Big banks are throwing extra resources into prime broking, betting on their embattled hedge fund clients to provide a much-needed revenue boost as other areas falter.
Despite hedge funds taking a pummelling over the past three months in choppy market conditions, executives in the banks’ prime broking divisions that handle their trading and lend them money still expect the smartest managers to outperform.
At the same time, the banks’ other significant sources of revenue, such as advising companies on mergers and acquisitions or trading fixed income, currencies and commodities, are more market-dependent.
The final three months of last year was the quietest period for mergers and acquisitions in more than a year, in a sign that market turbulence was giving dealmakers pause. Fixed income trading revenues are also falling, while companies are shying away from doing initial public offerings.
Jason Sippel, head of global equities and prime services at JPMorgan Chase, said that even if the market conditions for hedge funds worsened, the bank still wanted to grow in the space.
“Our management team has given us marching orders to take market share in equities, that is mission one,” he said. “Scale is critically important.”
One of an investment bank’s most capital-intensive activities, prime broking has been in and out of fashion with banks since the 2008 financial crisis, especially among European players who initially retreated before piling back in two years ago.
Post-crisis regulations require banks to have more capital for their prime brokerage activities, which has depressed their return on equity and made the area less attractive overall.
The high capital demands reflect the inherent risk of lending hedge funds money which is then put into equities, derivatives and other assets whose values can fluctuate wildly. Banks make hedge funds deposit “margins” to cover potential losses, but if asset prices fall too quickly, those margins can be inadequate.
As European banks retreated, US rivals have consolidated their grip on the market, with Morgan Stanley, JPMorgan and Goldman Sachs dominating the top spots. Now Citigroup, which was traditionally strong with foreign exchange and fixed income strategies, is also rapidly expanding in the hopes of winning market share from a wider range of hedge funds.
In Europe, Barclays’ prime business is also expanding, while BNP Paribas is quietly adding resources in the hopes of winning more business. Deutsche Bank promised to cut back prime under its latest restructuring, having already lost some top hedge fund clients when it faced worries about its own future. But Germany’s biggest lender is nonetheless still hoping to woo back clients.
The potential dangers to banks from prime broking — where most risk stems from counterparties rather than market direction — were laid bare in mid-December when it emerged that Citi faced losses of up to $180m on an Asian hedge fund’s foreign exchange trade that went bad.
The bullishness of the big banks on prime was rewarded in the first half of 2018, when prime broking revenues across the world’s 12 biggest investment banks rose more than 15 per cent, according to data from industry monitor Coalition.
But the world has changed since then. Hedge funds suffered their worst year in seven years. Hedge Fund Research’s index of all strategies is down 4.07 per cent for 2018.
Industry veterans including Jabre Capital and Highfields Capital Management, which once managed as much as $5bn and $12bn respectively, have shut down. Others are bracing for a potential wave of investors asking to redeem their money in the first quarter if performance continues to decline.
Money has already started to leave hedge funds as investors grow jittery about returns, as well. Investors pulled $6.43bn from hedge funds in November — the industry’s third consecutive month of outflows — leading to a contraction in the overall assets managed as performance also fell, according to eVestment.
“The concern for our business model would be if our clients were battening down the hatches and not doing anything,” said the head of prime brokerage at a top investment bank. “We don’t see that happening.”
JPMorgan, which leapfrogged Goldman last year to claim second spot after Morgan Stanley on the influential ranking from industry monitor Coalition, expects further growth and has made no secret of aspiring to the top spot.
Despite the recent turmoil, Dean Backer, head of prime brokerage at Goldman, said he did not expect to see significant consolidation in the hedge fund industry, primarily because if money is potentially redeemed from a fund, it is most likely to be reinvested in other hedge funds. Still, some closures will be inevitable, he said.
“There is a lot of talent in the industry, however, it’s crowded,” he said. “There are a lot of players.” For Goldman, gaining a greater share of quant funds that trade primarily using computer algorithms “is a core growth and strategic focus”.
Jon Cossey, who heads prime brokerage at JPMorgan, said: “The marketplace has dramatically changed in the last three or four years, particularly with some pretty aggressive restructuring at European banks.”
“We don’t view a rise in competition or the pricing pressure that comes with it as a bad thing because we are very much in a business where we believe in the value of scale,” he added.
Okan Pekin, Citi’s global head of prime, futures and securities services, said that “negative performance, coupled with net redemptions, have increased pressure on hedge fund managers”.
His comment was made before Citi’s forex loss became public. The division that was involved in the ill-fated Asian hedge fund trade was part of Citi’s fixed income unit rather than Mr Pekin’s remit at the time, but it has since been brought back into the main prime brokerage division, according to an internal memo.
“That said, funds and prime brokerage providers are taking a more long-term view on a $3.2tn [hedge fund] industry that is still growing in terms of assets under management,” he added.
While hedge funds have endured a challenging period recently, they are so far not pushing for lower costs from their banks, said the head of one prime brokerage. In times of stress, the executive said, funds are more focused on their investment strategies rather than negotiating fees or adding new providers.
George Kuznetsov, Coalition’s head of research, said competition, not market volatility, was the “biggest threat” to prime broking. “Sooner or later with the amount of balance sheet banks are committing to the business we should see that impacting on margins as well. It will be interesting to see how the top line will get impacted,” he said.
