Hedge funds benefit from lower prime broker fees
Hedge funds are benefiting from lower securities borrowing and financing rates as competition among prime brokers intensifies, according to David Geffen, founder of consultancy Geffen Advisors.
“For most hedge funds, it’s an excellent time to hire a prime broker,” says Geffen, who advises hedge funds on managing their prime brokerage relationships.
“There is a lot of competition and excess capacity. Currently, hedge funds have more transparency on securities borrowing pricing than ever before. Since the financial crisis abated, the ability to negotiate terms including prices with prime brokers has probably not been better,” he says.
The banking crisis effectively ended the duopoly of Goldman Sachs and Morgan Stanley in prime brokerage, with the likes of JP Morgan, Credit Suisse and Deutsche Bank winning market share as hedge funds sought to diversify their counterparty exposure. A number of other banks have also ramped up their prime brokerage operations. Last year, Wells Fargo became the most recent of the big US banks to enter the business when it acquired Merlin Securities, an independent prime broker.
Fees for certain prime brokerage services have been driven down as additional providers have entered or expanded their businesses, according to Geffen. He points to over-the-counter derivatives clearing as an example of the pricing pressure facing prime brokers.
Prime brokers made significant investments in their infrastructure to support OTC derivatives clearing for hedge funds clients. However, the industry is struggling to figure out how to make this a profitable business, says Geffen.
“Now that clearing is under way and the prime brokers have to bid for this business based on both capability and price, many have found they cannot charge the fees they hoped to charge. In some cases, they had to reduce their rates substantially in order to win the business,” he says.
Hedge funds are also paying closer attention to their prime brokerage and counterparty relationships and taking an active approach to managing credit and operational risks, as well as costs. Geffen advises all hedge funds to hire at least two prime brokers as this diversifies counterparty risk and promotes price transparency and competition.
“As most hedge funds now have more than one prime broker, they have a better sense of the pricing that’s available in the market-place.”
All this puts prime brokers in a difficult position. Tougher capital rules and changing market practices are driving up funding costs for prime brokers. These will eventually have to be passed on to clients.
“The banks will have to make some tough decisions,” says Geffen. “They need to figure out a way to increase the rates they charge clients but there is so much competition. No one wants to be a first mover in raising prices.”
However, he does not expect fees to rise materially in the short term. “Prime brokerage still delivers a good ROA [return on assets] for banks, particularly compared with other businesses. The cost of doing business will have to rise, but that has to be balanced against the fact that so many firms are still trying to build their books of business,” he notes.
Geffen was formerly a managing director at Barclays Global Investors (BGI) where he created and led the securities finance group that managed the company’s prime brokerage, financing, futures clearing and counterparty credit relationships. He held the same position at BlackRock after it acquired BGI in 2009. Previously, Geffen was a managing director and chief credit officer at Amaranth.
Geffen, who left BlackRock in 2011, established Geffen Advisors earlier this year. The group advises hedge funds on treasury management and counterparty risk. It also works with managers on fund launches and provides outsourced COO and training services.
“The firm’s goal is to provide guidance to hedge funds so they can be more rigorous in their decision-making and how they do business with their strategic business partners,” says Geffen.
This article was first published on Risk