small hedge funds and the shrinking prime brokerage business

The New YorkHedge Fund Roundtable

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New York Hedge Fund Roundtable’s May Education

and Best Practices Call:

“Small Hedge Funds and the Shrinking Prime Brokerage

Business”

May 26, 2016

Speakers:

Robert Akeson

Peter Marrinan

Introduction

• Hedge funds need prime brokers to access the public markets to operate

• Because of regulatory developments such as Basel III and Dodd Frank, the

prime brokerage business, which is dominated by firms that are owned by bank

holding companies, is experiencing new balance sheet constraints

• These regulatory developments are meant to reduce leverage & risk taking in

the financial system

• For these reasons, hedge funds, especially ones managing less than $500MM

and certain balance sheet intensive strategies, have become less desirable to

the leading prime brokers

• This is happening at a time when hedge funds, as absolute return investment

vehicles, during volatile times, should be in an especially good position to

launch, attract assets and excel

• What is happening and how can small hedge funds navigate these challenges?

2

The Hedge Fund Landscape

• Vastly increased hedge fund AUM/population since 1990:

– Now $3tril in industry AUM

– 10k active hedge funds

• 70% of all hedge funds are “small”

• Certain strategies are more balance sheet intensive than others

– Fixed income, global macro and multi-strategy—balance sheet intensive

– L/S much less so; comprise 33% of all funds

– Crowded trading strategies

• Reduced liquidity in fixed income

• Rise of “algo” trading/democratization of advanced analytical tools

• Many studies point to small manager outperformance

– Market impact

• Impact on 2/20 model

3

Prime Brokerage

• Provide central custody, clearance & settlement and financing– Facilitate margin, portfolio margining and short selling

– Facilitate a hedge funds ability to “trade around the street”

• Other products & services offered by prime brokers:– Research

– Institutional execution

– Derivatives

– Access to syndicate

– Enterprise technology resources/consulting

– Reporting

– Access to potential investors

• Prime brokerage requires:– Self-clearing capabilities

– Significant permanent capital to meet regulatory requirements

– Memberships in exchanges and CCP’s

• Consolidation among/contraction of activities, now occurring in the prime brokerage industry:

– Resulting in fewer openings for small hedges and those strategies that are balance sheet intensive

4

Executing & Introduced Prime Brokers

• Executing brokers:– Buy/sell securities

– Offer sector-specific research

– Risk management services

• Evolution of “Introduced Prime Brokerage”– As prime brokers “prune their trees” of smaller funds, non-self clearing firms have opened

accounts for them at their clearing firms

– These firms model themselves after Furman Selz and Merlin Securities

– Introduced prime brokerage requires access to “clearing firm” balance sheets:

• Clearing brokers are like prime brokers and clear/settle trades:

– Major difference is that their clients are non-self clearing brokers as clients

• Introduced prime brokers re-sell/mark-up the balance sheet and stock loan box of the

clearing broker to hedge fund clients

– Many of the clearing firms that support these brokers, are themselves owned by bank holding

companies, so we can expect to see further capacity reduction & industry consolidation

• JP Morgan sold their clearing business and Goldman Sachs is reducing its business

5

The Rise of Prime Brokerage

• Prime brokerage has become a huge business that rivals Investment

Banking, Sales & Trading and Asset Management at major firms:

– Originally viewed as an extension of a firm’s back-office

– Provides firms with significant cross-selling opportunities/ways to increase share

of wallet with hedge fund clients

• Financing is key to prime brokerage profitability; re-hypothecation enables

firms to expand balance sheet:

– Hedge funds open a margin account at their prime broker (or through the

introduced prime brokers clearing firm).

– They must then pledge the asset being borrowed against, as collateral. This is

known as “hypothecation”.

– The prime broker uses the collateral to meet its own funding requirements with

lenders—re-hypothecation. Having access to these assets increases the prime

brokers own borrowing capability and at a lower rate.

• Prime brokers earn “spread income” income, over and above their cost of funds.

6


– In the past, re-hypothecation of customer assets, coupled with hedge fund cash

on deposit made prime brokerage businesses largely self-funding

– Recent regulations such as Basel III and Dodd Frank have put restrictions on this

capability

– In the past, the brokerage industry relied heavily—for margin, short sales and

transactional activity—on short-term repo and the secured lending markets to

conduct its business

– Essentially, the industry borrowed short-term in liquid markets, typically on an

over-night basis, to purchase long-term, illiquid and risky assets

• During the “Great Moderation”—years of stable growth and low inflation—high

leverage and liquidity mismatches were less dangerous. During extended downturns

the consequences could be catastrophic for the existing fractional reserve financial

system

7


• “Repo” was a convenient funding vehicle for brokers because it was cheaper/ quicker

to arrange than equity and unsecured debt, such as commercial paper.

