The prime time bomb

The behaviour of the established prime broker industry following Lehman’s collapse merely encouraged the proliferation of these mini-primes. The immediate reaction by larger prime brokers was to squeeze funds and rein in margin, particularly in fixed income, and to a lesser extent equities; the collapse of the repo markets and sky-high haircuts served to push hedge funds around like bumper cars. With so many hedge funds scrambling to find a safe home, JP Morgan, Credit Suisse and Deutsche Bank all profited, but so did the smaller primes who offered an immediate haven for concerned fund managers.

Undoubtedly, large banks still have control of the institutional hedge funds market, and they’re able to make a tidy profit from it. “It’s clearly still a valuable business – if you look at Goldman’s market share and realise that the bank can achieve between 100-150bps per client, you understand why this business is seen as a good value proposition,” says Robert Sloan, managing partner at S3 Partners.

But, despite this control, every week a new prime broker sprouts out of an existing banking infrastructure or tries to head out on its own. Only last week, First New York Securities established a new prime brokerage unit targeting the smaller end of the hedge fund market (see news, p6). The unit was created by hiring two members of another prime broker that was only recently built-out, Lighthouse. This trend, which shows no sign of abating, has only one component holding it back, the lack of viable clients to make it sustainable.

“There are lot of rumours about more businesses hoping to set up boutique prime brokers – Knight Capital Group and SG Cowen Securities – it’s testament to the fact that the model (mini-PB) is doing well, and many businesses will grow and are solidifying. Yet there is not as much business out there as people think,” says Steve Simmons, managing director at Lighthouse prime services.

 “I think that it will be a phenomenon that will run for 1-2 years and then you will see some consolidation; either a number of smaller players grouping together or being absorbed by the broker dealers. There must be a quality variance – at the moment you are getting a new one popping up every week in the US and Europe is set to follow – this will slow by the end of the year because the demand is not sustainable,” according to Gunner Burkhart at Normura.

And because so many mini-primes provide only part of the full prime service, demand is even less sustainable, “there are already 45 introducing brokers out there. Many are riding on one or two key clients and will not last the distance,” says Lighthouse’s Simmons.

Are there still opportunities? Emphatically yes, according to Marty Malloy, head of prime brokerage at Barcap, but, of course, growth is relative. Barcap regards the US long/short equity space as one ripe with new clients, but its starting point is close to zero, having spent a lot of the time following the acquisition of the Lehman architecture on integration and Lehman legacy clients.

Not so with Newedge, Societe Generale and Calyon’s European brokerage unit. Built on servicing CTAs, it is now finally starting a push into the US, “In the US we feel there are a number of opportunities – as there are key differences, the US model is very much a stock lending one, which means they have dragged their feet a bit on other strategies, says Duncan Crawford, head of capital introductions at Newedge. “We feel that a dynamic portfolio approach could prove to be very popular to US managers.”

The larger prime brokers aren’t showing too much strain, outwardly at least. Large hedge funds remain the reserve of the Goldman Sachs and Merrill Lynchs of this world – the jury is still out on JP Morgan, as to how far from the tree the apple has actually fallen – leaving mini primes to service the rest. It’s a substantial amount, 90% of the hedge fund market. But, the available and profitable client base is shrinking by the week and unless you’re set soon, there may be nothing left.