Hedge Funds Diversify Away from Single Prime After Financial Turmoil Leads to Collapse of Major Brokers

Why It's Important: With the demise of Bear Stearns in March 2008 and the bankruptcy of Lehman Brothers this past September, hedge funds that had prime brokerage relationships with these firms were exposed to significant counterparty risk. Some hedge funds that primed with Lehman had their assets frozen as part of the European bankruptcy proceedings against Lehman, driving some to liquidate securities to meet redemption calls from investors and even forcing some out of business. "There are people who either had long assets on deposit and can't get them back or, worse, Lehman borrowed the assets and lent them out," explains Larry Tabb, founder and CEO of TABB Group.

Where the Industry Is Now: Most hedge funds with more than $250 million in assets have relationships with two to four primes, which are picked for their trading expertise in certain asset classes (e.g., FX or derivatives) or geographies, such as Europe or Asia. For smaller hedge funds, however, diversifying can be difficult because the large prime brokers have minimum-asset requirements and other constraints to weed out the smaller players. Smaller hedge funds, with $10 to $15 million in AUM, typically launch with a single prime broker that may provide trading systems, margin accounts, stock loans and clearing.

Focus in 2008: Hedge funds will move to diversify their prime brokerage relationships to protect their investors' assets. "It boils down to diversification," says Michael Levas, chief investment officer at Olympian Capital Management in Fort Lauderdale, Fla., who selected RBC Capital Markets as a prime broker because it has a triple-A rating and also has a second prime broker on tap in case he needs it. To offer smaller hedge funds the opportunity to diversify broker relationships, mini-primes (e.g., Cuttone & Co.) that partner with the larger prime brokers on the back end for stock loan and clearing services are emerging.

Industry Leaders: Prime brokers Goldman Sachs, Morgan Stanley and J.P. Morgan (which bought No. 3 prime broker Bear Stearns) will continue to be the three strongest players, along with Credit Suisse, which onboarded a lot of hedge fund clients after the Lehman bankruptcy. Barclays Capital (which acquired Lehman's North American trading business) will pick up where Lehman left off, and Bank of America will jump back in via its purchase of Merrill Lynch. However, global custodians -- The Bank of New York Mellon, Northern Trust and State Street Bank, as well as Citi and J.P. Morgan Chase -- also will emerge as strong players. "In the changing landscape, global custodians will have a bigger role to play in the context of prime brokerage because securities held on deposit at a global custodian cannot be rehypothecated [i.e., lent out]," explains Terry Ransford, SVP, director of trading and technology, Northern Trust Securities.

Technology Providers: Hedge funds will need software to capture daily data from each prime broker, reconcile their positions with each firm and monitor their risk. "You can't get the risk analysis done unless you have all the data from the primes," says Mark Coriaty, director of professional services at Eze Castle Integration.

Some of the third-party providers in the space include Nirvana Solutions, Sophis, Imagine Software, Paladyne Systems and FTEN. "We're multiprime out of the box," says Philippe Stefan, head of global business development at Sophis, which is used by large hedge funds to confirm and reconcile positions with multiple prime brokers.

Price Tag: Transitioning from a single-prime to a multiple-prime environment is labor-intensive and brings more complexity and operational costs --involving systems, IT staff, risk monitoring and compliance. "There are some software costs that could add a couple hundred thousand dollars in expenses per year just to manage this," says Donato Cuttone, founder and senior managing director at Cuttone & Co.