Newedge dares to be different
Newedge, the agency broker jointly owned by Credit Agricole and Société Générale, first entered the prime brokerage business as the provider of choice to CTAs and global macro and commodity funds. Now the firm is expanding its franchise along its most natural axes of growth: equity-based quant and statistical funds that trade frequently, and strategies which invest synthetically.
Prime brokerage is a surprisingly crowded market. Though there is a lot more differentiation and specialisation than industry-standard journalism allows for, it is still far from easy to develop a distinctive strategy. At bottom, the hopes of most new entrants to the industry hinge on securing 10 or 20 per cent of the business of hedge funds anxious to broaden their range of prime brokerage relationships, not so much to gain access to new capabilities or sources of stock or finance as to reduce counterparty credit risk and information leakage. What is striking about the fresh approach at Newedge is the fact that it breaks with the multi-prime consensus. Global head of prime brokerage Philippe Teilhard says the firm has instead reorganised itself to offer to those funds which can make best use of it an agency-only service in which prime brokerage sits alongside execution services of futures, options and securities instruments based on equities, fixed income, currency and commodities. The aim is to offer hedge funds a service that is integrated across the asset classes as far as Direct Market Access, clearing, settlement, reporting, financing, risk management, collateral management and stock loan are concerned whilst ensuring effective Chinese Walls with the service functions of research and execution. “We try to be different,” says Teilhard.
In fact, he is taking integration so seriously that he has scrapped even the geographical division of the business, which dated back to the merger of Fimat and Calyon that created the firm in 2008. “A geographical structure is fine from a market intelligence standpoint, but it is not only what our clients are looking for.” What clients are looking for, he says, is a global prime broker that offers a single face to hedge funds and their investors across borders, asset classes and services. This is why Newedge is helping hedge funds active in Brazil, China, India and other emerging markets, but also why it is delivering consolidated reports across all business with the firm, and netting collateral posted against positions in any asset class. Teilhard says the new approach marks the end of any conviction at Newedge that riding the multi-prime trend, in which the firm would seek a 10 or 20 per cent share of the wallet of hedge funds which bought most of what they needed elsewhere, is a sustainable strategy. Indeed, he argues that multi-prime is no more than a costly chimera for hedge funds to set up and maintain, without achieving either the main objective of cutting counterparty exposures to single investment banks, or the secondary goal of reducing the risk of information leakage.
One example of the Newedge alternative is to fold trade monitoring and mitigation, financing and stock loan into a new alternative trading services (ATS) business group. “ATS is a hybrid,” says Weng Cheah, Head of ATS Origination.”It brings together the traditional execution capability and the securities financing teams. They now sit right next to one another.” From a client perspective, the principal benefit of this integration is service on a platform that gives them a complete view of all of their activities across markets and asset classes (equities, derivatives etc), - whether voice or electronically brokered.A single platform is much easier for hedge fund clients to integrate. The simplicity of service delivery and information allows the hedge fund to use these services to meet another burgeoning obligation: reporting on their activities to regulators. Short selling, where hedge funds are under pressure not only to prove a sale is covered but increasingly liable to report short positions directly to regulators, is an obvious application for a reporting tool of this kind. The fruit of a three year investment designed to overcome perceived shortcomings on the reporting side, the new platform was launched in January 2011, and seems to have helped the French brokerage house put on business in the months since.
What really appeals about integrated reporting, says Jonathan Cantouris, head of origination and structuring, EMEA, within the prime brokerage business line at Newedge in London, is that the collateral to support transactions in different asset classes can be cross-margined, cutting the cost of financing positions. “Where we differ from some other prime brokers is that everything is booked into one single account,” he explains. “All the listed futures and options, cash, OTC swaps, are booked into a single account at a single legal entity, which is Newedge Group. That allows us to provide cross-asset, cross instrument portfolio margining, enabling us to monitor and manage risk on behalf of clients, using value-at-risk methodologies. We can also report all activities on a single statement: cash, trades and positions across all instruments and asset classes. The type of manager we service will trade across a whole range of liquid instruments across different asset classes, and the feedback we are getting is that optimisation of their collateral is very important. It used to be because managers wanted to obtain more leverage, pre-Lehman, but now it is much more about managing counter-party risk and operational risk. They want to optimise their collateral vis-à-vis their prime brokers, so using cross-portfolio margin techniques means we can provide optimal solutions to our customers. The excess cash can also be placed on deposit with a custodian bank or other third party cash manager for safety reasons.”
