Prime brokerage game changers

15 Apr, 2011

When HSBC announced it was forming a Prime Services group to service hedge funds, it was not hard to find scoffers, let alone sceptics. Now 18 months on, HSBC Prime Services is leading a quiet revolution in the prime brokerage industry. Cian Burke, a chartered accountant whose first exposure to investment banking was as an internal auditor to HSBC Global Markets, is leading it.

“As a fund manager, the key fiduciary responsibility you have to your investors is safeguarding their assets,” says Cian Burke, the former COO and CFO of HSBC Global Markets who is now head of prime services at HSBC in London. ”Our model addresses the fundamental concerns of investors: counterparty credit risk, segregation and security of assets, and the quality, longevity and commitment of the service providers backing the hedge funds in which they are invested. The custody proposition is one of the key drivers of the solution we are offering.” Custody as a lead product is certainly a novel approach to prime brokerage. But it has resonated strongly with investors – and by extension their fund managers – ever since the collapse of Lehman Brothers, which pitched assets managed by dozens of hedge funds into bankruptcy proceedings in London so prolonged that they have yet to conclude two and half years after the event. Indeed, there is not a prime broker in the industry which does not offer at least one “prime custody” product these days, and many which offer several. Goldman Sachs and Morgan Stanley have established bankruptcy-remote trust companies, where client assets are ostensibly insulated from the failure of the wider firm, though the model has yet to be tested in a live bankruptcy, as opposed to a legal opinion. Goldman has also developed tri-party arrangements with Bank of New York Mellon, which offer hedge funds varying degrees of control over the movement of assets between prime brokerage and segregated custody accounts. Prime brokers owned by well-capitalised banks such as Bank of America, BNP Paribas, Credit Suisse and Deutsche Bank have felt less need to innovate than stand-alone investment banks and the likes of HSBC, for which “prime custody” is a once-in-a-lifetime opportunity for a bank which went into the crisis without a prime brokerage arm but with a substantial custody business.

The challenge for HSBC is to differentiate its offering. To some extent, the size, credit rating and counterparty diversification it offers achieves this effortlessly. Burke cautions that hedge fund managers have yet to declare any one “prime custody” model the winner, but he does note that bankruptcy administrators are unhappy with the bankruptcy-remote vehicles devised by the stand-alone prime brokers – not least because they face personal liability when vouching for the ownership of assets, mitigated only by professional indemnity insurance. “Their ability to verify the ownership of assets held in a bankruptcy-remote vehicle depends entirely on a legal opinion issued by a law firm working for the now-bankrupt prime broker,” he points out. “The last thing an administrator is going to do is return assets to hedge fund managers on the basis of a legal opinion they have not had time to consider. So putting your unencumbered assets in a bankruptcy-remote special purpose vehicle with a stand-alone prime broker may address the asset segregation issue, but there is only a legal opinion to confirm that the vehicle does what it is supposed to do. As an administrator you need clarity, and quickly, over who owns which assets, how and where they have been segregated, what legal charges have been placed over them, and whether or not they have been re-hypothecated.”

Awareness of such minutiae has exposed Burke to the growing sense that the problem of safe custody for hedge fund assets might be insoluble, and that the opportunity to sell solutions to it has therefore passed. As the Lehman failure recedes into history, its lessons are certainly in danger of being forgotten, but Burke does not agree this means the opportunity to build a “prime custody” service no longer exists. “Whatever model eventually prevails, the need to ensure that your prime broker is able to segregate and make assets secure is going to be a permanent feature of the industry in the future,” he says. “Immediately post-Lehmans, whilst it may have lost some momentum, it remains an important consideration.” Investors have certainly lost none of their enthusiasm for ensuring their assets are in safe hands. The principal factor slowing down the adoption of prime custody arrangements is the cost and operational complexity of transferring assets efficiently from a prime brokerage account to a custody account and back again. Hedge funds need to finance assets, and it is not usually possible to lend or finance assets in a custody account. They have to be moved to a prime brokerage account before either of these things can be done.

