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By James Shekerdemian, Global Head of Prime Brokerage Sales, Societe Generale Prime Services
The regulatory environment implemented since the financial crisis brings a host of challenges for prime brokers and their clients. The new rules are enormous in scope and touch on so many aspects of the trading cycle and related market participants that they are changing the very shape of the providers that supply these services. What’s more, they are providing a tough test for those that wish to stay in the business, as it is critical to continue investing in service provision in this new climate.
Bank capital regulation is one of the key initiatives impacting the delivery of prime services. Basel III in particular has presented a variety of new hurdles for investment banks to clear ahead of its implementation date in January 2017. This is significant for prime brokers in investment banks. While heightened concerns about counterparty risk mean they have a market advantage in being able to lean on the financial strength of their parent banks, it also means they must meet stricter requirements in their own activities, some of which are especially capital intensive.
What’s more, the capital environment is facing challenges that are growing with new product regulation. New clearing requirements introduced through Dodd-Frank in 2010 and EMIR in 2012 have made the OTC business highly capital intensive. OTC products have always carried margin requirements but new regulations demand that collateral must be of high quality: exactly the same assets that are expected to be seen on a bank’s core balance sheet to prove its solvency. This is placing brokerage businesses under unprecedented pressure to source capital, and presents a unique challenge for those associated with financial institutions that fall under Basel III’s remit.
For some institutions, this has proved too much to bear, and they have simply exited prime brokerage. Those that have chosen to remain have made the substantial investments necessary to continue and also become ever more creative about how they tackle these issues. There are some more technical solutions that can be used. Synthetic trades ask less of the balance sheet, so these are growing in popularity. Assisting clients with collateral management is also key, given the competing demands on capital, and the more sophisticated market participants are helping clients to transform ineligible assets into “postable” margin to facilitate compliance with these demands.
The regulatory environment has worked to gradually reduce the amount of leverage in the system. This also affects prime brokers’ client selection, with providers seeking to work with clients that are themselves well capitalized and without excessive leverage on their balance sheets that will be able to implement effective collateral management processes.
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These conditions have all contrived to make the operating environment much tougher for prime brokers. This is in addition to tough competition, sustained low interest rates and the higher cost of accessing capital. As a result of this, many have had to undergo a difficult process with their clients, repricing services as the cost of prime brokerage has risen. They have had to make considerable investment into prime services divisions to accommodate the additional compliance, capital costs and technology needed for effective risk management, which SGPS has put at the core of its approach.
The climate has also pushed prime brokers to find alternative sources of income to ensure that the business can remain sustainable. This is one of the factors that has led to the relationship between prime brokers and their clients evolving and significantly deepening – stretching wider to cross-asset and multiple-product propositions. This has benefited brokers within bigger capital markets businesses that can help to match clients with the ancillary services and products that they need.
These economies of scale can bring advantages in a host of ways. Bigger institutions can more easily tap into market liquidity and financing, which is essential in a capital-constrained climate. Capital introduction remains paramount for hedge fund clients in a highly challenging launch environment, so players that can effectively connect nascent funds with financing and accommodate the associated due diligence will have a distinct edge over their competitors. This is key given the growing segment of emerging managers keen to mobilize amid the burgeoning economic recovery.
Equally, prime brokers have had to reconsider their own internal processes and structures. World-class technology that enables straight-through processing (STP) and automation is essential to provide the scale and efficiencies needed to compete in today’s market. The demands brought about by the implementation of Mifid II have reinforced this need as prime brokers must demonstrate that they are offering best execution to their clients, as well as complying with the increased reporting demanded by derivatives regulation. Manual processing, as well as being resource intensive, is simply too susceptible to error to meet the standards required for effective risk monitoring and compliance.
It is unsurprising, therefore, that recent years have been marked by a consolidation in the prime services universe as providers have been forced to undergo a tough and honest assessment of whether they can feasibly continue to provide services in this operating environment. The industry that ultimately emerges at the end of this challenging period is likely to be a smaller group of well-capitalized players that can offer sophisticated technology along with a broader and deeper relationship with clients than ever before to help them achieve their business objectives. It is no coincidence that this group will also be those that have continued to reinvest substantial amounts into their offering at a critical time.