MULTI PLE PRIME UTILITY: the key to transforming the fund manager/prime broker relationship
By Sudhanshu Bahadur, Valcony Sun, and Vishal Bakshi
In response to the financial crisis, financial markets across the world are transforming themselves. One
of the most significant changes happening today is in the Prime Broker/Fund Manager relationship—a
world in which Prime Brokers (PBs) provide a variety of services to Fund Managers. The Fund Manager’s
alpha generation bottom-line and the Prime Broker’s services-based business model were both
impacted by the turmoil in the financial markets, prompting a restructuring of the industry and a
transformation of the industry’s operating model.
In this article, Sudhanshu Bahadur, Vishal Bakshi and Valcony Sun explore the changing business model
of Fund Managers and Prime Brokers and the emergence of the multi-prime broker. They also analyze
the nature of the challenges these firms face and suggest a transformation path for the next generation
of Prime Brokers.
EVOLVING THE PRIME BRO KERAGE BUSINESS MODEL
Prime Brokerage was once described as the largest but least noticed banking system in the world. It is
the gateway between Fund Managers and the marketplace. The proliferation of Fund Managers in the
last two decades of the 20th century led to phenomenal demand for PBs. They contribute greatly to
their clients’ success and increase the profit margins for Investment Banks by providing custodial
services, margin financing, securities lending, portfolio accounting, synthetic lending and other services.
When large PBs offered a suite of services under one umbrella, Fund Managers could go to a single firm
to get end-to-end services. This allowed them to focus their energies on managing their portfolio
without being encumbered by non-alpha-generating operational functions. Having a single Prime Broker
act as a custodian of their assets was risky as it meant that the Fund Managers were “putting all their
eggs in one basket.”
Meanwhile, PBs would re-hypothecate these assets, often into pooled accounts, to lend them to other
parties. The market turmoil of 2008, with the collapse of Bear Stearns and bankruptcy of Lehman
Brothers, resulted in $65 billion in frozen Hedge Fund assets.1 The legal battles that ensued to find the
rightful owners resulted in huge losses for Fund Managers, and also to PBs as Funds withdrew their
capital. To decrease the re-hypothecation risk, Fund Managers demanded that their collateral be
segregated from their Prime Broker accounts. Instead of having the collateral sit with another custodian,
PBs stepped up and created a service called Prime Custody, where the Funds’ assets are held in a single
but segregated and protected account.
Having suffered considerable loss as a result of the crisis, Fund Managers realized that keeping all assets
under one custodian was a risky strategy and started looking at diversifying their risk by splitting the
basket under multiple PBs. This also gave them the opportunity to utilize different partners for the
different services that they offered, diversifying their asset portfolio mix and market reach. Fund
Managers have now largely switched to this multi-prime business model due to the flexibility it provides
and the associated reduction in counterparty exposure it offers.
While this model does provide the benefits of diversification, access to a wider product range and
competitive pricing, it also brings with it a new set of operational challenges.
CHALLENGES IN USING MULTIPRIME BROKERS
A number of factors drive a Fund Manager to adopt a multi-prime broker environment. As their
investment managers continue to expand into strategies that promise high returns, they look for
opportunities that provide access to new securities, geographies, mitigation of risk and competitive
pricing.
While a migration from a single-prime to multiprime model has benefited Fund Managers, it has also led
to increased complexity in their operations. At the same time, PBs are faced with a much more
demanding clientele that can use its diversified base for extracting better financial terms and
operational considerations. This new paradigm is also presenting the following challenges:
Administrative Issues
From an administrative perspective, funds now have to manage multiple relationships, with each new
relationship involving different products and services. Each of these new PB relationships offers a
significantly different operational flow. This brings about the challenge of evaluating each relationship as
it is formed, defining a new operating model for each and creating a new onboarding process.
Counterparty Risk
Because PBs range in size, product offering and complexity of service, they bring about different levels
of associated risk. In the past, Funds were aligned with a single PB, and their exposure had been aligned
to the PB’s ability to continue operating in an efficient and financially viable fashion. With multiple PB
relationships, Funds have to understand the counterparty risk associated with each one of them and
build a strategy towards mitigating that risk.
Trade Allocation
From the middle-office perspective, with Funds’ positions sitting with multiple brokers, trade allocation
across the primes becomes a challenge. Funds need to define more sophisticated trade allocation
processes not only to achieve best execution and generate alpha, but also to mitigate risk.
