most lucrative parts of their business because such a large amount of money is being traded. Since its inception more than a decade ago, the industry has been largely dominated by some of the biggest players on Wall Street and in the City, including Goldman Sachs, Morgan Stanley, Bear Stearns and UBS. Acting as broker for a large proportion of hedge fund assets, those banks have surfed on the tide of their respected names and maintained a reputation for being the best in the business. But despite Buy-Side Technology's sensitive probe into what makes them tick, all of the aforementioned banks responded with a resounding wall of silence, refusing to discuss their operations in any context. Their silence makes the market a difficult one to analyse, but whether they will continue to dominate the hedge fund world in the years ahead is ultimately a matter for the funds themselves to decide.

Making the choice

The advantage of using one of the top banks as a prime broker has been that investors have confidence that their hedge fund managers have chosen a reliable firm that can be trusted to finance their assets. But although hedge funds may traditionally have selected their prime brokers on the basis of their perceived standing in the market, those parameters are now changing as fund managers seek any competitive edge they can glean over their peers. "Prime brokers have historically always been selected on the basis of their ability to service the strategy that a fund manager is pursuing in his fund, and prime brokers have built up very strong skills in certain areas of the market," says Rory Gage, a consultant at Morse. "More recently, the larger prime brokers have been building out their multi-asset capabilities and looking at providing services equally as good across all asset types." The move towards cross-asset capabilities has driven some hedge funds to re-assess the prime brokers they are using and question whether they are being given the best service, says Gage.

Cost of services is another differentiator driving funds to re-think their prime broker relationships. Investment banks generate a great deal of revenue from the fees they charge to hedge funds, but those fees can vary a great deal from one broker to another. Sarah Williamson is managing director of HedgeMasters, a London-based consultancy that works to help hedge funds get the best possible deal from their prime brokers. Having worked previously in prime brokerage at Lehman Brothers and UBS, she saw the opportunity to level the playing field in prime brokerage and has advised 12 hedge funds over the past five years. "Prime brokers get their competitive advantage by having proprietary pricing strategies and they price their products in very different ways," she says. "We have seen hedge funds that look pretty similar in terms of strategies, assets under management and volumes, but they often have different pricing structures with their prime brokers."

Multi-asset broking

While cost is certainly important, the flexibility to handle securities across asset classes has certainly become more significant in prime brokerage, as in other areas of the financial markets. At Credit Suisse - one of the few investment banks to respond positively to our enquiries - multi-asset prime brokerage is a priority that executives have been working on for some time. They believe that the demand for this flexibility has replaced the hedge fund tendency to choose a big prime broker on the basis of its name and standing. Sal Ventura, Credit Suisse's managing director responsible for client services within prime brokerage, says that brokers who can give the highest quality service across the asset class spectrum are the ones that are faring well. "As hedge funds look to their prime brokers for alpha-generating ideas, it is certainly a distinguishing factor if the prime broker can provide the highest quality execution and access across a broad asset class spectrum."

But while Credit Suisse claims full asset class coverage, Ventura says this is not the case for all prime brokers. Different banks have developed their particular niches and expertise, he says, so there aren't many prime brokers who can meet the needs of all their funds across asset classes. Although they may have captured the lion's share of the market, Goldman Sachs, Morgan Stanley and Bear Stearns are known to specialise mainly in equity and equity derivatives prime broking and their expertise in fixed income and futures is less well-developed. But Credit Suisse merged its equity and fixed income desks two years ago and prides itself on providing cross-asset prime brokerage to hedge funds.

Going multi-prime

If multi-asset class is a developing trend in this market, multi-prime is its twin buzzword. As hedge funds continue to re-assess the deals they are getting from their prime brokers, many have chosen to contract the services of multiple prime brokers. Over the past few years, Ventura says he has seen the majority of funds becoming multi-prime, particularly if their assets have surpassed $500 million. "Many funds seek to become multi-prime in order to avail themselves of the expertise that one prime broker might have over another in a particular asset class or product."

The need to go multi-prime does not derive solely from a desire for extra asset class coverage, but also from a need to access other strengths of different prime brokers. "The classic is stock loan," says Williamson. "Some prime brokers are better than others at sourcing difficult stocks to borrow. If you're a very niche fund, you might need to access a few prime brokers to source the right stocks."

Dividing hedge fund assets between several prime brokers also has the added advantage of spreading risk and avoiding damaging data leaks. "Fund managers are uncomfortable giving out position-level data to their prime brokers, even though we do have Chinese walls in this business" says Gage. "A lot of prime brokers, including Morgan Stanley, have completely separate systems to make sure client position information is kept separate from the trading division. But if a fund manager is pursuing strategies in illiquid areas of the market, they will be keen to have more than one prime broker so as not to be out on too much of a limb."

While prime brokers have traditionally tried to bind clients into their services, some now accept that multi-prime is the way hedge funds want to operate and are offering technology and services that can be used with other prime brokers. Though it was late to the game in prime brokerage, entering the business in 2004, Citigroup has created a portfolio management system through Linedata's Beauchamp technology that allows funds to go multi-prime. The offering, known as OpenPrime, was launched last year and is now being used by a significant proportion of the bank's hedge fund clients.