– With repo the lender receives securities as collateral for the term of the transaction. Haircuts

and daily mark-to-markets provide the lender with additional comfort.

– It is estimated that repo represented nearly 50% of the brokerage industry’s funding before

the crisis.

• Liquidity risk is an acute issue for repo during periods of stress. Default risk for repo

is extremely low, yet lenders scale back their activity with any counterparty that

appears to be in trouble.

– This is what happened during the Financial Crisis. Lenders initially raised haircuts and then

reduced the amount of less liquid and risky collateral they would repo

– Finally, they cut-off borrowers completely.

– As a result, the markets froze and contagion ensued. Contagion meant that disruptions in

credit markets would cause market participants to rapidly deleverage, selling their long-term

assets at depressed prices. In the midst of the panic, market participants would often sell

their highest quality assets first in a frantic bid to quickly raise cash, causing unintended

consequences for securities that had no fundamental problems.

8

The Growing Role of CCP’s

• Central Counter Party’s (“CCP’s”) such as, DTCC & OCC, play increasingly important roles in facilitating clearance/settlement process for the public markets by:

– Supporting greater trading/share volumes through immobilization/dematerialization of securities

– Streamlining costs

– Mitigating risks

– Guaranteeing trades, by intervening between the trading and settlement layers

• Members include self-clearing firms

– DTCC members total 330

– Of the 4K broker-dealers licensed to conduct a public business the vast majority require the services of clearing firms

• Regulators have designated CCP’s as Systemically Important Financial Market Utilities (“SIFMU”) and must take additional steps to reduce risk. As are result:

– Their clearing costs/collateral requirements are rising.

– A ripple effect is impacting CCP members and their customers, like hedge funds

– A recent initiative, T+2, will be implemented in 2017; costs are directly borne by the self clearing firms that are direct members of the CCP’s will be passed on to customers

9

Regulatory & Market Developments

• The financial crisis caused the surviving “bulge bracket” firms that

dominate the prime brokerage business to be reconstituted as

commercial banks:

• In return, they receive government protections enjoyed by banks

• Significant regulatory and market structure changes ensued

• Basel III revolves around several key requirements:

– Minimum liquidity requirements:• Liquidity Coverage Ratios (“LCRs”): banks must have liquid assets

to sustain 30 days of stress

• Net Stable Funding Ratios (“NSFRs”): are long-term structure ratios

addressing liquidity mismatches and reducing reliance on short term

funding

• Initiatives apply to the entire balances sheet and offer incentives to

banks that use stable sources of funding

10


– Minimum capital/risk coverage requirements are increasing financing

costs & limiting off-balance sheet business:

• Seek to increase the level of common equity to 4.5% of RWA, net of

deductions

• Permits regulators to determine if shares can be written off, should the bank

be deemed non-viable; reduces likelihood of moral hazard

• Additional capital buffer of 2.5% of RWA included

• Banks that do not maintain these levels, will have restraints imposed on their

ability to make distributions

• A countercyclical capital buffer of up to 2.5% is required if regulators

determine that credit growth may result in systemic risk

– Leverage constraints are causing to shift balance sheet away from their

prime brokers

• Prime brokers must now emphasize ROA/ROE criteria in addition to

traditional profitability and cross-selling considerations

• This will be easier said than done as the there are so many

variables to consider11


• Dodd-Frank:

– Hedge funds with AUM greater than $100MM must register as RIA’s

• Those will fewer assets may be subject to state regulators

• Registering will results in significant compliance responsibilities/ costs

– Significant reduction in proprietary trading activity of firms that are owned by bank holding companies

– Reducing leverage in the financial markets is an overarching goal of Dodd-Frank

• Growing AML challenges: – Compliance now equal in stature to Legal & Risk areas at prime brokers:

• Special focus on offshore accounts regarding rationale for domicile

• Must ascertain off-shore beneficial owners are appropriate

• Must be confident that hedge funds have adequate policies & procedures in place to ensure compliance with regulations

– Rising costs & risks impact both prime brokers and hedge funds

12


• Market Developments:

– Prime brokers that are owned by bank holding companies are being impacted by

Basel III:

• Reduced access to balance sheet

• Less liquid and balance sheet-intensive hedge fund strategies are problematic

• May ask clients to modify their strategies to suit their ROA/ROE targets

• May ask clients to hold cash elsewhere

• Less capacity at these firms for prime brokerage activity

– Some firms are leaving the business

– Introduced Prime Brokers are also feeling the balance sheet squeeze:

• Especially if they clear through a firm that is owned by a bank holding company

• Rising clearinghouse costs are being passed on to them by their clearing firms, which is

shrinking profit margins

• Many of these firms have had to exit the business

13

What Can Small Hedge Fund Managers Expect?

