Jared Dillian
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The Great Rebalancing

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April 16, 2007

New Kid on the Block

By Gregory Bresiger

Also in this article

  • New Kid on the Block
  • Upstart doesn't expect all the stock lending business. It just wants to wet its beek

"Theoretically, the Quadriserv model should be attractive to hedge funds," says Vodia's Galper. "But what Quadriserv and others are really up against are cultural and business-practice change."

And there's another hurdle that keeps hedge funds from bringing in a new lender, Galper says. Switching any or all securities lending from a prime brokerage to a Quadriserv would mean higher technology costs.

But others are also getting into the act. Quadriserv's Weinhoffer says European banks are moving into the securities lending business and aim to provide cheaper financing to hedge funds. Weinhoffer says these businesses want to use securities lending to establish relationships with hedge funds.

Too Dependent

Still, many hedge fund officials are hesitant to change their relationships with a single prime broker. They depend on the broker for research, using its name to obtain meetings with company management. So hedge funds become dependent on the brokerage leviathans, which provide valuable soup-to-nuts services.

From the perspective of the big prime brokers, these services generate a lot of income through margin loans, clearing and securities lending.

Industry players tell Traders Magazine that securities lending, as part of a package of prime brokerage services, is generally a good business, one in which hedge funds will often overpay. However, competition has generally stayed among the top prime brokerages. Now, the entrance of new players is changing the securities lending, just as electronic communications networks and alternative trading systems changed stock trading in the late 1990s.

More entrants mean some aspects of securities lending-like margin lending-can be less profitable or even loss leaders.

Arms Race

The squeeze in this area has resulted in tighter margin spreads and what Bernstein Research calls "a technology arms race" in the securities lending business. Worse than that for those who want to be a part of this business, hedge funds are now demanding dirt-cheap rates.

"In margin lending," Bernstein Research writes, "the largest hedge funds have been able to negotiate their loans as low as Federal Funds plus 30 basis points, which means that the margin loans are generating returns well below the costs of capital for the lender."

Quadriserv began as a data business in the fall of 2001, providing stock loan transaction information to hedge funds, and growing by referral. By 2004, Quadriserv Securities, a broker-dealer, was launched. Quadriserv has been trying to undercut the prime brokerages by disclosing its pricing to both sides of a trade. But it does not reveal where the stock came from, according to Weinhoffer.

A typical Quadriserv client is a hedge fund ranging in size from $400 million to $12 billion that employs a long-short strategy. Agent banks, institutional lenders and broker-dealers round out the firm's client list.

Today, Quadriserv has 20 counterparties, a combination of brokerages and hedge funds. It expects to have 30 counterparties by the end of the year.

How? The firm is betting on the continued boom in hedge fund business and the acceptance of unbundling. That's something one Quadriserv official calls "an inevitability." It is also betting that the big prime brokers won't turn and swat down the new kid on the block. Maybe one of them might buy a Quadriserv and "move on," one trading executive suggested.

So who is the target client most likely today to benefit from Quadriserv's model?

Hedge funds that are not raising money, don't need research or capital introduction, and have dozens of executing brokers, Weinhoffer says. In his view, these funds are probably overpaying for securities lending.

A Share

Quadriserv's preference is for clients that give it about 20 percent of their securities lending business. The firm doesn't expect these clients to walk away from their prime brokerage relationships.

"There are valuable services that a prime brokerage performs," DePetris says.

He stresses that Quadriserv has a limited menu and that the best prime brokers can deliver vital services to hedge funds, including accounting, research, clearing and execution, and a deeper inventory of hard-to-get stocks than a Quadriserv could muster.

Bernstein's Hintz adds that hedge funds' dependence on prime brokers may hinge on other factors as well. Many funds with limited infrastructure rely on their primes for services they'd rather not build themselves. In trading, as in life, some fat may be inevitable-and even necessary.

"These hedge funds are run by the best traders in the world," Hintz says, "but they don't have the scale to make sure that they're not being nickled-and-dimed by prime brokers."