Prime brokers and the regulation rollercoaster
11 November 2014
Prime brokerage is changing in reaction to onerous regulatory requirements. Ben Cole of Lombard Capital Markets reports
Image: Shutterstock
The prime brokerage business experienced rapid growth in the 1980s and 1990s, and then declined after the economic downturn as banks were scaling back on their prime brokerage business, until markets started to pick up. Historically, we’ve all seen these cyclical events, now added to the mix, prime brokers have to adapt to harsh new banking rules.
Today, many hedge funds are finding it more challenging to sustain probability, which in turn impacts on their prime brokers’ ability to make a profit. Basel III requirements are focusing on higher capital constraints on banks. The increased capital charges that regulators are imposing means than a financial institution has to carry more capital to support a business that’s not as profitable. As a result, many prime brokers are reviewing their customers, with a view to identifying where the cost of capital is high, but the revenue outweighs the risk. Goldmans Sachs has been the most public in this space and exiting less profitable clients, while in other cases increasing fees.
In its discussions with prime brokers, Lombard Capital Markets is hearing that business models are also being challenged, with increasing pressure placed on risk weighted assets (RWA). As a result, there has been a real shift towards central counterparties (CCPs). In light of this shift, Traiana announced on 22 October the launch of Harmony CCP Connect, with Credit Suisse, J.P. Morgan and Instinet quickly adopting this model, enabling them to connect to three CCPs.
In addition, securities financing desks have also been shifting towards CCP solutions in order to reduce counterparty risk and improve operational efficiencies. Morgan Stanley was the most recent to announce it is to become a clearing member of the Eurex Clearing Íø±¬³Ô¹Ï Lending CCP.
Adding further regulations to the mix, the Alternative Investment Fund Managers Directive (AIFMD) is acting a driver for changes to the European alternative fund industry, causing a headache for prime brokers. The initial tranches of reporting for fund managers captured by the directive took place on 31 October 2014, and will so again on 31 January 2015. BNP Paribas Íø±¬³Ô¹Ï Services has been quick to exploit the reporting burden by offering an outsourcing service for AIFMD reporting, enabling alternative investment fund managers to fulfill their reporting obligations without the administrative and financial burden.
The backlog of AIFMD authorisation applications being processed by the UK Financial Conduct Authority has also highlighted that many managers have left their plans late, and illustrates just how slow funds have been to respond to the directive. These late applications have also meant that many managers have left it to the last minute to appoint depositories.
More concerning is the European Íø±¬³Ô¹Ï and Markets Authority (ESMA) is likely to force prime brokers to segregate alternative investment fund assets, which would have significant implications for the prime broker operating model. If and when these rules are announced, the news will not be well received. Dependent on the segregation requirements, prime brokers could have a long road ahead of them to make changes, with some prime brokers indicating the best part of two years to implement. Segregation will also cause a real headache in terms of re-hypothectaion, which is key to the prime brokerage model.
In every industry, the landscape constantly changes, and the rate of change is high at the moment, particularly to the already under-fire prime brokerage industry. With one challenge after another, it will be interesting to see how firms react in the coming years.
Today, many hedge funds are finding it more challenging to sustain probability, which in turn impacts on their prime brokers’ ability to make a profit. Basel III requirements are focusing on higher capital constraints on banks. The increased capital charges that regulators are imposing means than a financial institution has to carry more capital to support a business that’s not as profitable. As a result, many prime brokers are reviewing their customers, with a view to identifying where the cost of capital is high, but the revenue outweighs the risk. Goldmans Sachs has been the most public in this space and exiting less profitable clients, while in other cases increasing fees.
In its discussions with prime brokers, Lombard Capital Markets is hearing that business models are also being challenged, with increasing pressure placed on risk weighted assets (RWA). As a result, there has been a real shift towards central counterparties (CCPs). In light of this shift, Traiana announced on 22 October the launch of Harmony CCP Connect, with Credit Suisse, J.P. Morgan and Instinet quickly adopting this model, enabling them to connect to three CCPs.
In addition, securities financing desks have also been shifting towards CCP solutions in order to reduce counterparty risk and improve operational efficiencies. Morgan Stanley was the most recent to announce it is to become a clearing member of the Eurex Clearing Íø±¬³Ô¹Ï Lending CCP.
Adding further regulations to the mix, the Alternative Investment Fund Managers Directive (AIFMD) is acting a driver for changes to the European alternative fund industry, causing a headache for prime brokers. The initial tranches of reporting for fund managers captured by the directive took place on 31 October 2014, and will so again on 31 January 2015. BNP Paribas Íø±¬³Ô¹Ï Services has been quick to exploit the reporting burden by offering an outsourcing service for AIFMD reporting, enabling alternative investment fund managers to fulfill their reporting obligations without the administrative and financial burden.
The backlog of AIFMD authorisation applications being processed by the UK Financial Conduct Authority has also highlighted that many managers have left their plans late, and illustrates just how slow funds have been to respond to the directive. These late applications have also meant that many managers have left it to the last minute to appoint depositories.
More concerning is the European Íø±¬³Ô¹Ï and Markets Authority (ESMA) is likely to force prime brokers to segregate alternative investment fund assets, which would have significant implications for the prime broker operating model. If and when these rules are announced, the news will not be well received. Dependent on the segregation requirements, prime brokers could have a long road ahead of them to make changes, with some prime brokers indicating the best part of two years to implement. Segregation will also cause a real headache in terms of re-hypothectaion, which is key to the prime brokerage model.
In every industry, the landscape constantly changes, and the rate of change is high at the moment, particularly to the already under-fire prime brokerage industry. With one challenge after another, it will be interesting to see how firms react in the coming years.
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