Pershing and Fidelity, two recent prime brokerage entrants backed by deep-pocketed parent companies, hope securities lending will propel them among the elite primes. Still, these prime brokerage units-launched by financial services giants Fidelity Capital Services and BNY Mellon’s Pershing-are competing with long-established, bigger firms like Bear Stearns and Goldman Sachs.
“Fidelity, as an agency-only broker, could be an effective prime broker player,” says Josh Galper, managing principal with the consultant Vodia Group.
Galper, however, questions if Pershing’s prime brokerage’s unit, also an agency only broker, will receive adequate support. He says this is because its parent’s core custody business at BNY might end up competing with the prime brokerage unit for some would-be accounts, so the unit might not receive the support it needs.
Hurdles Ahead
Without a doubt, Fidelity’s and Pershing’s prime units face many hurdles. Recent history hasn’t been good for new primes. Industry observers say that entrants typically have ended up competing for the scraps, aiming their services at the small and midsize hedge funds that the bulge bracket primes ignore.
But Fidelity and Pershing hope they have a wedge that will help them become significant players-securities lending. It will be a key factor in making inroads into the booming hedge fund business, officials of the two firms say.
Pershing launched Pershing Prime Services last July. It now has 20 clients. Half are mutual funds engaged in 130/30 strategies.
Jeremy Todd, who runs the prime brokerage’s sales effort, says some customers may have as little as $100 million in assets, but that the median size is about $2 billion.
By contrast, Fidelity Prime Services has been around for a few years, according to Mark Haggerty, president of Fidelity Capital Markets Services. Its largest client manages some $10 billion in assets. “We could have some portion of those assets,” Haggerty says.
Galper notes that Fidelity could make an effective securities lending argument with hedge funds because it has access to a huge equities pool. Fidelity Prime Services has about $1.5 trillion in customer assets, according to its Web site. However, not all these assets are lendable.
Fidelity Should Push
A hedge fund manager, who declined to be identified and who mostly uses a bulge bracket’s prime unit, says that “the question about Fidelity is: Why haven’t they been more aggressive in pushing their prime service?”
Constance L. Hunter, a portfolio manager and partner at New York-based Coronat Capital Management, with $45 million in assets, thinks the two new primes offer benefits.
“They would make for good supplemental prime brokers,” says Hunter, who uses prime brokerage services. She adds that it’s reassuring for asset managers to use secondary or tertiary counterparties.
One benefit of Fidelity and Pershing to date is that neither has been affected by recent subprime issues. Therefore, using them reduces custodial risk, according to Hunter.
But market problems may or may not be gone in a relatively short period. So after the market turbulence, how will Pershing and Fidelity sell themselves as alternatives to the big primes? Haggerty says Fidelity’s prime has been “highly focused” on funds pursuing long/short strategies. They have access to the securities Fidelity handles for correspondent broker-dealers and registered investment advisors. Fidelity also has a big retail brokerage customer base.
Pershing’s Todd says its securities lending operation has an inventory that includes the clearer’s some 1,000 broker-dealers and RIA customers. He adds that Pershing will have competitive pricing. Easier-to-borrow securities are typically lent at an adjustable rate below the federal funds rate, so that rates are competitive and similar across the market. The rates for hard-to-borrow stocks fluctuate much more.
Prime brokers that do not have those securities in inventories must find them elsewhere. That usually means a higher borrowing rate. The rate would be above the original lender’s wholesale rate, which Pershing officials like to emphasize.
Todd notes that Pershing holds $950 billion in securities under custody. Much can be borrowed. “We’re able to be very aggressive on the pricing we offer,” he says.
A Tout That Fails
A hedge fund manager who declined attribution says that touting access to hard-to-borrows is an unreliable long-term approach. Availability of those securities is unpredictable, he adds.
Nevertheless, if the two primes offer the wholesale rate to their own hedge fund customers, “it could be a huge savings for them,” the manager says.
Still, Linda Munn, co-founder of Hedgepros, a New York-based consultancy, says that may be short-lived. “Price is negotiable … so savvy CFOs will negotiate the price with Fidelity [or Pershing] and browbeat their current provider,” Munn says.
And both Fidelity and Pershing could have another problem. They both have sophisticated risk management systems that track customers’ exposures. However, neither offers risk management systems to clients.
Clients of both who seek risk management services must choose from third parties, such as RiskMetrics Group and Imagine Software. Still, clients of the big primes can just obtain these risk management systems as part of a total package of services. Big prime brokerages, no doubt, will mention this to potential clients, arguing that sometimes bigger and older is better.
Indeed, the quality of risk management services offered by primes is important, Munn says. She adds that the latest hot button among hedge funds is software to view total risk, across multiple prime brokers, asset classes and trading strategies, even if the manager decides to override warnings. Those applications’ tools include sensitivity analysis and what if?’ scenarios.
“Everybody wants to know what total risk is,” says a hedge fund manager who declined to be identified. “Risk management is a huge part of running a fund, and you either have to get a system from your prime or a third party.”
The manager also notes that third-party risk management systems are often costly. Typically, they are affordable only by larger hedge funds managing at least $200 million in assets. That leaves smaller funds dependent on primes or in a bind. Todd points to three categories of risk management: pure portfolio risk, which is measured using standards such as value at risk, R-squared and the Greek coefficients used for options; counterparty risk; and the sophisticated risk systems that slice and dice exposures and measure risk across portfolios.
Counterparty Risk
Pershing received increased attention for the second category, Todd says. “We’re getting a lot of calls from people concerned about counterparty risk,” he says. He hopes it’s a selling point that will attract business.
Moreover, Todd says, current customers of other parts of the bank can potentially obtain better pricing by beginning a prime brokerage relationship. Says Todd, “It’s been a natural discussion for us to say, Why not look at us?'”
Vodia’s Galper, who questions whether Pershing will make the commitment to securities lending, says there’s a way to silence any doubts about the commitment.
“If Bank of New York is really ready to leverage its balance sheet,” Galper says, “and provide securities lending and margin financing services on a global basis, then they could become a player.” And how can one tell if the commitment at either firm is real?
Galper says Pershing or Fidelity will start getting more of the $5 billion to $10 billion hedge funds.
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