It follows that the prime custody model which does eventually prevail will be the one that makes the transfer of assets between accounts as simple, cheap and rapid as possible. That in turn implies the model which gives the hedge fund, as opposed to the prime broker, the maximum degree of control over the movement of assets between accounts. To deliver that degree of freedom and control, even and perhaps especially for the large and sophisticated hedge funds which prime brokers would trust to make best use of it, entails the creation and operation of a complex technology and servicing platform. It has to be capable of moving encumbered assets from a custody account to a prime brokerage account, and unencumbered assets from a prime brokerage account to a custody account without excessive costs or delays. An ideal system would incorporate cross-margining capabilities, to minimise collateral costs for hedge funds, and include collateral optimisation capabilities that ensure every piece of available collateral is always being put to its best use, whether that use is in the repo market, or at a CCP, or in a swap, or in the reverse repo market. That, of course, is not how prime brokers have traditionally preferred to interact with hedge fund clients. Even as they develop CCP services for hedge funds ahead of the mandatory clearing of OTC derivatives, a large part of the attraction is the receipt of collateral gross rather than net. Prime brokers are not, in other words, naturals when it comes to economising on collateral costs for hedge fund clients.

So what has HSBC got? Nothing as sophisticated as a client collateral optimisation engine, or at least not yet, says Burke. The bank has built a data warehouse which encompasses assets being traded by HSBC Global Markets as well as in custody with its global custody arm (HSBC Securities Services). It has added a collateral management and portfolio margin system from the now Advent-owned Syncova Solutions. Former Deutsche Bank prime broker Rob Perks leads a newly formed collateral management group whose brief is to help clients optimise the cost of their financing, while ensuring that the bank covers its exposures properly. In fact, to be quite sure he has the financing and counterparty risks under control, Burke has established a separate risk management function led by Dominic Semenchuk-Green, who came to the bank from a buy-side perspective at Citadel. His team makes use of risk management systems used by HSBC Group as a whole. It could be argued that getting risk management right makes HSBC a more reliable financing counterparty, but Burke resists such arguments as too obviously self-serving.

However, there is one major competitive advantage he does claim for HSBC. This is the ability to make the process of transferring assets between custody and prime brokerage accounts more efficient, because both accounts are held at the same bank, and run off the same platform. “The efficiency, control and transparency of the transfer process is key to the appeal and success of a prime custody service,” says Burke. This is an advantage Goldman Sachs and Morgan Stanley can match on all counts save the crucial one: creditworthiness. What HSBC lacks, on the other hand, is an investment bank of competitive caliber. Burke confronts that perceived weakness head-on. “The bank is not trying to build a prime brokerage business from scratch,” he says. “It is trying to build a particular prime services proposition on a solid custody base.” If that sounds hard, it is worth remembering that HSBC Global Markets may have lacked profile in the past but its stock has risen dramatically since the financial crisis.

HSBC Global Markets trade credit, rates, equities and FX in 65 markets around the world. The FX franchise is the most obvious strength, but also the closest to being commoditised. There is a strong presence in rates (which is run by Eli el Hayek) and credit (run by Niall Cameron) but it is equity which will interest hedge funds the most, and it is in equities that HSBC is aiming highest. In fact, the Global Markets equity business - led by co-heads Patrick George and Christophe Chazot are aiming at a top five or ten slot in every market where they reckon the bank has a competitive advantage. That tends to be measured by whether the bank has bodies, bricks and mortar on the ground, executing trades and safekeeping assets. “Anybody can execute,” says Burke. “It is understanding the market that makes the difference. Having a genuine local presence, and people on the ground, can only get more important.” But execution and custody are not at the heart of a prime brokerage operation. Financing and stock loan are, and it is in these two fields that HSBC continues to recruit the equity financing and short covering talent it needs.

HSBC has of course had an agency securities lending capability within HSS for decades, which is now led by Wayne Burlingham. It lends client assets to all major investment banks, including HSBC Global Markets, which in turn offers buy-side clients a stock borrowing service via the equity financing desk headed by Karl von Buren. Though the relationship must be conducted at arm’s length, hedge funds will expect to be impressed by the ability of HSBC to gain access to large portfolios of general collateral and especially hard-to-borrows. It is at this point that the custody ambitions of HSBC meet the prime brokerage ambitions of the bank. It would be easy to characterise HSBC Prime Services as the safe custody option that can protect client assets from Lehman risk, but Burke views custody in a much broader perspective than that. The fact that he is co-head of the custody business of the bank as well, alongside Drew Douglas, a former hedge fund administrator with Bank of Bermuda who co-leads HSBC Securities Services, underlines the importance of custody to the hedge fund strategy of the bank.

