Buffeted by higher capital and liquidity requirements from regulators the economic model for prime brokerage has been upended. As a result the tradition of hedge funds keeping “relationship maintenance” balances has become a thing of the past given that ROA (Return on Assets) is the new mantra being chanted by PBs.
Nowadays hedge funds need to look at how much they are contributing to the “share of wallet” on a risk-adjusted balance sheet basis at their prime brokers. Generating high gross revenues (based on commissions, swaps, shorts etc.) or maintaining large collateral balances will not necessarily mean that funds will remain part of the “client franchise” at their prime broker(s) of choice. The trading strategies they pursue, the illiquidity of the asset classes they trade and the term structure of their financing will all need to be factored in as well to ensure they can clear the ROA hurdles that banks are setting for their prime brokerage units.
Hedge funds will need more transparency into how their brokers are assessing the economics of their relationships across multiple business lines, including the ROA criteria and assumptions (e.g. which positions or exposures can be deemed offsetting or the margining rules on their trading book). Research shows the average hedge fund could see a drop in returns of 10–20 basis points if financing rates for less liquid assets rise by 25–50 basis points*.
Once PBs are comfortable (and able) to support such a transactional level of transparency, rules can be codified, feeds can be generated and solutions can be implemented so that a dialogue with hedge fund clients can become meaningful and mutually beneficial.
Technology will be crucial in helping to facilitate this two-way dialogue between fund and broker and to subsequently support real-time decision-making.
Hedge funds can then allocate financing across their preferred set of counter parties to ensure they meet any ROA criteria, as well as give themselves the ability to compare rates between brokers and optimize/secure their financing requirements on an ongoing basis.
Solutions available in the marketplace today represent only stage one in the evolution of Active Treasury Management. It is likely that there will be a three-stage evolution:
Stage 1. ROA – how attractive is your hedge fund to PBs? Do you have a “house view”? Can you allocate your portfolios/positions to ensure optimal financing at your PBs?
Stage 2. Funding term structure – how well is your hedge fund managing all of its financing, across the next week, month, quarter? Do you have funding calendars? Can you approximate to your PBs funding curves?
Stage 3. Balance sheet management – what is the impact of your financing decisions (i.e. 1 and 2) on your own balance sheet overall.
Such solutions will favour funds that are willing to spend strategically on technology. Given the ROA lens that PBs are now scrutinising hedge funds through it is likely that the bulk of financing accrues to the largest (and by definition most profitable) funds.
Without an Active Treasury function other hedge funds will find it hard to compete with them. Access to financing and leverage could become a competitive advantage only available to the biggest.
—-
As a side-note, all of this assumes there will not be any technology-led disruptive innovation in the hedge fund financing market. It is entirely possible – although somewhat unlikely in the short-term – that new business models emerge to make up for the shortfall in available financing to an industry that is expected to grow to $5.8 trillion in 2018. The development of peer-to-peer collateral platforms, or the entrance of non-banks into some aspects of the Prime Brokerage business (e.g. Inter-dealer brokers or exchanges) could be examples of this.