Many Happy Returns (On Assets)

Citigroup’s Prime Services Consulting group’s white paper that came out in the early summer (Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization) is the best paper yet on the impact of the new regulations on prime broker profitability and hedge fund return on assets (ROA). These new regulations, especially those affecting, liquidity and leverage, are having a significant impact on the profitability of the prime brokerage business.  The initial response by the prime brokers has been to raise prices for their services and consider off boarding less profitable clients.

The Citigroup paper (Part 2, Section 6) presents a detailed description of another way to approach the issue: Hedge funds need to work with the prime brokers to make their portfolios more efficient. Efficient being defined as maximizing how a hedge fund’s long and short positions can be used to reduce the funding of the prime broker’s overall client book, thereby reducing balance sheet usage and increasing the hedge fund’s ROA.

This more efficient relationship carries with it one very big assumption: That primes will share detailed optimization data (i.e., what long and short positions they need to reduce their funding and balance sheet usage) with a broad range of clients. Until now primes have viewed this information as highly confidential – even restricting access to this data internally. Now they are being asked to have regular conversations with clients about the makeup of their prime brokerage book. This type of transparency is a significant cultural shift for the primes. In addition there are the technological and security challenges of communicating this information to their hedge fund clients.

The prime broker book is, to state the obvious, made up of all their clients’ individual books.  This makes the optimization process, if taken to its extreme, somewhat circular.   For example, by the time the prime gets to the tenth client the book has changed from what the first client did to make their book more optimal.  Changes to one changes the overall and changes to many… well you get the idea. What makes sense in concept may not be as straightforward in practice.

Another issue is not all the primes have achieved the same level in their ability to calculate ROA, balance sheet usage, etc.  So in addition to the aforementioned challenges some primes still have some work to do before they can even think about having constructive conversations about portfolio optimization with their clients.

The examples in the white paper lay out how a hedge fund could re-balance their portfolio across primes to maximize ROA.  The examples use a multi-prime structure of four primes where one prime has 60% share, one 20% and the other two 10%. The size of the book is $2.4B in debits and shorts. The number of primes for this size book is reasonable. However the distribution of balances, post crisis, is generally not this skewed.  It would be interesting to see this analysis with a more even distribution of balances across primes.

Still this is a very thoughtful paper that lays out a roadmap for how hedge funds and primes can work together to optimize their financing relationship in the new regulatory world order.  How quickly the industry adopts this approach is an open question. My guess is the primes will move only as fast as their senior management makes them.

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