There’s a lot of fat in the securities lending services sold to hedge funds by the biggest prime brokers. At least that’s what the leaders of upstart securities lender Quadriserv contend, as they target the sweet spot in the industry: hedge funds. These funds’ voracious appetite for borrowing stock for short-selling strategies is well known-and a key component to prime brokerage profitability.
But Quadriserv execs say they have a broker-neutral securities lending platform that won’t tie funds to prime brokerages.
“Now when [hedge funds] need to borrow a security and get a locate on it, they need to execute with that same prime broker,” says Gregory DePetris, one of Quadriserv’s founders. And that often means higher costs, he says.
The firm’s new automated agency model is a kind of cooperative securities lending service designed to take advantage of unbundling. By decoupling a piece of the prime brokerage service, Quadriserv hopes to convince hedge funds that they can lower funds’ borrowing costs.
Tighter Pricing
If a guy is long margin stock, he may be borrowing at Fed Funds plus 30 [basis points]. We’ll show him how he can do it at a Fed-plus-15 rate,” says Joseph Weinhoffer, founder and CEO of Quadriserv. “And now he knows he can borrow money from us cheaper than he can from his prime broker.”
Quadriserv’s supporters say the securities lending market today is opaque, reminiscent of Nasdaq in the early 1990s.
Josh Galper, managing principal of consultant Vodia Group, sometimes advises clients to use the firm. He says Quadriserv is an unbundling play.
So maybe this upstart can lend cheaper and shine light on the market. But does it have the flow? To do battle with the primes, Quadriserv must convince prospective clients that it does.
“When you’re dealing with an illiquid over-the-counter marketplace, you don’t inherently know that there’s enough internal liquidity there, as you would with Goldman [Sachs] or Bear [Stearns],” says one trading industry player who knows Quadriserv, but asked not to be named.
Early Stages
According to Quadriserv, the firm has
commitments from custodians for $2 billion in exclusive assets. Quadriserv also has a $50 million letter of credit with the Bank of New York. The firm isn’t profitable yet, since the brokerage arm only launched a year ago. But Weinhoffer expects profitability in the next 12 to 18 months.
Brad Hintze, an industry analyst with Bernstein Research, believes prime brokerages are ripe for competition. For example, say a fund is paying a legitimate high price covering a hard-to-find stock as a short, Hintze says. But the market shifts. Now the security is no longer expensive.
“Nevertheless, you’re not going to get a cut. They [the prime brokers] are going to leave it at its original price,” Hintze says.
DePetris believes Quadriserv’s agency model will appeal to hedge funds that have the ability to borrow stock away from their primes, enabling them to save money. He hopes many will believe it isn’t necessary to give all their business to the major prime shops like Goldman Sachs, Morgan Stanley and Bear Stearns, all of which declined to comment for this story.
“There’s room enough in the world for both of us. We provide a pretty targeted service to a pretty targeted constituency,” DePetris adds.
“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.”