Reconciliation
Numerous relationships, each with its own complexity, create error-prone processes. This leads to
reconciliation breaks between the Fund and the PB. While each PB may support a reconciliation process,
they will have a different methodology, and Funds need to reconcile with each to reduce breaks.
Risk Management
In the past, the Fund Manager had all its positions sitting with a single PB. Hence, it was able to rely on
the risk reports produced by the PB. With positions straddling multiple PBs, Funds have had to invest in
internal risk technologies to aggregate balances across PBs and calculate Value-at-Risk (VaR), greeks and
other risk measures.
Portfolio Accounting
Portfolio Accounting is another function for which Funds have relied on the PB in the past. Once again,
the dispersion of positions across PBs required Funds to bring this function in-house, increasing
operational overhead and reducing profit margins.
Integration
One of the biggest challenges in establishing a new relationship between a Fund and a PB is the
integration between them. It can take months (and sometimes over a year) for a PB to onboard and
integrate a large Hedge Fund. The pain is felt on both sides as operations and technology teams struggle
to cope with the different interfaces involved. With Fund Managers now seeking to integrate with
multiple PBs, it has become an overwhelming task involving a huge cost and operational burden.
Reporting
All major PBs spend a considerable amount of resources on technology that provides their clients with
extensive sets of reports and extracts. These reports inform Fund Managers about their activity,
positions, performance, collateral utilization, margin situation, risk assessment, rebates and fees
incurred, etc. With multiple PBs providing these reports and extracts in custom formats, the Fund
Manager is no longer getting a consolidated set of reports. Instead, they have to collect all data from
multiple PBs, aggregate it and generate reports.
Additional Documentation/Counterparty Monitoring
Mounting regulatory oversight has increased the amount of documentation required to onboard a new
prime. This is further complicated if the Fund is comprised of Employee Retirement Income Security Act
(ERISA)/pension money. New Anti-Money Laundering (AML)/Know Your Customer (KYC) practices need
to be followed before adding another prime, which increases the complexity of relationship onboarding.
TRANSFORMATION PATH
Fund Managers must reassess their operating models to identify opportunities for improving the
efficiency and profitability of their current business, and conduct an assessment of their strengths to
identify how to invest in innovation and capability building.
In order to transition/onboard seamlessly to a new prime, it is often beneficial to leverage third-party
services. Involving these services early during the PB integration can help Fund Managers overcome the
challenges mentioned above and focus on core alpha generating efforts. Some critical areas of focus
should include service provider selection and defining the Target Operating Model (TOM) to overcome
operational inefficiencies.
As Fund Managers demand more transparency from their PBs and adjust their business models to
diversify counterparty risk, PBs also face new operational challenges around middle/back-office
functions as they try to accommodate clients’ needs and remain competitive. This has led to a
reorganization of the business model and competitive landscape of the Prime Brokerage industry.
In either case, reviewing the operating model is the key to flexibility, business agility, scalability and
minimum operational risk—which all contributes to future growth.
As the operating structure becomes complex, one area requires increasing attention: operations and IT.
This has been largely bypassed by Fund Managers who usually focus on other corporate and front-office
functions. Efficiency in these areas was never aggressively pursued because they are considered
business support functions rather than profit-generating functions. Recent years, however, have proved
that this uneven focus is a costly lapse, strategically as well as financially.
By defining a mature TOM, both PBs and Fund Managers will be able to transition to the nextgeneration
business model and more effectively address the challenges of today’s brokerage market.
TARGET OPERATING MODEL
A TOM is the idealized business vision of how an organization will operate. It includes the principles that
will be used to guide the organization’s behavior. Outputs typically include business processes,
objectives and organization ownership. The objective of an operating model is to ensure business agility
and scalability while minimizing operational risk. The processes defined within a TOM stand as the
foundation for business use cases.
The key areas of focus in operating strategy in the multi-prime world include:
1. Effective Counterparty Risk and Collateral Management
The counterparty risk in a single prime model is overbearing, a fact confirmed by the resulting turmoil
following the fall of Lehman Brothers as Fund Managers lost their collateralized assets. In the multiprime model, there is a need for stringent collateral administration and counterparty monitoring to
efficiently manage collateral across various PBs. The focus areas to ensure effective collateral
management processes include accurate valuation of assets, collateral allocation and optimization.