But HSBC is as yet a relatively small global custodian, claiming just $1 trillion in genuinely global – as opposed to domestic – assets in custody, not all of which are available to lend. But there is no doubt the bank wants to grow its global custody franchise. “We want to build and develop a genuinely global custody proposition,” says Burke. “Becoming a genuine global custodian is key to the strategy which Drew and I are pursuing. We want to move up from being a sub-custodian to build a genuine global custody franchise. Linking the custody proposition to HSBC Global Markets through prime brokerage not only gives us an opportunity to deal with the security and segregation of assets, but also gives us an opportunity to organise more effectively the sourcing of stock to borrow off the custody platform. We can offer hedge funds access to the inventory of a global custodian on an arm’s length, agency basis, and as principal.”

Burke accepts that co-heads are viewed cynically from outside HSBC, and does not dismiss out of hand the risk of internal opposition to competing for clients with investment banks that are also major clients of the sub-custody business of the bank, but says there is nothing but excitement internally. “If you set up a global custody and prime brokerage business, you are inevitably competing with the clients of your sub-custody network,” he says. “Increasingly, the world is globalising, and if we choose not to compete as a global custodian we are missing a huge opportunity. But we do not intend to compete with the large global custodians in the US domestic market. We have been very clear about that. We are going to set up a global custody operation where we feel we have got a competitive advantage and where we feel we have got a value proposition to offer. But we are not going to compete with the likes of Bank of New York Mellon and State Street et al in their domestic market. It is far too over-banked; the margins are too tight; and the regulatory environment is such that we are not going to bring anything that is going to add competitive advantage there. Can we be a global custodian to managers, investing in Europe, Asia, Latin America, and the Middle East and to European, Asian and Middle Eastern asset managers? Absolutely. A number of other providers are trying to do the same thing, for the same good reasons. The ability to bring execution, custody, prime brokerage and fund administration together, while respecting the segregation of function you need to have, makes a lot of sense for clients.”

A noticeable absentee from that list of services is one the traditional prime brokers are investing heavily in at the moment: capital introductions. Burke knows that one of the principal ways in which hedge funds now judge prime brokers is their ability to raise money for them to manage. The industry as a whole is gradually recovering the assets shed during the crisis, and investors spooked by that experience are now taking a much slower and more selective approach to alternative investing. Burke thinks HSBC can help, not least through its Private Bank’s links to HSBC Alternative Investments but it is not a major area of focus at the moment. “We have got an interesting opportunity around capital introduction because of our relationship and tie up with the Private Bank, which is still a very significant investor in hedge funds,” he says. “We are a huge introducer of capital to the hedge fund community through the Private Bank. We just need to be a little more focused and clearer about what capital introduction means for HSBC. Cap intro is an important part of a prime services proposition. Do we need to go and hire a team of expensive cap intro people? No, I do not think we do. I think we just need an improved level of co-ordination around the investor base of the firm, and the Private Bank. That is much more interesting value proposition for hedge funds than a traditional cap intro function.”

It is that integration leitmotif again. Its recurrence is not surprising. After all, the highly regarded Burke is an HSBC lifer who knows his success in his current role, and his credentials for his next role within the group, will be judged by his ability integrate the HSBC capabilities hedge funds use. Appointed in August 2009 to set up and run HSBC Prime Services, in March 2010 he became co-head of HSBC Securities Service as well, with the aim of bringing together the custody and prime brokerage and Global Markets capabilities of the bank, in order to offer hedge funds a single set of financing, securities lending, custody and asset-servicing functions. He reports, in his capacity as head of HSBC Prime Services, to Spencer Lake and Jose-Luis Guerrero, Co-heads of HSBC Global Markets, and as the Co Head of HSBC Securities Services to John Coverdale, head of Global Transaction Banking at HSBC. “A lot of this is just about connecting and bringing together the various component parts of the firm around the client and providing and hooking that all together with a first class prime services proposition,” he says. The opportunity to integrate services is the privilege of the newcomer, but the true test is implementation, not opportunity. Burke is confident he can pull it off. “Prime Services is not some ethereal concept we have come up with,” he says. “We had a custody proposition which evolved in the crisis into the Custody Plus proposition – and bear in mind a lot of the hedge fund assets we now have in custody came in post-Bear and pre-Lehman – to which we are now adding a degree of financing, while continuing to offer the protection of safe custody. Prime Services is about adding scale and service quality to Custody Plus. Frankly, the service provision that comes out of a custodian is very different from what comes out of a prime broker. A custodian will only ever deal with long-only assets, on less aggressive timetables. In hedge funds, we are dealing with a more demanding, driven client set that require a much greater degree of focus and attention. A large part of what we are building in Prime Services is the ability to bring the firm together around the client. Much of the investment we have made has gone into client service teams to bring clients on board and bring together the services those clients require from within the bank.”

