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Shaking Up Prime Brokerage: Unbundling Securities Lending, Financing, and Derivatives Transactions

Shaking Up Prime Brokerage: Unbundling Securities Lending, Financing, and Derivatives Transactions

According to a new report by Aite Group, LLC, in partnership with Vodia Group, LLC, over the next three years, alternative venues for executing securities lending and derivatives transactions will create a host of new challenges to the top Prime Brokers.
By Josh Galper

Boston, MA, October 17, 2005 – The Prime Broker divisions of major banks have established themselves as reliable, consistent earners in a highly volatile market environment. Their dominance has been achieved by secrecy surrounding the business, knowledge of profit margins, and in the bundling of products and services to all strata of the hedge fund marketplace. Competition between the large and small Primes has driven some margin contraction; soon however, a new wave of entrants will have a much greater impact than any Goldman/Morgan/Bear competition.

New offerings will succeed to at least some degree by providing transparency and unbundled, a la carte solutions. We estimate that currently, hedge fund service providers earn between US$8.7 billion and US$12.2 billion annually in the area of securities lending. A willingness by newer Prime Brokers and independent service providers to accept lower margins in exchange for a piece of the pie will push this figure down to between US$7.2 billion and US$10.5 billion, a reduction of between 16% and 21% of current industry revenues.

For specific trades, we found that hedge funds lost between US$17,574 (overpaid) and US$29,592 (lost interest) on an annualized basis by not knowing where the best securities lending price could be found. While these numbers are small in themselves, multiplied by 100 or 1,000 they begin to have a meaningful impact on a fund's returns.

The Prime Brokers will find shortly that their margins are under more pressure than usual, but that does not mean that hedge funds will migrate en masse away from their traditional service providers. The bundled services that a Prime provides will be onerous to reproduce for some firms, particularly in post-trades allocation, risk management and capital introduction. We estimate that between 2005 and 2008, 10% of hedge fund securities lending and derivatives trades will be executed outside of the traditional Prime Brokerage arena, and another 10% will be managed by hedge fund "aggregators" able to negotiate with Primes more effectively than individual firms on their own.

This is a 28-page Impact Report. Clients of Aite Group's Institutional Securities service can download the report.