Prime Brokerage Article

Saw this interesting article in the Economist today about the prime brokerage market for hedge funds. If you can't access it online, the main points are: Background 

• As much as $10bn is spent on prime brokers, with banks reaping up to 40% return on equity.

• Emerging market and commodity funds have been hit hard this year.

Trends

• Big banks are seeking to build out the Prime Brokerage business to forge closer relations with the Hedge Funds, including securities lending, leveraged-trade executions, cash management and even computer systems if they need it.

• Prime Brokers have been tightening their own risk management through daily mark-to-market of their exposures, especially after Long Term Capital Management's spectacular demise, Bayou Management (hedge fund / fraud) and Refco (prime brokerage arm collapsed due to alleged fraud).

• Return to Quality: Hedge Funds are seeking the best investment banks to provide credit.

• Hedge funds are growing fast, but remain lightly regulated and often shift strategies, sell stock short and hold illiquid assets. Their growing use of derivatives quietly traded away from exchanges is also testing the appetite of prime brokers to lend, because they find it hard to price the business.

Challenges For (Prime) Brokers

• Declining commissions for brokers and especially with the big clients who have the power to demand thinner margins.

• More professional fund managers know how to play banks off against each other.

• When funds get big, they need more than one prime broker, so each broker gets only a share of the business.

• Although there is more business to go round, the battle among the brokers has also picked up.

• Regulators
  

  • More focused on how to manage and disclose commissions, and what clients are actually paying for.

  • The “unbundling” of broking services—separating the cost of research from the cost of trading—This will free buy-side firms to trade with whomever they choose, without having to buy research.

• TECHNOLOGY - direct market access without intermediation of brokers.

(Separate but related to the technology angle: DLG has some good stuff on Hedge Fund Integration over on his blog.)