So it is significant that the highest-profile recruit to HSBC Prime Services is Terry Minkey, a high profile former Goldman Sachs and Bear Stearns prime broker whose experience lies largely on the client side of the prime brokerage business. As head of client service and integration, Minkey has recruited Anthony Bennett from Goldman Sachs. Between them, they have assembled a client service and integration team of a dozen people that includes alumni of Credit Suisse, Morgan Stanley and UBS. “We recognised we needed people with previous experience of dealing with hedge funds in a prime services environment,” says Burke. “You can build the culture and the proposition from within, but you have got to have that experience.” Where an external perspective could not be purchased, Burke opted to create one artificially. To build the technological infrastructure that underpins HSBC Prime Services, 120 IT staff were deliberately redeployed into a new “change management” group to avoid the risk- an HSBC abbreviation, this – of BAU, or Business as Usual. That said, BAU has to go on, not least to ensure the Prime Custody clients are still serviced while the Prime Services platform is built. A team of 30 are looking after the existing book of business.

New business is being sought by a sales team headed by global head of sales Chris Barrow, who re-joined HSBC from Nomura in November 2009. His reports include Hamish Anderson, who has worked in prime brokerage sales at both Dresdner Kleinwort Wasserstein and Bank of America Merrill Lynch, and Jamie Wise, who helped sell the Custody Plus product for HSBC Securities Services. Importantly, HSBC is not confining its ambitions to London. It is also building a presence in Asia, were the bank is naturally strong, and the fund administration business run by Lillian Wong more or less owns the domestic marketplace. Ex-Citi banker Matt Kirally is now heading sales from Hong Kong, reporting to Chris Barrow, and the changed management team and the London technology platform are both being rolled out there too. “North America is not off the agenda, full stop,” says Burke, in answer to the obvious question. “What we have to understand in North America is how we facilitate our clients’ access to the North American market, and how we service their North American requirements. You ignore the US market at your peril. It is still the largest market, with over 60 per cent of the world’s alternative funds.” HSBC has inherited American hedge fund relationships from the old Bank of Bermuda business, but the obvious new route into the market is to piggy-back on the efforts of HSBC as a whole to service American institutions investing abroad, as well as helping non-American clients to access the US markets.
Burke knows what type of client he wants too, and they do not necessarily include start-ups, or at least what he calls the “multiplicity” of them. “No, we are much more focused around building a business with established players who have got a track record in terms of performance,” says Burke. “We are not in this to go picking off start-ups on an opportunistic basis. Our strategic intent is to recruit as clients the established funds. We will look obviously at start-ups, but I would expect them to be spin-offs either from established funds or established fund managers that are now setting themselves up rather than two guys who fell out of an investment bank last week because they are not happy about what the Volcker Rule means for prop trading.” The fact is, of course, that HSBC has long preferred relationships with large and established hedge funds. On the fund administration side, it trimmed the Bank of Bermuda client list unsentimentally. “We are leveraging a lot of the existing relationships that we have,” says Burke. “We have had hedge fund administration and global markets businesses as well as a custody franchise in Europe and Asia for many years, servicing hedge fund clients.” He reckons HSBC is well-placed to add to those relationships because it brings something different to a marketplace in which hedge funds are looking to diversify their counter-parties.

It is a commendably realistic assessment of the competitive position of the bank. Indeed, Burke cannot be accused of grandstanding. “We are in a multi-prime broker world, and our strategy is about competing as another prime broker to some of those core hedge fund managers, bringing them asset segregation, counterparty strength, and depth of balance sheet and liquidity,” he says. “We are looking to build long term relationships with these clients, not be here- today-gone-tomorrow, which a lot of funds have suffered from. A lot of prime brokers have invested considerable amounts of time and money in building relationships with funds, only to pull back completely in times of crisis. There is value in developing and building relationships, and in a multi-prime brokerage environment, we have got an ideal opportunity to do that. In the multiple prime broker world there is absolutely an opportunity for us, because of what we bring to the party, to play as one of those multi-prime broker partners. We know that to compete, you have to deliver a service of a quality that at least matches, and preferably exceeds, the quality of the service provided by the other prime brokers to the same funds.”