• Difficulty opening both prime brokerage and introduced prime

relationships because:

– Fewer prime and introducing prime brokers are operating

– Existing service providers require a higher bar to gain entry

– Decision not just driven by profitability alone; ROA/ROE factors

are critical

• Financing costs to rise

• Liquidity constraints

• Difficulty depositing cash with prime and introduced prime brokers

• Trading away may not be offered by many firms

• Prime brokers may ask hedge funds to modify their strategies or,

simply leave

14

Steps Small Hedge Funds Can Take to Adapt & Thrive

• How important is the PB to the success of the fund? – Are they a utility or are they a “partner”?

• Address business risk issues to make themselves more attractive to prime brokers:– Business planning; understanding the order of operations for the business launch

– Strategic outsourcing; reputable legal, administrator, accountants

– Strong/diversified team; address “key man” risk issues

– Stress “operational alpha”

– “Culture of Compliance:”

• Demonstrate an understanding of the regulatory landscape

• Proper segregation of duties

• Solid WSP’s

• Consider consolidating counterparties

• Query prime broker regarding how their strategy/asset mix will impact their balance sheet (ROA/ROE)

• Consider third party solutions for collateral management

15

The Shape of Things to Come

• “Shadow banks” can/will fill the void left by prime brokers owned by bank holding companies

– They are not directly impacted by Basel III

– However, shadow banks are impacted by rising CCP clearing costs/collateral requirements

• Possibility that the existing CCP model will evolve along the lines of the distributive exchange model

– Regulatory changes have caused the market structure of stock exchanges to evolve from a centralized framework a distributive one

– Could CCP’s in the future geared more to specific asset types and liquidity profiles?

• Potential impact of “blockchain”– Facilitates point-of-sale transactions and promotes heightened integrity of clearing/settlement

process

– May reduce compliance burden/costs

– Could revolutionize collateral & risk management

• Sources:– “Equity Prime Brokerage: Exploring Uncharted Territory,” Tabb Group 2014

– “Accessing the Financial Power Grid,” AIMA/S3 2016

– Various “Hedge Fund Law Reports”

16


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Q&A Session

Robert Akeson

Robert E. Akeson

Chief Operating Officer

Daewoo Securities (America)

• Mr. Akeson is Chief Operating Officer of Daewoo Securities (America), a subsidiary of Mirae Asset Daewoo Co. Ltd. Mirae Asset

Daewoo Co. Ltd is an affiliate of Mirae Asset Group, which is Korea'a leading financial group. The group has assets under

management of approx. $83bn and has been a pioneer in the Korean mutual fund and ETF’s businesses. He is a member of Daewoo

Securities (America) Management Committee.

• Mr. Akeson is also a member of DTCC’s Systemic Risk Roundtable, Chair of the New York Society of Security Analyst’s Business

Management Interest Group and a member of the New York Hedge Fund Roundtable. He is also a frequent speaker on issues related

to hedge funds, liquidity, clearing and Basel III and Dodd Frank. Mr. Akeson maintains the following FINRA licenses: 7, 9, 10, 24, 63,

79 and 99.

• In the past, Mr. Akeson was Business Head of Neuberger Berman’s (“NB”) Professional Investor Clearing business (“PICS”). While at

NB, he re-positioned PICS into a leading boutique provider of prime brokerage, clearing, agency execution and research sales

services to hedge funds, Registered Investment Advisors, introducing broker-dealers, and Family Offices. He has also worked at the

Industrial and Commercial Bank of China Financial Services, Morgan Stanley and ADP (now Broadridge Solutions).

• Mr. Akeson has taught Money, Banking and Financial Markets at Molloy College. He holds an M.B.A. from New York University and

a B.A. from Washington College.

Peter Marrinan

• Peter Marrinan is the Chief Risk Officer for ConvergEx

Group. He has over 25 years of experience in the

securities brokerage industry with senior management

capabilities that extend across multiple business lines,

financial market segments and geographic regions.


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small hedge funds and the shrinking prime brokerage business

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