The Incredible Shrinking Prime Broker

Terry Flanagan

Reports that Goldman Sachs is cutting ties with smaller hedge funds in its prime brokerage business come as no surprise to market veterans who have seen similar cutbacks in prime brokerage over past decades.

“We were aware that Goldman had been cutting back on its prime brokerage business, as have several other firms,” Doug Engmann, chairman of Sage Brokerage Holdings, the holding company for SageTrader, told Markets Media. “The big investment banks go through cycles where they like businesses at certain times and then they dislike businesses at other times.”

SageTrader provides execution and clearing for hedge funds and proprietary trading firms. “We’re not self-clearing yet but we clear through Merrill Lynch and Wedbush Securities, so we provide execution, clearance, and specialized reporting for those clients,” said Engmann. “Occasionally we’re able to help them raise some capital, and we provide certain other software services that they might need.”

Engmann, a former CEO of ABN Amro Clearing, has seen at least four or five cycles over the 30 years that he’s been in the business where servicing the active trading community, of which the hedge fund community is the largest group, becomes undesirable for large banks. “So firms exit the business, sell the business or scale it down,” he said. “Inevitably, three, four, five, six years later they want to re-enter the business.”

The new Basel requirements are placing much higher capital constraints on banks, and while capital is relatively cheap, profitability is low because interest rates are low. “The increased capital charges that regulators are imposing means you have to carry more capital to support a business that’s not as profitable,” said Engmann.

The prime brokerage business experienced rapid growth in the 1980s and ‘90s, then declined after the 2001-2002 economic downturn. “People were scaling back on their prime brokerage business and it occurred all through the 2000’s until the market really started to come back,” said Engmann. “It’s not the first time that the prime brokerage business has either been the star or the dunce of an investment bank. Historically, we’ve seen these kinds of ebbs and flows in interest in the business.”

In the late 1990s, more than 50% of prime brokerage revenues were generated by interest charges. With interest rates at 10%, the spread between what a bank borrowed and what it lent to a hedge fund as a prime broker was fairly significant. “If you had somebody with big balances you could make a lot of money by lending them money and marking it up,” Engmann said.

Today, with many hedge funds struggling for their own profitability, their prime broker’s profitability is struggling as well.

“Many prime brokers are taking a close look at the list of their customers–and Goldman has been doing this for quite a while–weeding out those customers where the cost of capital is high but the revenue doesn’t justify carrying those accounts,” said Engmann.

SageTrader has picked up some of the hedge funds that were formerly served by the likes of Goldman. “We’re a very specialty firm so we deal with hedge funds that are $2 million to $25 million in assets under management,” Engmann said. “Those firms probably are no longer at Goldman anymore because Goldman exited clients with assets under management less than $25 million.”

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