11 December 2012

Hedgeweek: New regulations set to raise costs and erode margins

"The operational expense and sheer implementation cost under all this new regulation is not something prime brokers will be able to pass on easily to their clients, so I expect their profit margins will be impacted...", comments Claude Brown, prime brokerage expert at law firm Clifford Chance.

These are challenging times for prime brokers. On the one hand their hedge fund clients are becoming more demanding by wanting better solutions at lower cost, at a time when trading volumes are down significantly and leverage levels remain modest at around the 2.5 to 2.5x mark. On the other hand, they’re facing increased costs of doing business because of the raft of regulation coming down stream.

Put simply, prime brokers are going to need to firewall themselves from the bank’s depositary function (if it has one). As one prime broker stated, this will involve creating new contractual relationships between depositaries and primes, adding that they themselves were now currently “working with all the top custodians, who will become depositaries, to jointly address the issues our clients will face”.

This means that those who stay in the game are going to have to restructure themselves so as to ensure the depositary function is completely separate from the prime brokerage business. Clearly, there’s a cost, both material and operational, to doing this. The whole point of having a depositary function alongside the prime brokerage is for banks to create synergies. Under the Directive, banks will have to run an autonomous organisation within an autonomous organisation – rather like the Russian doll – and in one fell swoop remove the very operational efficiency it was designed to achieve through this forced separation.

The degree to which prime brokers are affected by the AIFMD will depend on whether they are “pure” prime brokers – that is institutions like Goldman Sachs and Morgan Stanley – or whether they are universal banks that have decided to do prime brokerage. These institutions, provided they effectively re-structure themselves based on the above, will find it easier to provide the depositary function. For the independent prime brokers, it might prove tougher.

Another key concern for primes is the liability issue under the Directive. Up until this year a lot of trust was placed in ESMA’s recommendations that securities being held as collateral would not have to be treated within the strict liability requirements under the Directive. That’s no longer the case.

The issue of prime brokers using the repo markets and re-hypothecation to finance a lot of the services they provide is also important in light of the fact that the Financial Stability Board (FSB) last month released a white paper on the potential regulation of the shadow banking market, entitled Global Shadow Banking Monitoring Report 2012. The objective here is to ascertain the degree of potential systemic risk created by such activity. Says Richard Frase, partner at Dechert LLP: “Is there a mismatch between the assets raised by prime brokers on the back of clients’ securities and their obligations on the other side? The answer might be no but it’s likely to be re-examined again.”

It’s too early to tell what impact potential shadow banking regulation will have on primes but Brown thinks it could actually be a positive development because it would, in effect, level the playing field: i.e. bring hedge funds and other non-banking institutions who are increasingly starting to lend into a regulatory framework.

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