Prime Time For Multi-Broker Model
As fear grips Wall Street, a reality emerges: the single prime broker model is dead
By Gerelyn Terzo October 20, 2008
Rumors about Morgan Stanley and the potential demise of its prime brokerage business--which provides financing, clearing and settlement services for hedge funds--have been swirling for weeks. That dose of fear, which was perpetuated by the collapse of Lehman Brothers, was enough to trigger an exodus of hundreds of billions of dollars in hedge fund assets out of the doors of the once-dominant prime broker Morgan Stanley and into Deutsche Bank and Credit Suisse.
"Some brokers on the street started setting up 24-hour operations just to handle new clients," said a source close to the hedge fund community who declined to be named. "They were doing nothing but setting up accounts, 24/7."
The fear tied to Morgan Stanley was mitigated by the recent capital infusion by Mitsubishi UFJ with the implicit backing of the US government, which gives the Japanese bank a 21% stake in the bank. On top of that, the US government itself plans to buy $10 billion of preferred shares in Morgan Stanley. "It has been a saving grace and has placed a floor under their business," says Robbert Van Batenburg, head of research at independent broker dealer Louis Capital.
But fear can be powerful. And while Mitsubishi's guarantee indeed may have provided a bottom, investors certainly are not treating Morgan Stanley's stock that way. Also, the spreads on Morgan's credit default swaps--a key indicator of a bank's overall health--have widened.
Hedge fund managers tend to follow a herd mentality more than most investors. They are a curiously close-knit group that talk frequently and collaborate on deals. So when a fund manager began withdrawing funds furiously on Sept. 15, which is when much of the transfers began, others were not far behind.
"The Monday after Lehman's demise was the catalyst," said a source in the hedge fund industry. "Everybody was convinced 100% that before the end of that week, Goldman Sachs and Morgan Stanley would be belly-up as well." Consequently, they all began moving their assets rapidly.
Indeed, fund managers are leaving Goldman's prime brokerage, as well. Combined, some 1,000 hedge-fund clients have fled Goldman Sachs and Morgan Stanley since Sept. 15, according to the source in the hedge fund industry. "Once the dust settles, hedge funds say they would move their business back to Morgan Stanley and Goldman Sachs. But those banks are never going to get 100% of the business again," said the source. Goldman and Morgan weren't available to comment.
As Lehman collapsed, hedge fund managers collectively realized the importance of a multi-prime-broker platform. Until then, Goldman and Morgan Stanley (and the former Bear Stearns) ruled the roost, and used that clout to strong-arm clients into keeping all of their assets under their umbrella.
"The risk of using a single prime doesn't make any sense," says Sameer Shalaby, chief executive at Paladyne, which provides technology solutions to hedge funds. "Having a single prime brokerage relationship clearly is risky from a counterparty and credit exposure standpoint. At this point, everybody recognizes the single prime model is dead." Shalaby says an appropriate number to have is three.
One beneficiary of the diversification is Merlin Securities, a technology-driven prime brokerage founded just over four years ago. The firm services hedge funds that on average manage $50 million to $1.5 billion. Merlin clears its hedge fund business with Goldman Sachs and JPMorgan, and runs a multi-prime reporting platform. Aaron Vermut, chief operating officer at Merlin, says that at the rate hedge fund clients are flocking to Merlin, the firm could feasibly double its business by year's end. "We happen to be very fortunate to be well-positioned for this. There's no way we could have foreseen what's going on in the markets today."
San Francisco-based Conifer Securities has for the past 20 years been providing the very technology that allows hedge funds to use multiple prime brokers. On Oct. 15, the company launched its prime brokerage business and is already fielding calls from several multi-billion-dollar funds interested in the program. JPMorgan's broker-dealer business will serve as the custodian of Conifer's hedge-fund assets.
"We're facilitating and expediting hedge funds' desires to have multi-prime relationships," says Jack McDonald, CEO of Conifer. "It's going to be a fit for the smaller and mid-sized managers looking for a lead prime or for those who want to add a second."
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