2. Standardized Trade Allocation Process
The multi-prime broker model necessitates an approach for trade allocation across the primes.
Depending upon the fund size, Fund Managers have to define an allocation methodology, such as static
allocation that can be by Fund, by market or by strategy; dynamic allocation that distributes by security,
at a pro-rata basis or arbitrarily; or opportunistic allocation by borrow availability or by executing
broker. Each option has its pros and cons and the final approach may vary from Fund to Fund. Based
upon resource availability, Fund Managers may opt to add staff or leverage outsourced organizations to
assist with allocation. Having a structured and effective allocation process ensures that the output data
can be sliced and diced in meaningful ways to suit data consumers’ needs.
3. Structured Reconciliation Process
Along with the issue of having to deal with a larger number of brokers comes the challenge of
maintaining accurate trade data. Standardized processes are required to manage cash and position
reconciliation with multiple parties—and to resolve exceptions/breaks in a timely manner. This requires
an investment in processes and technologies that can reconcile and report, minimizing breaks between
counterparties.
4. Aggregation
When using a single PB, the entire Fund Manager’s book is managed through a single counterparty, thus
enabling easier access to positions, balances and risk reports. With multiple primes, one of the biggest
challenges is to set up a process for the daily aggregation of data across multiple primes in order to track
the entire portfolio risk, performance metrics, etc. This also requires consideration by Fund Managers to
build infrastructures or outsource services to a third party. The infrastructure has to be efficient to
consume inputs from numerous primes that may be using different systems and various protocols, such
as flat-file, XML, SWIFT and FIX. It may also require customized integration with other existing systems
within the Fund. The in-house option can be complex and involves significant cost, but it also offers
complete control over the data and required reports. It has the added benefit of giving each Prime
Broker access to only their portion of the portfolio. Additionally, there is a tradeoff in the form of risk—
distracting the fund from its central purpose of alpha generation. Other options that can be considered
are hearsay reporting using a selected Prime Broker and using a Fund Administrator for aggregating and
reporting across PBs.
5. Sound Data Architecture
An operating strategy typically drives data aggregation requirements. If a fund is split between many PBs
to acquire better financing and also to spread risk, it becomes necessary to aggregate data from multiple
primes in order to generate consolidated reports. Hence, Fund Managers need to acquire technology to
achieve the same level of service and transparency as a single prime environment. This requires the
creation of a data architecture that allows for the consolidation of data ingested through various
mechanisms (ESBs, queues, messages, files, etc.), collection into usable packages (ABOR, IBOR, etc.) and
storage in an easily reportable format (data warehouses, dimensional data marts, etc.).
By establishing a TOM that addresses these focus areas in the multi-prime world, Fund Managers and
Asset Managers can increase their competitive advantage. Opportunities that could potentially set them
apart include looking into fast-growing solutions and technology that enable the firm to move with the
market, increase alpha, improve operational agility, reduce expenses and expand into innovative
products.
INDEPENDENT MULTI-PRIME UTILITY
In the future, PBs and Fund Managers will need to create an environment in which they can regain focus
on their core competencies. In this environment, Fund Managers will be able to concentrate on
generating alpha for their clients, without being burdened by aggregating positions and performing
other middle- and back-office functions. The PBs will be able to focus on providing value-add services,
such as Securities Lending, Margin Financing, Synthetic Lending, Repo
Financing, Swaps, etc.
A key element of this environment is a utility that would provide a seamless platform upon which to
conduct various business transactions and related operations. It would mitigate the complexity of
handling different systems, formats and associated protocols and enable the consolidation of backoffice
functions that neither PBs nor Fund Managers are well-positioned to perform. An independent body—
hosted either by a collaboration of PBs and Fund Managers, or by a third party—can act as an interface
between the PBs and Fund Managers.
This independent utility will be built upon an independently hosted infrastructure maintained by a third
party. It will integrate with multiple PBs and provide a single interface to Fund Managers, enabling
simple access to many PBs offering different services and market access. To access a new PB, the
Hedge Fund will only need to subscribe to that PB, without having to go through the long onboarding
and integration exercise that is required today.