As it happens, Newedge steered clear of the 2009-10 craze for asset segregation and safe custody models, though Teilhard says the firm was approached by a number of consultants wanting to collaborate with the firm to develop services for hedge funds. “They all said, ‘By the way, if you do not do this, your business is dead,’’ recalls Teilhard. ‘’I had a catch-up meeting with one of the parties that approached us, and asked how the safe custody products were going. They admitted that none of them were doing that well, and some of the clever structures they devised had been closed already.” Although he agrees that investor anxiety about asset safety increased during the crisis and has yet to diminish, Teilhard says that security was always less of an issue for Newedge. This is not for the obvious reason: two parents with large balance sheets and AA credit ratings. “We are not a department of them,” says Teilhard. “We are backed up by them, but we have our own organisation, are independently managed, and it is pretty strong. I think the market sees us as a firm having its own governance.”
Newedge publishes its own separate accounts according to Teilhard. But it hardly matters, he adds, since the Newedge strategy is not a classic prime brokerage play, which depends on maximising control of clients’ cash and securities in order to re-hypothecate them in ways that benefit the firm as well as exploiting clients trading flows. Thanks to its transaction-based approach, and especially to its longstanding strength in managed accounts, Newedge is comfortable seeing only part of the inventory of its clients. “We were always used to having only a portion of our clients’ assets with us, and are used to dealing with security interests in client assets held somewhere else, by mutual agreement,” he explains. “It is not too much of a cultural revolution for us. In fact, when it comes to dealing with third party custodians to Ucits funds, it is bread-and-butter work for prime brokers like us.”
Where Newedge did decide to invest it was counter-cyclically, in two areas which were badly hit by the financial crisis: capital introductions and securities lending. The capital introductions team was expanded in 2008-10, at the very time other prime brokers were cutting their cap intro staff aggressively. Newedge now has a global cap intro presence in San Francisco, Chicago, New York, London, Geneva, Dubai, Singapore and Hong Kong. The firm has also established a dedicated investor research team to produce highly focused quantitative information and topical research as a service to investors for their manager selection needs. Similarly, Newedge has invested in improvements to its securities lending and borrowing capabilities at the nadir of the international stock loan markets. It has raised the size of its global stock loan team from two people to 30, and purchased and adapted new systems from Loanet and ForeSight. “It has been quite a forceful build-up over the last two years,” says Teilhard. “We now have an efficient equity finance set-up, from the stock locate, through short covering, to synthetic capabilities as well as the more transactional types of securities finance.” Levels of automation are high. According to Cheah, Newedge has automated the search for stock to borrow. “Hedge fund clients can use the system to generate requests for stocks or baskets of stocks automatically and electronically transmit them to Newedge,” he explains. “We take the portfolio, price it, look at what we have, or what our custodians have available, allocate the stock, and send it back to the client. It is a fully automated stock borrowing service, right through to the actual allocations to the client. It is extremely quick process, even with large basket of names. We also enrich the information. In a normal securities lending interchange, most people just exchange information about what is asked for and what is given. We include a bit of colour about what you asked for and what we are giving you in the form of a commentary from the stock loan desk.”
This functionality is all delivered via the new client electronic execution platform, which Newedge has dubbed Ultraedge. “It is a platform that delivers a range of execution services, and from which we can manage risk for clients more effectively,” says Cheah. Clients have access to low intrusion risk management functionality built into execution at the time of the trade. The risks managed include fat finger, concentration risk and compliance with short selling requirements. “It also gives us a platform from which we can be more pro-active in terms of client service,” adds Cheah. “If, for example, they are a quantitative/systematic trader and are consuming locates, it would be helpful to get a message from our ATS desk once they hit a trigger - for example, 80 per cent usage of the locate, where we would ask, `Would they would like us to find more or give them colour on the borrow market?’ Similarly, if networks are running slowly, we can call the quantitative/systematic trader to let them know we are running 2 or 3 per cent outside our normal latency, and advise them to change the way they send their orders into the marketplace. They can adopt a much more defensive stance, as a response to network traffic. Giving hedge fund clients feedback and clarity on how our systems are performing can be critical to decisions a client needs to make.”
The use of quantitative/systematic traders as exemplars is telling, for NewEdge has only recently added turn key support of high frequency trading to its repertoire. If that sounds fashionable, high frequency trading fits the historic character of the firm, whose origins lie in the FCM franchise built by Newedge legacy firms Fimat and Calyon Financial. As a prime broker, Newedge is still more transaction and clearing-based than financing-driven. To bolster that position, the firm’s build of its ultra-low latency equity and derivative execution platform is logical. Run on a trial basis with a small number of pilot clients last summer, it is now live for all clients. The platform is based on entirely new technology, and utilises some services from Paris-based low latency data infrastructure specialists Quant House, in which Newedge had acquired a 25 per cent shareholding. The platform enables clients to co-locate their servers alongside Newedge inside stock exchange, futures exchanges and MTF server facilities. The firm has also linked its data centres via a single fibre optic “mesh” that enables it to provide millisecond “jumps” between data centres. “In the old days, a client co-located at Liffe who also wanted to be co-located at Eurex had to build two data centres,” says Cheah. “With the new platform, once they have built a data centre in either location, they can within a millisecond jump between Liffe and Eurex or vice-versa.”
