The prime brokerage industry has undergone an unprecedented rate of change in recent months. With overall trading volumes lagging and a heightened focus on compliance and risk controls, prime brokerage firms have either chosen or been forced to change their longstanding business models. This is especially true when it comes to the smaller introducing prime brokers. Some of these small firms have merged or exited the business altogether; some have opted to save costs by consolidating their custody and clearing relationships, while others have been acquired by larger firms looking to increase their product offerings and shore up their balance sheets. All of these changes have given rise to a new space that is being called 'mid prime', 'integrated prime' or 'independent prime'. Here is a quick look at how all of these changes impacted the prime brokerage landscape.
For many of the smaller introducing primes who opted to merge, this was done largely in part to create greater economies of scale. For those unable to meet capitalisation requirements, the only option was to close up shop. The end result took the form of clients placing greater scrutiny on the stability and balance sheets of the firms that remained. While hedge fund assets were safely held in custody at their respective clearing firms during these closures, clients of these smaller providers were left scrambling to find new homes. But despite this, these smaller independent introducing brokers still offered a good solution for the very small start-up hedge funds who fell below the minimum asset size requirements of middle-tier prime brokers as well as traditional bulge bracket firms.
Many of the smaller prime brokers that emerged in the mid 2000s grew fast enough that they became acquisition targets for larger financial services and technology firms looking to expand their services. The recurring revenue model and client loyalty associated with the smaller primes was very attractive to the acquiring companies. These new prime service providers have created more alternatives to traditional bulge bracket prime brokers, especially for medium-sized hedge funds. The larger balance sheet and increased global reach of the new 'integrated prime service' providers offer clients the enhanced risk controls and broader services that had only been available to the largest hedge funds. Integrated prime service units also now have access to very large technology budgets and hundreds of additional employees that can be leveraged to provide greater services, often worldwide. These larger integrated prime services providers are now an industry segment unto themselves due to the fact that they provide services that were previously only available to clients of bulge bracket firms, but they still focus on providing very personalised service.
Another trend that shaped the industry followed the turmoil of 2008. This was the use of multiple custody and clearing options in order to mitigate potential systemic risks and to further protect assets with an alternative clearing relationship. Hedge funds, as well as prime brokerage firms, formed relationships with a second and even third clearing broker in order to facilitate a 'multi-prime' solution. There is still great demand for this protection from medium- and larger-sized hedge funds, but some smaller prime brokerage firms were not able to support the additional financial and logistical obligations that these relationships brought with them. Capitalisation issues at these brokers made the multi-prime approach less feasible and there has been a move recently for some of the mini-prime brokers to discontinue one clearing relationship in order to protect their primary one.
There are still some smaller prime brokers that may or may not have had the ability to merge with another firm or join a larger entity and therefore have chosen to stay independent. These firms believe that they have the resources to stand alone. They may have invested heavily in proprietary systems or they may have other business lines that they believe will allow them to grow their business organically. These prime providers may have a loyal client base and staff and believe that independence outweighs the benefits of further reach. Prime brokerage began with this spirit and there will probably always be stand-alone firms that subscribe to that school of thought.
In every industry, the landscape constantly changes. In the prime brokerage space, that rate of change is high at the moment. It will be interesting to see whether traditional bulge bracket firms make an attempt to gain market share by courting smaller funds or whether they continue to compete with one another for the largest players in the industry. It will also be worth watching to see which firms consolidate further and which ones give up on independence and seek out an acquisition. One way or another, healthy competition in the prime services space remains.
Michael DeJarnette is a prime brokerage veteran and the co-founder of NorthPoint Trading Partners, LLC which was purchased by ConvergEx Group in 2009.
This article first appeared on FINalternatives on 7 December 2010. For more details, please visit www.finalternatives.com