That would sound trite, were it not for the fact that the senior management of the bank has a committed balance sheet to the project. This reflects the fact, says Burke, that the creation of HSBC Prime Services was demand-led rather than supply-driven. Group CEO Stuart Gulliver, when head of the Global Banking and Markets business at HSBC, found clients pressing him to develop a prime brokerage service, especially in the aftermath of the Lehman collapse, which generated a massive appetite for segregated custody at banks with fortress balance sheets. But custody is one thing; equity finance another. On the face of it, collateralised leverage for hedge funds does not look the type of lending business likely to appeal to the HSBC board, which is famously conservative about the balance sheet. But Burke says it did not agonise about the decision. “It was not a particularly difficult decision for them,” he says. “If we were going to do this, clearly the bank has to understand that there is a balance sheet commitment. The key point the bank has made to me is that, when we allocate a scarce and valuable resource like the balance sheet, we do not misprice it. Some of the strategies out there are about a race to the bottom. It is about price. Our strategy is not about undercutting the market. The balance sheet of the banks is the Crown Jewels of HSBC. We have absolutely no desire to make that balance sheet available at the wrong price or to finance the wrong type of assets. That constraint apart, there is a huge amount of sponsorship of this initiative at the very highest levels within the HSBC Group, but there is also expectation and understanding. ”

There is expectation among hedge funds too. Burke directs their attention to the fact that HSBC did not wait until the formation of Prime Services to start financing client assets. The bank has financed assets in custody with it since it launched its Custody Plus offering in July 2009. The formation of Prime Services has simply broadened the options, but the bank is still not interested in financing assets that are not in custody with it. “We start from the fact that your assets are in custody with us,” explains Burke. “That is the fundamental principle behind the prime brokerage model at HSBC.” In theory, HSBC could finance assets by taking a charge over assets in custody with third party custodians, but Burke says the bank sees no need to do so because it makes no difference to clients whether assets are in third party custody with HSBC or any other bank. “Do you believe the trust company structure of a custodian works?” he asks. “Whether it is BNY Mellon or HSBC, what matters is the operational efficiency. We think it will be much easier and more efficient for us to take a charge over assets in custody with us, so the terms of the financing will, subject to balance sheet constraints, always be finer with HSBC.” Pricing, he adds, will also be more transparent. “We will also be able to offer financing on a synthetic basis, which given our expertise in Asia and emerging markets is often the preferred and only route to market for our clients.”

“If we need those assets as collateral for any indebtedness that a hedge fund may have with us, the fund has two options,” explains Burke. “First, it can allow us to put a charge over the assets that we need to cover the exposure, with the assets remaining in the custody account. In the event of the fund defaulting, we exercise the charge, liquidate the collateral, and use the proceeds to pay off the debt. In the event that HSBC defaults, the assets are held on trust for the investor. Secondly, the hedge fund can go down the traditional re-hypothecation route, and transfer title to the assets to HSBC. The assets come to us not as custodian but as prime broker. They sit on our balance sheet, and we re-hypothecate them through our equity finance division. So while you cannot completely have your cake and eat it – that is to say, have assets in a prime brokerage account and a custody account – to some extent you can, with a prime custodian model like ours.” There is of course a price difference between these two options. The money to fund assets in custody has to come from the HSBC balance sheet, and none of it can be recouped by re-hypothecating the assets to a third party. It costs more. But the HSBC model is almost certainly on the right side of history. Levels of re-hypothecation in the prime brokerage industry are unlikely to return to pre-crisis levels, given investor distaste for the practice in the aftermath of the Lehman collapse. Pre-crisis, the industry was built on the understanding that prime brokers could do anything they liked with the assets they financed. Now, re-hypothecation is a matter of negotiation and disclosure. “Wherever those levels finally settle, it is abundantly clear that they are not going to include the full right for the prime broker to re-hypothecate everything the hedge fund places with their prime broker,” predicts Burke. That sounds innocuous enough. In reality, however, prime brokerage without unlimited rights of re-hypothecation means re-writing the rules of prime brokerage. HSBC Prime Services – unlike some investment banking purchases which looked far more promising a year or two back, but which are now quietly closing down – might just be proving to be the one newcomer which understood that the game had changed enough to create an opportunity for a bank with a surer and steadier approach to hedge fund business.