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Larry Tabb
Larry Tabb
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Developing a New Prime Brokerage Model

As hedge funds move away from prime brokers and toward using traditional custodians, the prime brokerage model is becoming endangered.

It's nuts out there. The market this year is off more than 30 percent. We have had thousand-point intraday swings, redemptions are plaguing both hedge funds and long-only managers, and financial institutions are merging like there is no tomorrow (and for many, there may not be).

And while the volatility has changed the way that investors trade, counterparty risk increasingly is changing the fundamentals of the industry. Besides dealing with the posttraumatic stress of this volatile market, the breakdown of trust stemming from the Lehman debacle as well as regulatory changes in how firms manage shorting is shifting the way that hedge funds manage not only their positions but their prime brokers as well.

While traditional long-only managers house their positions at bank-owned custodians, hedge funds typically have bypassed these safeguards and deposited their collateral with prime brokers. Hedge funds employed prime brokers because they provided credit intermediation as well as better pricing and servicing models aligned to hedge funds. Credit intermediation enabled clients to trade using the brokers' credit rating, providing better market access and pricing for credit-dependent markets. In addition primes provided financing, technology and research, as well as stock loan facilities. Custodians rarely offered such a complete service package.

In addition to their investments in technology and people, one reason prime brokers were able to provide their services so responsively and aggressively was their ability to quickly locate collateral for covering short positions. While a significant portion of collateral is typically borrowed from bank-owned custodians, the more collateral hedge funds had on deposit with prime brokers, the easier it was for primes to lend this collateral out to third-party borrowers. By taking in long-position collateral and lending it out to funds that were short, brokers could pocket the borrowing fees, offsetting any additional operational cost.

This business model worked well until two major shocks: first, the credit downgrade of a few of the larger prime brokers; and second, the bankruptcy of Lehman Brothers. The credit downgrade hurt primes because their creditworthiness no longer was much better than that of the hedge funds they supported. This reduced funds' ability to obtain price improvement through credit intermediation. Lehman's downfall also hurt the prime brokerage business model because of Lehman's significant lending business and funds' difficulty in getting back collateral that Lehman had lent to third parties.

The confluence of these two issues has created a stampede of hedge funds moving their asset custody business from prime brokers to traditional custodians. While traditional custodians do not provide all of the prime services that prime brokers provided, primes and traditional custodians are beginning to work together to form new hybrid models. These new models involve the segregation of services between primes and custodians, where custodians hold the long assets and the primes provide financing and lending for short covering. While this new model is a bit more expensive, it provides greater security around hedge funds' long assets.

While the traditional prime brokerage model is not dead (yet?), it certainly is challenged, especially while the markets are still volatile, credit is problematic, regulation impedes short selling and prime brokers' credit-worthiness is challenged. This specifically impacts the two largest prime brokerages, Goldman Sachs and Morgan Stanley. These behemoths not only defined the prime brokerage industry, but continue to be the two largest U.S. prime brokers.

So what will these firms do to maintain their market share? If I were a betting man, instead of Morgan Stanley and Goldman Sachs buying a commercial bank, I would look for them to acquire a custody bank. With TARP capital in hand, the Federal Reserve and U.S. Treasury looking to remake the financial landscape, and assets migrating from primes to custodians, it would not shock me if Morgan and Goldman already have a custody bank in their sights.

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
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