Intermediaries, like Hedge Fund Administrators (HFAs), Third-Party Administrators (TPAs) or even large
PBs, might be well suited for the creation of such utilities, which will work on a feebased model and
provide services to both Fund Managers and PBs. This utility could provide a number of benefits,
including:
1. Integrating multiple Prime Brokers onto a single platform
The utility will integrate with multiple PBs into their custom environment using the PB’s protocols and
interfaces, removing the integration burden from the Fund Manager. The complex operational
processes currently part of onboarding a new Fund Manager into a Prime Broker, or vice versa, will be
undertaken by the utility. When onboarding another PB, the utility will create interfaces to access the
transactional, positional and other information from the PB and perform additional analytics on it.
2. Convenient access to multiple Prime Brokers for Fund Managers
The utility will build a standard interface that Fund Managers will use to gain access to PBs. This model
will require a one-time integration for the Fund Manager into the utility, after which the Fund Manager
will gain access to all the PBs that the utility offers under its umbrella. Both PBs and Fund Managers will
be able to avoid the burden of integrating multiple parties—a process that brings no financial benefit to
either. PBs will no longer have the burden of integration, while Fund Managers will have a single channel
to a broad market of PBs. As this model matures, it will provide Fund Managers ease of portfolio
movement from one Prime Broker to another, increasing their accessibility to the market.
3. Independently hosted technology
The multi-prime utility will be an independent body that will host its solution on its own infrastructure.
The utility will be responsible for maintaining that infrastructure and all operational processes involved,
and will have clearly defined SLAs with both PBs and Fund Managers. It will utilize best-of-breed
technologies for performing data integration, portfolio accounting, risk management, data management
and reporting functions.
4. Consolidated back-office functions across PBs
The utility will take over the job of performing back-office functions from PBs and Fund Managers. With
the availability of aggregated positions across multiple PBs, the utility will be best positioned to perform
risk management, portfolio accounting, reporting, compliance and similar back-office functions. Fund
Managers will receive consolidated data and reports, while the PBs will be able to focus on core
operations—instead of spending millions on non-value-add services.
CONCLUSION
The Fund Manager/Prime Broker relationship is continuing to evolve with the changing dynamics of the
marketplace. While Fund Managers are looking at diversifying risk and increasing revenue, PBs are
focused on improving their service offerings. Meanwhile, both parties are spending considerable
resources on integrating with each other and performing back-office functions that neither is well
positioned to perform.
Both parties will be better served by investing those dollars to strategically address the new paradigm of
a multi-prime marketplace, by creating a TOM that creates the right structures to overcome operational
complexities in a more holistic and fungible fashion. This may involve the realignment of non-profit
generating functions consolidation of services, refocusing Operations and IT teams and the creation of
technology solutions that enable seamless integration. In the long run, this will improve operational
efficiencies, reduce integration expenses and help them regain focus on their core competencies.
As the market becomes more competitive, a third-party multi-prime utility, offered by a Hedge Fund
Administrator, third-party administrator or a large PB, that integrates with multiple PBs and provides
single interfaces to Fund Managers, is a solution that could satisfy the evolving requirements of Fund
Managers.
Resources
1. Axel Pierron, “New Basis for the Hedge Fund / Prime Broker Relationship,” Celent, June 29,
2011, http://www.celent.com/reports/new-basis-hedgefund-prime-broker-relationship (August
13, 2014)
Sudhanshu Bahadur leads the technology domain for Sapient Global Markets in Canada. He advises
capital market firms in formulating, architecting and defining their solutions. Sudhanshu has 18 years of
extensive experience focused mainly on applications and products in risk management, trading systems
and data domains. Prior to Sapient, Sudhanshu led the Prime Brokerage Technology team in Toronto for
Bank of America Merrill Lynch, building risk, trading, financing and business intelligence platforms.
sbahadur@sapient.com
Valcony Sun is a Toronto-based Business Consulting Associate, specializing in capital market initiatives.
Since joining Sapient Global Markets, she has been involved in multiple strategic initiatives, such as
assessing the current technology landscape of a leading Canadian Prime Brokerage to position it for
future growth and defining the Target Operating Model of a major pension fund with a focus on the
investment lifecycle. Valcony is currently helping a top Canadian investment bank to design and
implement an entity data platform as part of a regulatory response initiative. vsun2@sapient.com
Vishal Bakshi is a Senior Associate of Trading and Risk Management based in Toronto and has over 10
years of consulting experience within the financial services industry. He has worked on numerous
transformation projects involving prime brokerage, regulatory compliance and wealth management
(financial planning). Vishal is currently helping a top Canadian bank manage operational risk across its
capital markets division. vbakshi1@sapient.com