"A lot of our competitors offer solutions that bind hedge funds to using that prime broker exclusively and won't work with other prime brokers," explains Denis Jackson, managing director of prime finance sales for Citi in EMEA. "We think it's unrealistic to expect our larger clients to do all of their prime brokerage with one firm and an open architecture approach has to be a more scalable and robust product over time for our clients."

Credit Suisse prime brokerage took a similar approach to its technology when it launched Advanced Prime in June this year. Taking front-office technology from Paladyne and back-office servicing from Viteos, the bank packaged up a platform which allows hedge funds to aggregate multiple prime broker feeds.

"Hedge funds are facing the difficult challenge of quickly implementing new alpha-generating ideas while also adhering to their internal controls and mitigating the infrastructure costs associated with obtaining the right operations personnel and technology platforms," says Ventura.

"Advanced Prime allows fund managers to concentrate on alpha-generation and improves their time to market by providing access to skilled personnel and robust technology."

Technology wins

The recent launch of Open Prime at Citi and Advanced Prime at Credit Suisse are testament to the fact that technology has become a central tenet to what differentiates one prime broker from another. Sarah Williamson says it is no longer satisfactory to select a prime broker without fully assessing the strength of its technology. "If I were an investor, I would want a hedge fund to have rigorously checked out all the systems that were available to it and make an informed decision based on their investigations, rather than just use a system because it was part of another deal," she says.

Mike Pratt, founding partner of Modulus Capital, a US-based statistical arbitrage hedge fund, selected Goldman Sachs as his prime broker when he founded the fund two years ago. Pratt says he made the selection largely on the basis of Goldman's technology. "We do high-speed, high-frequency automated transactions and we needed robust technology in our prime broker to clear all those trades," he explains. "Where some hedge funds need to evaluate the prime's ability to raise money and borrow, we were only concerned with the technology, which made it an easy selection."

With between 50,000 and 100,000 transactions each day, Modulus may not be a classic example of how a hedge fund selects its prime broker, but it is a testament to the centrality of technology. Modulus uses New York-based Lime Brokerage for connectivity to Goldman Sachs as well as reporting and monitoring of positions. Lime has taken a different approach to prime broking and prides itself on a specialised, high-tech offering. "Most major primes try to be all things to all people," says Kevin Snow, director of sales and marketing at Lime Brokerage. "But we try to be a more high-end offering than what these banks can offer and we do only execution and clearing, catering for fully-automated electronic traders who trade very high volumes."

Turbulent times

Recent squeezes in liquidity resulting from the US credit crisis are certainly having an effect on prime brokers as numerous hedge funds have buckled and survivors seek stability from their counterparts. "At a time like this, there's a lot of volatility and the prices of securities held by hedge funds are moving quite a lot," says Williamson. "The last thing a hedge fund needs is suddenly to have to put up more margin, because that might mean liquidating positions, and worse, losing money on those positions. We sometimes advise funds not to leave large excess cash balances with the prime broker and not to put all their eggs in one basket - relying on one bank can be a big credit risk."

One sign of the liquidity squeeze, she says, is that funds are increasingly asking their prime brokers to provide segregated accounts so that hedge fund assets are ring-fenced and easily extractable if the broker goes bankrupt. Citi has seen a rise in demand for segregated accounts in the past few months and offers the service to hedge funds at an increased cost. "Over the past two months, we've seen more focus from hedge fund managers on the liability side of their balance sheet than we have seen for some time," says Jackson. "People are making very careful decisions about who they want to have their financing balances with. At this point we're seeing a lot of business based on who we are and what we stand for during a period of financial turbulence. Market conditions are certainly playing to our strengths." ><

Multiple choices - the seven questions a fund may ask of a PB

- Is the broker part of an investment bank or a broker-dealer?

- Can it service the strategy I want to pursue?

- Does the prime broker have expertise in more than one asset class?

- How much does the prime broker charge for its services?

- Can it perform back-office services efficiently?

- Can the prime broker be trusted with the my position-level data?

- What technology does the prime broker offer out to its clients? Is it robust enough to handle my assets?

Prime brokers, brokers - what's the difference?

Prime brokerage refers to the package of services offered to hedge funds by investment banks. Prime brokers provide a range of services including asset servicing and clearing, securities lending, financing, operational support and technology. Prime brokers earn fees for the services they provide to hedge funds.

A broker refers to any party, bank or otherwise, that mediates between the buyer and seller of any type of security.

Salient points

- Hedge funds are increasingly choosing to use multiple prime brokers and are especially keen to find those that can service securities across asset classes

- Some prime brokers, including Credit Suisse and Citi, have created open architecture technology that no longer locks clients into a single prime broker

- During recent market volatility, hedge funds have looked to prime brokers for stability, meaning the big banks have done well.

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