Prime brokers face rapid evolution as regulations bite

As global regulatory frameworks become more intrusive over the coming years, prime brokers and hedge funds will be forced to implement radical changes to their business models, a forum heard.
Prime brokers face rapid evolution as regulations bite

Prime brokers' and hedge funds’ business models will see rapid evolution over the next three years as the impact of new global regulations take effect, a forum heard.

With Basel III rules becoming more fully implemented around the world, the leverage that hedge funds can deploy is expected to be hit as financing costs rise.

A robust and diverse investor base has been cited as one way for the funds and brokers to cope with a still-uncertain global regulatory environment.

Chris Nash, COO of Hong Kong-based hedge fund manager Senrigan Capital, said that he saw a very different prime broker model evolve over the next 2-3 years as regulations such as Basel III are rolled out.

“We are going to see a whole change in the structure of balance sheets,” said Nash, referring to prime brokers' balance sheets.

He sees that impacting the amount of leverage that hedge funds will be able to deploy and the cost of financing. “There will be more incentive to move activity off balance sheet and use institutional custody models,” he added.

Hedge funds are reacting by trying to diversify their investor base and cut costs by outsourcing, agreed members of a panel discussion at a forum hosted by Linedata, a provider of portfolio management software, in Hong Kong last Thursday.

“There is a lot of interest around the middle office space,” said Grant Suttie, managing director for alternative investment services at BNY Mellon, referring to hedge funds’ aim to cut costs by outsourcing more functions in addition to back office activities.

Suttie said that predicting how regulatory changes would impact his clients was the biggest challenge facing his business.

Uncertainty about the future regulatory landscape endures. Last week, for example, the Volcker Alliance – set up by former US Federal Reserve chairman Paul Volcker – released a report calling for a new Prudential Supervisory Authority in the US.

Gregoire Dechy, COO of Hong Kong-based hedge fund SPQ Asia Capital pointed to the importance of having a robust and diverse investor base. Launching more products is one way to achieve this goal. “If we found a good seed investor who wants us to have a Ucits fund we would love to have it,” said Dechy.

The number of liquid alternative funds has grown rapidly in recent years. A total of 64 new Ucits funds were launched globally last year, bringing the total to 798, according to data provider Preqin.

The trend is for more balance sheet-friendly equity strategies to take a higher share of new launches. Equity strategies accounted for 51% of Ucits launches last year, up from 26% in 2005.

The share of less balance sheet-friendly macro and credit strategy Ucits launches declined from 32% and 21% respectively in 2005 to 17% and 9% last year.

In addition, changing prime broker priorities are impacting the type of hedge funds launched. “I wouldn’t want to be trying to launch a convert fund,” Nash said. Prime brokers fall over themselves to service  multi-strategy hedge fund clients but are less keen on servicing credit and macro strategies, said an industry source. That is because the mix of strategies run by a typical multi-strategy hedge fund range from more to less balance sheet-friendly, balancing each other out.

Dechy pointed out that the ability of systems such as Linedata’s Global Hedge platform to apply different rules across different funds means that “we don’t really have to focus or think too much about how we allocate our trades as that is handled by the system”.

Senrigan’s Nash pointed to the need for flexible mechanisms to supply different sets of data to the growing number of counterparties that managers need to connect to – from regulators to service providers, including prime brokers.

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