http://hfm.global/hfmtechnology/opinion/the-ctos-role-in-dealing-with-the-newpb-world/
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.