July 20, 2017
The prime brokerage market in the United States has experienced significant changes in the last decade. The financial crisis of 2008 brought a wave of new financial regulations that put a strain of many of the biggest players in the prime brokerage market, and a continuing embrace of FinTech by the newest hedge fund managers has changed the list of demands they have of their prime brokers. The changing nature of the market has created ample opportunity for smaller boutique prime brokers, or mini-primes, as they have the technological capability that many hedge funds desire, along with the balance sheet flexibility to maintain compliance with new regulations.
First published in 2009, Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision, and risk management within the banking sector. Largely in response to the credit crisis, banks are required to maintain proper leverage ratios and meet certain minimum capital requirements. These new requirements only apply to financial institutions with over $10 billion in assets, thus impacting some of the largest prime brokerage operations in the United States as they are operated by large banks (Morgan Stanley, Goldman Sachs, etc.). This has resulted in some of the biggest players in the market rolling back their prime brokerage operations to help maintain Basel III compliance.
As an example of the above rollbacks, banks such as Deutsche Bank and Barclays have been pulling out of the US because various regulatory constraints around unencumbered cash and risk ratios are raising their service costs to uncompetitive levels. Despite this, the prime brokerage market is still being dominated by a small number of the largest competitors. As per the SEC filings by hedge fund managers, the top 25 prime brokers by number of clients have a total of 10,033 fund clients; 5,172 of these clients belong to the top three prime brokers (Goldman Sachs, Morgan Stanley, JP Morgan) representing over 50% of all clients held by top 25 brokers.
However, these major firms who have remained in the market are still feeling the regulatory squeeze. Unable to avoid capital charges associated with the increased regulations, these banks have been re-evaluating their client relationships, focusing their efforts on supporting larger, more profitable clients.
Additionally, we have seen that many major prime brokers have ended their relationships with their smaller hedge fund clients in favor of larger institutional clients.
While the prime brokerage services operated by large financial institutions (over $10 billion in bank assets, requiring Basel III compliance) are typically constrained by their balance sheets resulting in the situations mentioned above, an opportunity exists for smaller ones and new entrants to fill the gap with hi-touch services, as well as alternative lending models such as enhanced custody, which gives the client greater visibility and control over their assets. This has allowed mini-primes to become legitimate contenders to the major market competitors who have had to scale back their operations to comply with new regulations.
These mini-primes are also taking on the business of smaller, startup hedge funds who have had trouble attracting the business of the major prime brokers; before the recession, major primes had no interest in smaller startup funds because it can take them years to generate the returns necessary to produce meaningful fees for the broker; and after the recession, they didn’t have the balance sheet flexibility to take them on anyway. This has allowed boutique mini-primes, which charge upfront fees for individual services, to begin accepting this business.
On top of their enhanced balance sheet capabilities stemming from their Basel III exemption that enables them to attract clients, mini-primes can also offer more tailored and proactive services to hedge funds. Many newer hedge funds are run largely by millennials who have grown up with the Internet and who bring a different mindset to the industry. They want quality service and top-rate technology solutions, along with a prime broker that will be nimble and responsive to their needs. They are also less impacted by the stigma of not partnering with a bulge bracket prime, caring more about quality and value than name recognition.
All of this has created ample opportunity for mini-primes to step in. With their strong technology backgrounds, mini-primes have the ability to deliver an abundance of fund and market price information at a moment’s notice, a valuable commodity to a wave of younger fund managers whose embrace of technology is quite different than that of the older generation of fund managers. Not only does this create an opening for tech-savvy mini-primes, it also shows a shift in the prime brokerage paradigm towards a market where savvy adoption of FinTech can give you a significant leg up on competition, especially when trying to establish yourself early on.
While everything certainly seems to be in place for mini-primes to carve out a significant niche market, there are some potential holdups. For one, regulatory rollbacks by the Trump administration are a distinct possibility. The administration has made a commitment to roll back financial regulations, particularly Dodd-Frank, but this is clouded by uncertainty and has many financial institutions simply waiting to see what happens. If capital and liquidity ratio requirements end up being eased, it could reopen the door for many of the major banks who pulled out of the United States prime brokerage market.
Additionally, there are questions about how many small hedge funds are seeking the services of boutique mini-primes and thus many smaller brokers are joining forces with bulge bracket primes rather than continuing on their own.
Additionally, there is a potential desire amongst bulge bracket primes to take on as much business as possible regardless of its balance sheet impact so they can gather valuable information on the whole market. However, despite these potential setbacks, there is still opportunity in the market for mini-primes – especially those that embrace FinTech innovation and use it to separate themselves from the competition.
Of course, innovation and change in capital markets aren’t limited to the prime brokerage space. Everything from blockchain to artificial intelligence is being implemented throughout capital markets in order to streamline efficiency and shape the future of the industry. For a comprehensive and detailed view of FinTech implementation throughout capital markets, be sure to check out our full research report on the topic.