Prime brokers play key role in helping hedge funds in trade execution and regulatory compliance

Prime services are evolving as the hedge fund industry faces increasing compliance pressure from regulations in the US and EU. OTC derivatives exchange clearing will also develop service offerings.

The collapse of Lehman Brothers and the bankruptcy of MF Global, announced a year ago, brought issues of counterparty risk and asset protection to the fore for hedge funds. The fallout from MF Global has also highlighted the need for a reassessment of the relationship between hedge funds and their prime broker.

The result has been a much more responsive prime services offering. For example, Goldman Sachs set up a custody service in partnership with BNY Mellon around 18 months ago. The service, known as Custody Plus, enables Goldman’s clients to shift fully paid-for assets back and forth between the bank and custody accounts with BNY Mellon.

“Hedge funds continue to focus their attention on counterparty risk and asset protection by optimising their exposure to the prime brokers and clearers,” says John Willian, global head of prime brokerage at Goldman Sachs .The bank has developed several offerings, which enable Goldman’s clients to move fully paid assets to bankruptcy remote entities while still receiving the reporting and asset servicing benefits provided by the traditional prime brokerage business.

Goldman has nearly completed integration of all its clearing-related businesses into a single client platform. In order to offer what Willian describes as a “one-stop shop for everything to do with clearing”, it has focused on bringing prime brokerage, futures clearing and OTC clearing together.

After the collapse of Lehman in 2008, hedge funds adapted their businesses and thought they had learned all their lessons, particularly on re­hypothecation of assets and the need for segregated accounts.  MF Global taught them needed to do more.

Spurred on by this realisation plus client demands for reduced counterparty risk, hedge funds have increasingly used prime custody services to ring-fence unencumbered assets.

Hedge fund assets available for prime custody have increased by 40% since 2010 to $684 billion at the end of August 2012, according to a study by BNY Mellon. The increase in assets kept with custodians is a result of increasing industry assets coupled with reduced reliance on prime brokers for financing, according to BNY Mellon, which was ranked number one custodian for a second year.

Goldman was one of the first prime brokers to offer an independent prime custody service, creating Montague Place Custody Services in 2009.

Over the past year, demand for this Goldman service has grown. Hedge funds have started to refocus on client asset protection and minimising unnecessary exposures to their prime brokers.

In this year’s rankings, voters were able to have a say on the different areas of service provided by their primes. Deutsche Bank topped the prime custody sub-category.

Confidence in Deutsche seems well placed. It too launched a custody solution in 2009, DB Integrated Prime Custody, a platform that allow hedge funds to place unencumbered assets in a custody account also held at BNY Mellon.

It may be a surprise to some that Goldman, one of the world’s biggest prime brokers and a first mover in prime custody, came third in this category below Morgan Stanley.

However, Goldman was voted top for prime services overall by both global and US voters (Europe’s votes put it in second position below Deutsche). Being number one and the most preferred prime, however, can have some drawbacks. One UK-based hedge fund manager says he thinks the organisation could be more personal in its services.

“There are individuals in Goldman who [understand being personal] and those individuals are like diamonds when you find them because they have all the backing and all the resources and all the brilliance of Goldman plus the nous to understand what the investor needs,” says the manager. “If you come across someone who goes the Goldman ‘computer says no’ route, it can become tricky.” Nevertheless, he praises the service he receives from Goldman and thinks it is the “gold standard” at nearly everything it does.

Deutsche also topped the securities lending sub-category. It has expanded this business in the past year by opening an agency securities lending desk in Hong Kong in May to service its Asian clients.

The top three ranked prime brokers by global votes dominate the sub-categories. The only prime ranked in the top three for some sub-categories but not in the top three for the main category is Morgan Stanley. It came third for securities lending and second for prime custody.

Goldman topped the poll for finance and engineering. The bank’s work in asset protection, particularly its custody service with BNY Mellon, helped put it in pole position for this category. This is where clients see financial engineering come together. Goldman has also done work around its own liquidity and asset liability modelling ahead of Basel III liquidity and capital requirements.

The bank also came top in the technology sub-category. One of its UK-based hedge fund clients notes that Goldman’s reporting service is “second to none”. Information is delivered on time every day and fits into a manager’s own systems easily, he explains.