Newedge has been careful to ensure sufficient back office capability was in place to handle the high volumes of business at these speeds. Teilhard adds that Ultraedge is not aimed at high frequency traders only, but at “everybody along the chain. The connectivity, the tools and the algos are valid for everybody, even on the long-only side.” However, Cheah admits that the impact of quantitative/systematic trading on the equity markets is “staggering.” He reckons it now accounts for up to two third of all equity executions, and an even higher proportion of exchange-traded derivative transactions. High frequency traders are of course a varied class, encompassing quantitative and systematic hedge funds, professional arbitrageurs, and the proprietary trading desks of the investment banks and CTAs, but they are all recognisably “alternative.” Cheah says the opportunity for Newedge is greatest at the point where these traders intersect with long-only fund managers. “Long only asset managers are very focused on rebuilding their performance, and expanding the range of asset classes they invest in,” he says. “To remain competitive, they recognise they have to consider the electronification of their trading process as well. There is not a single asset manager out there that has not built or considered already using some kind of order management system, integrated some kind of execution management system or gone through the evolution to some kind of algorithmic trading tool. When all these people meet in the marketplace, there is intense competition for liquidity. The speed at which computation and execution occurs is now much higher than it was ten years, or even five years ago. The amount of information available to the market participants, and used by market participants, has increased as well. To make good decisions, people need to deal with information density. Shortening the distance between the portfolio managers and the execution of the decision, by using algorithms, is essential.” Although the execution arms of Newedge have to deal with the hedge fund clients of the prime brokerage group at arm’s length, clients of the prime brokerage group do of course get access to the voice execution services of the firm. That interaction between quantitative/systematic traders and long-only funds is business the firm would also like to capture. In seeking it, the principal advantage of Newedge is that it does not engage in proprietary trading. The firm is resolutely an agency only broker, so its execution capabilities appeal to hedge funds that favour the unconflicted. “Since 2008 there has been a strong desire among hedge funds to work with unconflicted counterparties,” says Cheah. Newedge is also offering clients use of its in-house algos. Of course, sophisticated quant traders who know exactly how they want to place their orders in the market devise their own algos. But Cheah says the Newedge range of algos is being used by other hedge funds that know their investment objectives, but have no micro trader to implement them. Which is a reminder that integration crosses functional boundaries – including those between execution and financing – at the reinvented Newedge. Of course, not every hedge fund is in a position to make good use of an integrated, agency-only prime broker – and that is how Teilhard likes it. “The strategic decision we made some time ago was that we did not wish to service 100 per cent of the hedge fund industry,” he says. “We want to focus on the 75 per cent of the marketplace whose investment portfolios are liquid, easy to price and to which we can provide financing and leverage safely, using our cross-margining tool or stress test methodologies. We do not want to get involved in financing complex credit strategies, or leveraged bank loans, and other non-standard collateral such as CLOs and CDOs. There is plenty of room for us to grow in the other three quarters of the business, which we can industrialise. In our minds, the prime brokerage business is going the same way as the listed derivatives business, and will consolidate. Settlement cycles are getting more homogeneous, clearing houses are merging, exchanges are getting more active, and so on. You do not need to be Einstein to work out what the industry will look like in five or ten years’ time. It will be a much more industrialised sector, where the differences between hedge funds and other types of asset manager will be less obvious, with each of them using techniques common to both.”
The interesting question is what makes Teilhard confident Newedge will be a consolidator rather than a consolidatee, in an industry where many have tried and failed, and several high profile new entrants have only recently abandoned their ambitions. “Our goal is to participate in the industrialisation of the industry, and try to put value-added and content-driven ancillary services on top of the industrial scale services,” is how Teilhard sees it. “We will service a whole range of strategies but we will always stay in the liquid part of it, and make quant strategies our area of excellence. If you look at the biggest hedge funds in America, they are all quant-driven funds, and the same trend is already developing in Europe. We are also planning to service existing clients that we believe will make greater use of OTC derivatives as they move towards a centrally cleared model. All of these developments tally well with the DNA of our firm.”As to how he plans to sells his unusual but integrated offering, Teilhard does not even pretend to have a magic formula. “Knocking on doors, explaining and proving what we can do,” is his recipe for long term success. “We can only demonstrate what we do. We have to rely on the products selling themselves. We cannot do much more than that.”