Wall Street is raking in record revenue from prime broking as banks look to build deeper ties with their lucrative hedge fund clients.
The top 12 prime brokers made $20.4bn in 2023, up more than 25% in a decade, according to analytics firm Coalition Greenwich.
The jump comes despite the latest challenge to the sector: the collapse of Archegos in 2021 that cost Credit Suisse $5.5bn, led to the closure of its prime broking business, and ultimately helped scupper the bank.
“Prime was the outperformer last year as it wasn’t necessarily impacted to the same degree by low volatility and low cash volumes,” said Jon Cossey, head of global prime finance and global clearing at JPMorgan. “There was a plentiful supply of people needing financing.”
The big three keep winning
Goldman Sachs, Morgan Stanley and JPMorgan continue to dominate a top-heavy space with a 40% market share.
Each of them now has about $1tn in client balances, servicing more than 1,000 funds, according to the Bank for International Settlements. Fourth-placed Bank of America services around 500.
The top 12 prime brokers make up 84% of the sector, fighting it out to provide a suite of trading and financing services to hedge funds, but the dominance of the big three was reinforced by the Archegos collapse as hedge funds flocked to quality.
“Credit Suisse, Nomura and others took a step back, and the hedge funds wanted to work more with the top three for being more reliable and having better risk management,” said Youssef Intabli, head of equities and wealth management competitor analytics at Coalition Greenwich.
Absent market shocks, prime brokerage provides a low-risk way for banks to earn a steady stream of income by financing trades for hedge funds.
But while in good times financing is low-risk, during times of market stress, risk can snowball quickly. As the BIS report published 4 March notes, the wrong-way risk of hedge fund trades can create vulnerabilities to prime brokers.
That hasn’t stopped banks from growing the business; prime services grew to account for a record 40% of equities revenue last year, according to Coalition Greenwich.
JPMorgan’s Cossey said prime broking’s growth was less to do with doubling down on the business and more to do with a subdued market for equities trading more broadly.
“If prime isn’t doing great because interest rates are low or funds aren’t borrowing stocks you can make money in trading,” said Intabli. “If volatility is high, then you want to be stronger on the trading side.”
Prime power
For a bank to be successful in prime brokerage, it needs strong product lines across clearing, custody and security services.
“Building a prime business requires a huge investment in infrastructure,” said Cossey.
It’s not just the fees from financing and securities lending that is enticing banks, but the “halo effect” it can have on the rest of the business.
“The multiplier on a steady stream of revenue is far higher than a trading business, which can have losses and volatile earning streaks,” said Ashley Wilson, global head of prime services at BNP Paribas.
“When you get prime brokerage business correct, you become a strategic partner to the hedge fund, and then you’re creating a much deeper relationship rather than a pure tactical trading one.”
“It’s a business that requires both a balance sheet and capital to support it,” Penny Novick, global co-head of prime brokerage at Morgan Stanley said.
That complexity of decisions on how to deploy capital and balance sheet is only increasing.
Though financing hedge funds’ long/short strategies in equities is still the majority of the prime business, funds are increasingly using multi-asset strategies, growing the need for prime brokers to be able to service other asset classes.
“Hedge funds are looking for prime brokers to be broad, supporting their entire business and not just supporting a particular asset class,” said Novick.
Take for example, the rise of the basis trade, which generates returns from price arbitrage between US Treasuries and their futures market. Not only does it require a high deal of leverage for sufficient scale, but hedge funds are also asking their prime providers for the full service in managing the trade.
“A client looking to do the basis trade with us may require us to help offset some risk, help finance the bonds and then deliver those bonds into expiry,” said BNP Paribas’s Wilson.
Competition heats up
With such high barriers to entry and the increasing need for the prime brokerage to be full service, the big three hold an advantage in their ability to offer finance across regions and asset classes.
But the rest of the field is gaining ground.
“We expect to start seeing a redistribution to the tier two and three banks,” said Intabli.
Some of the mid-tier players like BNP Paribas, which bought Deutsche Bank’s prime brokerage business in 2019, are investing heavily in the space.
BNP Paribas’ Wilson said non-US prime brokers have the biggest opportunity as hedge funds look to diversify away from counterparty risks, and regulatory ones.
“There’s a diversification angle of ‘don’t put all your eggs in one basket’ and not to be completely under a US regulatory environment,” he said.
Wilson said he believes $1tn in client balances is around the upper end of what a bank can comfortably finance without cannibalising other parts of its business.
“The big three US firms in this space, they’re getting constrained around the balance sheet they can deploy, they’re hitting a natural boundary line,” he said.
Wilson said BNP Paribas’ client balances in prime services are now north of $350bn.
“I can see BNP Paribas getting to the $500bn mark in the near term. There’s no reason that BNP can’t join that trillion dollar club.”
The grip of the big three is starting to loosen as interest rates factor into cost considerations for hedge funds, Intabli said. Pricing at the big three is slightly higher than the rest, but in a zero-interest rate environment it rarely mattered.
“Now that interest rates are higher, it makes a big difference,” he said.
JPMorgan’s Cossey said price was only one part of the puzzle.
“Leading generically with outright cheaper financing than the rest, that’s a very specific use case,” he said. “Someone may have better rates in emerging markets, for example, but that might just suit the shape of their balance sheet or liability profile.”