JP Morgan topped the rankings for capital introduction and trading and execution. It has undergone a programme of significant investment in its execution capabilities, explains Teresa Heitsenrether, who took over as head of prime brokerage at JP Morgan earlier this year. This includes improving access to different markets and the algorithms it uses to help clients source liquidity in different markets. She says the bank’s offering in this area is now state of the art.

Like Goldman, the bank’s prime brokerage business has noticed the increased interest in counterparty credit risk and client demands to know exactly where assets are and how they are being used at all times. It is now having more detailed conversations with clients about their portfolios, where assets are and the appropriate levels of financing, says Heitsenrether.

JP Morgan is also undergoing a push to globalise its prime brokerage business. The bank acquired Bear Stearns’ prime brokerage business in 2008 and has been building its offering since then. Having previously been primarily US focused, it launched a London operation in 2011 and is also expanding in Asia with the aim to have a full service offering there in 2013.

The regulatory environment is another factor shaping the provision of prime brokerage. “Funds are very reliant on their providers and what a firm like JP Morgan can bring to bear to help navigate those [regulatory] changes,” says Heitsenrether.

One example is the requirement for Securities and Exchange Commission-registered hedge fund managers to fill out Form PF.

Across the board, prime brokers have been working with hedge funds to help them prepare for these new reporting requirements as well as other regulatory compliance issues.

Regulation is also changing the way in which hedge funds trade. In the past year prime brokers have seen a significant increase in clients being active in shorting bonds, particularly as rules have come into place that ban naked short selling via credit default swaps (CDS) on European sovereigns.

Hedge funds have started to express those views more heavily through shorting physical bonds, a trend which is expected to continue, with more funds moving away from CDS into physical form given mandatory exchange clearing and bans on naked CDS.

Goldman expects to see more futures trading as the move to trading listed products takes place but there are technical issues that still need to be addressed. One example is that regulators need to finalise rules on portfolio margining, says Willian.

However, it is in securities lending, where Goldman ranked second, that one US-based hedge fund manager finds its service particularly good. “From a servicing perspective they have been very responsive when items come up. With regards to capabilities, we are an Asia-focused fund so we felt they have done a good job in terms of sourcing borrows for us to get short exposure.”

Goldman is the funds’ number one prime for three reasons, according to the manager. “Its performance – in terms of them being able to get us access to corporate management – being able to locate stock borrows and the day-to-day servicing of the account.”

The manager also appreciates the attention Goldman pays to their account. “I would say Goldman is the best on the Street in terms of understanding their marginal revenue from their clients. If we started giving them less business, they would be calling us and asking if there is a problem.”

Goldman has always been known for its capital introduction service and it holds some of the largest events in the industry. Earlier this year, it filled Yankee Stadium in New York for one of its cap intro events. However, it has slipped from ranking top in capital introduction in 2011 to second this year, with JP Morgan taking the top slot.

At JP Morgan, Heitsenrether believes the expansion of its cap intro team and spending “a lot more” time looking at its coverage of the investor community has paid off. She is also looking at the way it delivers content in order to improve this area in future.

While Goldman maintains a strong position in the rankings, the investment that others are putting into their prime services businesses is clearly paying off.

Prime services/broker - global votes
1 Goldman Sachs (17.2%)
2 Deutsche Bank (14.5%)
3 JP Morgan (11.1%)
4 UBS (10.8%)
5 Morgan Stanley (10.1%)

Prime services/broker - US votes
1 Goldman Sachs (20.8%)
2 JP Morgan (15.3%)
3 UBS (12.6%)
4 Deutsche (10.5%)
5 Credit Suisse (8.5%)

Prime services/broker - Europe votes
1 Deutsche Bank (17.5%)
2 Goldman Sachs (15.2%)
3 JP Morgan (13.2%)
4 Newedge (11.9%)
5 Credit Suisse (11.0%)

Prime services/broker global votes: finance and engineering
1 Goldman Sachs
2 Deutsche Bank
3 JP Morgan

Prime services/broker global votes: securities lending
1 Deutsche Bank
2 Goldman Sachs
3 Morgan Stanley

Prime services/broker global votes: prime custody
1 Deutsche Bank
2 Morgan Stanley
3 Goldman Sachs

Prime services/broker global votes: technology
1 Goldman Sachs
2 Deutsche Bank
3 JP Morgan

Prime services/broker global votes: capital introduction
1 JP Morgan
2 Goldman Sachs
3 Deutsche Bank

Prime services/broker global votes: trading and execution
1 JP Morgan
2 Goldman Sachs
3 Deutsche Bank