Long before Wal-Mart became a four-letter word in downtown business districts in the United States, there was a chain of stores in the U.S. Pacific Northwest called Fred Meyer. In one trip to Freddy's you could buy everything necessary to host a barbecue on the your back deck, including the food, the grill, the charcoal, a table and chairs, new clothes, an apron, and all the lumber, nails and other materials to build the deck.

When Fred Meyer was expanding in the 1980s, it was a big deal to get one in your town. The lure of one-stop shopping was hard to resist. Downtown businesses loathed Fred Meyer, and some closed because they couldn't compete from a convenience standpoint. But now a number of those old downtowns are making a comeback, riding a wave of nostalgia for traditional downtowns and populated by niche businesses featuring folksy customer service and unique merchandise. It's classic market economics at work.

Something similar may be happening in the hedge fund industry—a natural, market-driven shift away from one-stop shopping and toward a more fragmented landscape made up of niche businesses that wear their individuality as a badge.

For the better part of five decades, the hedge fund industry was itself a niche, chugging along mostly with assets from high-net-worth investors and later from endowments and family offices, but never with more than a few billion dollars—until the mid-1990s. In 1995, industry assts stood at about $76 billion, according to the Hennessee Group in New York, down from a high the previous year of $99 billion. By 1998, hedge funds had $210 billion. Everyone knows what happened after that—industry assets today are approaching $1.5 trillion by some estimates.

When the boom started, there were only a few players who could handle the sudden demands for infrastructure, trading and technology from the ballooning number of start-up hedge fund managers. Prime brokers were among those players, and specifically the larger prime brokers. In addition to the critical core brokerage functions, they had the economies of scale to respond to the need for ancillary services like office space, computers, phones, risk management, information technology, etc.

At the time, it was just what the industry needed to grow. And it's still a fine system for plenty of hedge funds. Getting all the help they need from a prime broker they have to have anyway makes sense. The lure of one-stop shopping can be hard to resist.

Things are changing, though. New technology firms are seeing opportunity in the rapidly expanding number of hedge fund managers. Independent providers of so-called hedge fund hotels have begun operating on both U.S. coasts, providing office space for start-up hedge funds. Even some financial services firms have begun to market their ability to provide better execution of some non-core trading functions, like foreign exchange, than prime brokers, and at a lower cost.

Brown Brothers Harriman & Co., New York, is actively seeking foreign exchange business from hedge funds. Marc Chandler, senior vice president of currency strategy at BBH, says his firm has been acting as a custodial bank, catering to the back-office needs of mutual funds for years. Many mutual funds give their foreign exchange business to their custodians because there's less paperwork involved and it's just easier, Mr. Chandler says.

So BBH is touting the job it does for its mutual fund clients in a new push to attract hedge fund FX business away from the prime brokerage houses. In discussing BBH's strategy, Mr. Chandler uses the term "captured business," which means non-core business that a prime broker gets from its prime brokerage clients—like foreign exchange trading—perhaps simply because it's easier.

"Captured business is less likely to get the best prices," Mr. Chandler says. "For hedge funds that trade currencies through their prime brokers, we say that what we do for the mutual funds is the same thing we can do for a hedge fund that trades through its prime broker. It's a business proposition. Seeing that some people, because they're captured business, don't get the best execution, we think we can improve on that."

In Toronto, a new firm called KnowledgeSuites has opened a hedge fund hotel to start-up firms in Canada. To date, few of the prime brokerage firms there have opted to provide that kind of service, mainly because there hasn't been much demand. Hedge fund industry growth in Canada is still in its early stages. But the Canadian hedge fund industry is growing and maturing quickly, and W. William Woods, president and chief executive of KnowledgeSuites, says that opens up room for new service providers to thrive.

"In the early phase of growth in the hedge fund market, the prime brokers are critical players," Mr. Woods says. "They generally provide two crucial things: seed capital or introductions to seed capital, and secondly leverage that enables the manager to get going. As the market grows and it's successful, the prime brokers tend to go after the bigger hedge funds and are less and less interested in start-ups. You get this secondary market of service providers focused on the start-ups. That's where more neutral hedge fund hotels come in."

The number of announcements for new businesses to serve the hedge fund industry attests to the fact that, certainly in the U.S. and European markets, hedge fund industry growth has reached a stage of maturity at which the secondary service provider market is expanding rapidly.

Earlier in May, Reuters Group and the Chicago Mercantile Exchange announced they were expanding their partnership to provide spot trading in electronic FX via Reuters desktop stations to create a new platform that will allow for the creation of a centrally-cleared global FX marketplace. FXMarketSpace will, in theory, cut prime brokers out of the trade clearing and credit provision functions they have traditionally had in foreign exchange, allowing users direct access to the marketplace via CME's Globex platform and clearing through CME Clearing.

Many of these new players bidding for hedge fund business are not trying to steal core services from the prime brokerage firms. Instead they are operating on the margins. Sameer Shalaby, chief executive of Paladyne Systems, a New York-based firm providing front- to back-office technology for hedge funds, says the prime brokers probably won't even miss any non-core business they lose.

Take hedge fund hotels, for example. "Those are all over and they're probably going to be fine for a while because they're executive office suites," Mr. Shalaby says. "I wouldn't put those kinds of service providers in the prime arena at all. Prime brokers are less and less interested in offering those kinds of services. It's not really their core competency."

What prime brokers are noticing, however, is another new trend Mr. Shalaby and Paladyne have identified: The growing tendency for hedge funds to employ multiple prime brokers to reduce costs, get better execution, disguise trading strategies or diversify risk.

As things stand, using multiple prime brokers can be tricky because prime brokers have not cooperated thus far on making it easy to integrate data from multiple sources. The same difficulty is present to some extent for hedge funds that shop around for the best deals and best execution for non-core services, Mr. Shalaby says.

The issue is how to bring all the disparate data from multiple sources together to generate one clear picture of what's going on in terms of positions, risk, profit and loss, order management, etc. "You need an accounting system that can pull in the trades," Mr. Shalaby says. "An order management system can also pull them in and give you profit and loss reporting. Then you integrate that with the risk system, and with an accounting system. Then you need a consolidated security master that covers all the systems, then an end-reporting system, counterparty risk management, compliance. That's a pretty significant investment. Very quickly it could be a million-dollar annual cost, whereas in the past they were getting it all from Morgan as a consolidated platform and they weren't paying anything except commissions."

So there are drawbacks to shopping around. Just as in towns with new boutique-y business districts offering alternatives to Wal-Mart or Fred Meyer stores, some people will ultimately decide that it's just easier to drive to one place and do all their shopping. They either don't mind paying a little more for the convenience, or they figure that what they save in time and energy will end up making the one-stop shop less expensive anyway.

However things shake out in Hedge Fund Town, it should be fun to watch classic market economics at work.

CClair@HedgeWorld.com