How a clearer understanding of financing relationships will benefit both hedge funds and prime brokers
Hedge funds and prime brokers have a symbiotic relationship that began as early as the 1970s and will likely continue for many decades more. Hedge funds rely on their prime brokers to lend them securities for short selling and cash for leverage, without which they cannot execute their strategies. Prime broker divisions are often the jewel in the crown for investment banks, contributing multiple billions of dollars in annual revenues and providing a central point of ownership for the bank’s broader relationship with the hedge fund community. The nature of this partnership has evolved over the years, with the most recent shifts coming primarily from increased competition, regulation, and improved technology.
Hedge funds now have multiple prime relationships, largely as a reaction to the collapse of Bear Sterns and Lehman Brothers that left ~$65bn of their assets being frozen and opened the door for more institutions to offer prime services. Prime brokers have had to recalibrate their businesses to comply with new capital ratios and leverage limits, leading to a more selective approach as to which managers they are willing to work with. Amid this diversification and selectivity, hedge funds have been under pressure to lower their fees as investors are lured towards the low running costs and strong recent performance of beta products. The reaction has been to pass the pressure along the chain, playing their multiple prime brokers against each other to reduce fees in exchange for a greater proportion of the fund’s financing business. But with prime brokers facing more competition, rising operational costs, an increase in less-profitable split mandates to service, and regulatory limits on how much they can lend, there is only so much they can lower spreads while maintaining the same calibre of service levels. They fight a continual cross-divisional battle to secure the finite, regulatory constrained resources the banks have, so salespeople are tasked with sourcing the most profitable clients and securing the most desirable part of their portfolios. It has become a delicate balance, with both parties looking for the other to improve their contribution to the relationship, while each is on the lookout for more attractive opportunities.
A critical function
Now, more than ever, the treasury function plays a critical role for alternative investment managers in how they manage these relationships and control fund overheads. With a collaborative approach, and the right technology, they can reduce their costs and improve profitability for their prime brokers.
Funding balances and fees paid are valuable metrics, but they don’t reflect profitability. Take unsecured funding balances – they attract a higher financing cost to the hedge fund, but often lower profitability to the bank than if there was some reasonable quality collateral they can use.
Prime brokers have made considerable effort to share more relevant information that will help attract the most profitable balances. Not only has their reporting suite extended to show which securities they are utilising, and even which securities they are willing to pay for access to, but quarterly client meetings to review a portfolio’s value are now commonplace. Once the elephants in the room, profitability, revenue hurdles, and wallet have become an explicit part of the dialogue. The challenge investment managers face is how to convert this knowledge into actions when faced with so much non-standardised raw data.
It is no longer enough for hedge funds to simply reward their prime brokers with balances. They need to be mindful of the impact their inventory has on the prime broker’s book, and whether or not it is actually beneficial to them.
For the majority, building an in-house solution is unrealistic as the cost of hiring a sufficiently skilled team far outweighs the returns the investment manager will generate through improved fund performance. For the minority, the largest investment managers who have the resources to dedicate, they are unlikely to sell their solutions as they are not incentivised to see their competition benefit. The solution has been for independent third parties to build the technology that will aggregate, cleanse, and normalise the data into a digestible format. ENSO Financial was one of the first to address this, and for hedge funds it provided a new dawn of understanding. Not only did they see where their portfolios were carrying inefficiencies, they saw the solutions as well. A few simple movements of balances could result in meaningfully reduced financing costs.
Today, API connectivity takes this a level further with data transferred seamlessly in an instant. Portfolio analysis no longer needs to run overnight but can be reactive to the changes in a portfolio as they happen. APIs also enable smooth integration into similarly sophisticated third parties which can offer valuable context when combined. For example, provide traders with each prime broker’s cost of borrow and margin requirement and they can direct trades to the most favourable terms at point of execution. New market entrants like Kayenta are leveraging this technology. With a team of finance veterans who have sat in both buy and sell side roles, they know where the pain points are and the solutions that are missing. In conjunction with a team of developers who can harness the technology available today, it’s a powerful combination.
Having spent 30 years in this market I have a pretty strong understanding of how it works. But it’s only recently that technology has reached the capacity to solve for a lot of the nuances – there’s a reason nobody else can reconcile financing accruals at a security level, or offer a valid estimation of a prime broker’s financing wallet.
But transparency is a sensitive topic, especially for investment managers who are fiercely protective of their proprietary data. The events surrounding Archegos’ demise are a case example where transparency could have helped avoid huge losses; but had Hwang provided that transparency, it’s unlikely he would have attained the leverage he wanted. Sentiments may change if prime brokers adjust their risk models as selective transparency might help managers negotiate more aggressive margin terms, but that is speculation for now. What is clear is that control of data is sensitive, and security paramount.
Defense-in-Depth is one of the foundations of cybersecurity, and with segregated networks and a layering of fully audited systems we know that leveraging cloud-based architecture is as secure, if not more so, than the legacy on-premises solutions, and at a fraction of the cost.
For a treasury technology solution to be effective it must have visibility on the whole portfolio and security must be watertight throughout the process, from source to delivery and everything in between.
We collect via Secure File Transfer into self-contained customer environments within Microsoft Azure’s Hub and Spoke architecture. It ensures clear separation of each customer’s data and a robust level of security.
Financing a hedge fund strategy is costly, and since the electronification of execution and MiFiD’s impact on research it is likely to be the most expensive overhead the strategy suffers. With the cost of providing that finance going up, control and efficiency are not only the fiduciary responsibility of the manager, but crucial to remaining competitive.