Evolution of the prime broker (PB) market

Will reverberations following Archegos’ collapse shake up the industry?

In March this year Archegos Capital Management crashed spectacularly leaving a gaping $10 billion hole in the prime broking world. How and why did the failure, whose magnitude has been compared by some to 2008 Lehman Brothers’ devastation and its fallout, happen? What lessons can the market learn from the damage and what will the PB landscape look like in 2022 and beyond?

Bill Hwang, Wall Street’s “stock-picking genius”, established private investment firm Archegos to manage his own wealth and that of some relatives (a family office) in 2013 and succeeded in turning $200 million into $20 billion over just seven years. Having cemented his reputation as one of the most liquid investors of the age, he attracted funding from some of the top investment banks and prime brokers in the world. This enthusiasm despite Hwang and his hedge fund Tiger Asia Management having been found guilty of wire fraud and insider trading and fined $44 million in 2012.

One word can aptly explain the dramatic breakdown: swaps. Or, more accurately, three words: total return swaps. Hwang’s firm used these derivatives to gain exposure to securities without directly owning them. As he was able to trade anonymously using the instruments, the scale of his holdings, the amount he was borrowing and the source of his funding were all concealed. With very little cash being laid out, the borrowing/swapping cycle continued to spiral unchecked until, before imploding, Archegos was leveraged by five times its size. Disaster struck when stock values started falling in March and, to claw back their cash, lenders triggered a fire sale resulting in $10 billion losses.

The incident was and is evidently damaging from a risk management, due diligence, concentration and transparency perspective. Its immense impact has forced leading investment banks to reconsider the wisdom of PB market involvement and driven their withdrawal. However, we need to clarify that, as a family office, Archegos was not subject to the same stringent regulatory controls governing hedge funds. This is an area industry executives expect regulators to home in on. The Federal Reserve and the UK’s Prudential Regulation Authority are assessing whether to introduce more stringent oversight.

Such increased regulation is likely to accelerate the trend for major investment banks to reduce their prime brokerage operations, thereby increasing the pool of high-quality clients for smaller, specialist prime brokers to service. Looking holistically at every facet of prime brokerage: reporting, clearing, settlement, execution, significant changes and hefty investment will be needed if the banks are to fulfil more robust regulatory direction and satisfy sophisticated customers.

“This is a massive and understandably challenging problem for banks to tackle. There is no easy path to modernize existing prime technology stacks to meet the needs of modern finance,” comments Brad Bailey, Head of Market Intelligence at Clear Street.

There will be intense pressure for extensive updates to legacy technology infrastructure to make accurate risk and margin tracking possible and transparent in volatile markets. In such trading conditions, customers need and are demanding agile, prompt handling of their service requests so they can operate effectively and smaller PBs unencumbered by legacy technology and free of bureaucracy are better positioned to respond.

This is especially pertinent for emerging hedge funds who need to perform efficiently from day one and demonstrate results that will retain clients and attract new business. Unlike a discount broker, specialist prime brokers have the expertise, market knowledge and experience to share vital operational support and free up a fund manager to focus without distraction on core account management and business development activities. As we’ve covered previously, outsourcing time-intensive processes such as trading, settlement and reporting to specialists optimises use of resources as well as time and maximises cost benefit.

I shared in a recent interview with Hedge Funds Club’s Stefan Nilsson that the withdrawal of some of the larger banks from the PB market gives Linear a chance to shine. “I see these changes in the market as an opportunity, not a concern. We identified the challenges in the PB market some time ago and foresaw that there would be some casualties at some of the larger banks. We have always managed risk carefully and the current market dictates that we are more risk averse as the market is more volatile… Linear is flexible, agile and ready to do business.”