Traditional Asset Managers, Credit and Transparency in Prime Brokerage

Finadium Research Report

Traditional Asset Managers, Credit
and Transparency in Prime Brokerage

Finadium
June 2008

In spite of the broad troubles of the financial industry, prime brokerage continues to grow by impressive bounds, though new trends affecting the market will lower profit margins and change how brokers run their businesses. Unsurprisingly, a downturn in traditional assets has lead to greater interest in long/short investing, with prime brokers reaping the dividends. Traditional asset managers are increasing their presence as prime brokerage clients, bringing with them new requirements for custody and reporting. At the same time, the collapse of Bear Stearns has led to a new focus on net capital and liquidity management, causing concern for both brokers and their leveraged trading clients in understanding counterparty credit risk.

Based on a recent survey of traditional asset managers, Vodia Group research shows that large managers want to use prime brokers for financing but maintain their current custody relationships. These managers currently have 3% of AUM in leveraged strategies and expect this figure to grow substantially in the next few years. They expect an endgame where hedge funds and traditional asset managers run overlapping boutique strategies and compete for the same mandates, though cultural differences will persist.

Driven by the Bear Stearns failure, Prime brokerage is entering a new age of disclosure for net capital and liquidity requirements. Like the 1984 bailout of the Continental Illinois National Bank and Trust Company that led to the Federal Deposit Insurance Corporation Improvement Act (FDICIA), we expect the Bear Stearns bailout to spawn a new layer of Federal regulation for major brokers. Brokers may take action first, however, driven by the needs of their clients or shareholders. Certain prime brokers, looking for a market advantage or seeking to dispel rumor, may chose to do so proactively.

We have developed a methodology for evaluating broker-dealer margin balances and liquidity risk. We calculate a ratio that assesses credit exposure versus readily available capital to give a ranking of the liquidity of prime brokers. Along the way we size the book of prime brokers by assets under custody and leverage extended to clients. While our methodology relies on certain assumptions that are by definition inexact, it does provide a general framework for measuring relative stability in the brokerage community.

This report should be read by prime brokers, their trading partners and their clients. It is also of value to market strategists looking to understand how the prime brokerage market will evolve in the next several years. From the impact of a major new type of client to understanding the dynamics of net capital and liquidity in the brokerage business, this report provides core data and analysis on major forces shaping the securities industry.

This report is 32 pages with 17 exhibits.

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TABLE OF CONTENTS
? Executive Summary
? Prime Brokerage Goes Mainstream
– The New Drivers of Leveraged Trading Assets
? Traditional Asset Managers on Prime Brokerage
– The Asset Manager Footprint in Leverage
– How Asset Managers View the Growth of Leveraged Trading
– Asset Manager Opinions on Prime Brokerage and Custody
? Understanding Net Capital Requirements for Broker-Dealers
– Alternative Net Capital Requirements
? Net Capital, Liquidity and the Bear Stearns Failure
– The Rescue
– Counterparty Credit Security from the Buy-Side Perspective
? A Methodology for Measuring Broker-Dealer Liquidity Risk
– Sizing the Book of the Major Prime Brokers
– Broker Liquidity Risk Calculations for Q1 2008
? The Age of Disclosure
– The Hidden Value of Portfolio Margining
? About the Author
? About Finadium