Rise of the Mini Prime?

November 2, 2015

We live in a world where the tendency is for bigger to be better and the view of a prime broker has never been different: bigger balance sheets mean greater market coverage, which leads to larger client Assets under Management (AuM).  However, as the biggest primes have begun to re-focus, is there room for smaller players to enter the fray?

Over the past few years, Tier one banks have been faced with a raft of regulatory and other changes, which have significantly impacted the organizational structure of their prime divisions. As a result, banks have been forced to reduce levels of existing business that consume large amounts of assets and re-price it based on whether or not the client has enough non-balance sheet related revenue to meet their required return on assets (ROA).

With the introduction of Basel III, balance sheet pressures have never been greater, leading tier one primes to concentrate on the top 10 to 20 per cent of their clients.  It’s more cost-effective to increase the wallet share of a USD10bn hedge fund from 5 per cent to 7 per cent than to add 10 new clients.

Many tier one primes have taken the decision to terminate certain hedge fund relationships, which could provide opportunities for the mini prime industry to develop, particularly in London. Unlike in the US, there is limited competition in the mini-prime brokerage space in London, and with the large banks scaling back this could reap rewards for mini primes. A number of prime brokers including Goldman Sachs and Credit Suisse have made no secret of the fact that they will cease working with hedge funds that they view as being unprofitable or unscaleable as they are unlikely to grow AuM to sufficient levels.

So how does a mini prime model operate? They are essentially acting as “introducing brokers” to the traditional prime brokers. These mini primes pull in a lot of smaller managers and then feed that aggregated AuM as a larger client to larger prime brokers. They provide execution, clearing and custody services through correspondent clearing relationships with these banks. Mini primes also have access to the financing and stock loan capabilities of the top-tier prime brokers, so their clients can apply leverage and take short positions.

Total AuM into hedge funds is anticipated to reach record levels in 2015 and by March had already passed the $3tn mark. There has recently been a change in allocations by pension funds away from larger managers to smaller ones, who continue to outperform. The backdrop for mini primes to grow has never been better.

A fly in the ointment was the recent announcement from J.P. Morgan that the bank has notified the “introducing brokers” it works with that it will no longer clear trades or offer financing to their hedge-fund clients. The brokers have 90-120 days to find new clearing banks for clients that had been using J.P. Morgan and the move is estimated to affect about 800-1,200 hedge funds.

This abrupt retreat of J.P. Morgan from the mini prime arena marks the first time a major prime broker has stopped working with introducing brokers altogether.

So what next? As continuing regulatory change aligned with liquidity and capital adequacy requirements continues to place pressure on the funding models of primes, will we continue to see a re-balancing of their existing client bases? With the European landscape light on mini primes, will US shops look to expand from their traditional US bases? Will the move by J.P. Morgan encourage other banks to follow suit, undermining the mini prime business model? The world of prime brokerage remains anything but predictable.

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