Craig MacDonald (Chair): To start with, I'd like to ask you as the specialists in the prime brokerage world, how has the Lehman default changed your business model and the way you interact with your clients?
Raymond Blokland Fortis Bank: For us it's a little bit different than the other participants at the table. We had just launched our product at this time, then a couple of weeks after Lehman we collapsed ourselves. The bank was split up, as you know, into a Belgian and a Dutch part. Luckily for us the Dutch side kept all of the functions required for prime brokerage such as custody, security finance, clearing and risk management. But in terms of developing the products the roadmap more or less changed completely: suddenly you are not run by a large Belgian and Dutch bank but by a smaller Dutch bank. When you have to keep the bank alive the focus is on keeping existing business rather than developing new products or winning new clients. On the other hand the speed of nationalisation helped us in the credit discussion that arose after the default of Lehman. In one weekend we went from almost bankruptcy to – I'm not going to say AAA but – to a nationalised bank, and that's helped in discussions with clients.
Eddie Guillemette Bank of America Merrill Lynch: I'd like to focus on the client side of this and how it affected us. In the past pricing, service and relationships were the three key things that clients looked at from a financing provider. Post-Lehman – and it really started with Bear Stearns – counterparty risk became probably the only thing that mattered. So clients gave you business based upon their view of your counterparty risk – something that's a little bit outside of your control. Obviously Merrill Lynch was going through the merger at the same time with Bank of America: the communication with clients was frequent and I think helped us through the situation – it helped us keep clients fully informed.
Robert Maloney Credit Suisse:Yes, I'd carry on from that. Even before Bear Stearns we saw a flight from broker dealers to well capitalised banks. We therefore had an increase in market share and that's continued, not just in prime services but across our equities division. It's fair to say we were beneficiaries of September/October. Now we have taken on a number of new clients but we've always employed selective processes and procedures internally to evaluate the partners and clients that we do business with, to discern whether these partnerships will be beneficial in the long term for us and our counterparties.
Philippe Lopategui RBS: In the aftermath of the Lehman event there was a flight to quality by hedge funds. Previously the model had been very different, with most funds holding most of their assets with their main prime brokers and then trading away in an open architecture with other brokers. But with the flight to quality hedge funds went for safety first, quickly moving assets to the strongest counterparties with whom they had open accounts. The relationship became focused on credit quality, safety and potential segregation of assets – including rehypothecation – rather than on service. This opened the door for universal banks with strong credit ratings and a decent platform to gain market share away from traditional prime brokers. I viewed this as a historical window of opportunity.
Chair: That diversification happened through October and November. Do you think the old model where two major prime brokers dominated the market, will ever return?
RM: It is not optimal for our clients to only have one prime services provider: they haven't got the ability and flexibility to move assets quickly enough. In addition a number of established funds with large assets under management who were happy with maybe one provider, have now diversified into two or three or four. This means there is much more flexibility with regard to moving of balances, but it's also about the quality of the shop over the long term – who retains the business and what market share you have.
EG: Yes we've definitely seen pricing, service and the relationship become important again. That's not to say that counterparty credit isn't a concern but things like rehypothecation limits, ring fencing collateral, using tripartite arrangements for initial amounts – there are now a few accepted ways to reduce counterparty credit risk. This means hedge funds have a greater choice, so they've got their line up of banks and now they're starting to move business around based upon price and service. And we're seeing increased appetite for more leverage as volatility comes down. When volatility is high people tend not to need the leverage because they get paid for taking the risk; when volatility comes down they use leverage to achieve the returns that they require.
Chair: Has the hedge fund market bottomed out in terms of redemptions yet?
RM: I don't think there's any doubt redemptions have slowed considerably compared to Q4 2008.
RB: Yes redemptions have stopped but new money is not yet flowing back into the hedge funds. Definitely the feeling we have is that it bottomed but as a fund administrator we see that a lot of these fund of funds are cash long: waiting for investment opportunities but keeping quite substantial cash balances at the moment.
RM: I think leverage levels are still at historical lows but having said that the average hedge fund has returned in the first half of the year just under 10%. I think we all would echo the comments that we see most investment funds are long a large percentage of cash.
RM: If funds had a poor year last year it's not just about getting good performance in 2009, it depends where the watermark is for them to be able to charge performance fees.
EG: For those funds the real challenge is keeping people in the firm and being able to pay those people, which is probably why we've seen start up funds raising fairly significant amounts of money.
PL: All kinds of restructuring is coming into play within the hedge fund space, precisely to try and overcome this issue of retaining key people if you have a fund which is below watermark.
RM: Not only do our clients have a potential issue of retaining the quality individuals but whether we're talking about a start up or a fund that didn't perform last year, they're now competing against the bulge bracket hedge funds who have got the performance and are now open to investors again.
Chair: That must be very difficult for the smaller funds if these big guys are opening up again.
RM: I have heard of two significant start ups this year. Apart from those, I'm not actually aware of anything over say $200 million this year.
EG: The challenge is passing the operational due diligence tests: here the bar has been raised not only due to Lehman but more importantly due to Madoff. Scrutiny on the operational risk side is much closer.
RB: Going back to the agenda for a second, is the barrier to entry to go into say cash prime brokerage or synthetic prime brokerage too high right now? For the cash prime brokerage product we had all of the basic functions in house so it was more a question of building the overlay and combining everything. If you have to build that from scratch I think it will be quite challenging. On the other hand you have natural players – Fidelity for example – who because of their asset base have everything in house to build that. I was recently with a prospective client who had Pictet as a second prime broker: I wasn't even aware that Pictet was in this business but they were very happy with them especially on the reporting side. In terms of the commitment for the cash product Fortis Bank Nederland has said that the focus will be totally on the client servicing business and this fits quite well.
PL: It's a very interesting question because on one hand you have a massive reduction in activity from the hedge funds, which means that there is less business to go around; and on the other hand you also have this desire for credit and diversification as well as service. I think the goalposts have changed. As a synthetic prime broker, it is very important not only to lead with balance sheet and/or financing, but also to be able to provide the services and the suite of products that the hedge funds require.
EG: This is a business that, if you segregate financing and balance sheet from services, it should have always been run by the banks. But it wasn't because investment banks that didn't have big balance sheets provided great service. And because they had the first mover advantage they made it hard for everyone else to get in. There will always be room for niche providers, but to be a full service cash prime broker I think the bar has gone up because the repo markets have changed. It's not just about the collateral that's provided, there is now a haircut or a probability of default assigned to the counterparty that's giving you the collateral. It makes it harder for a non-established bank to get into the business because they just won't be able to fund it effectively.
Chair: But the changes that you've had to implement around risk in particular – are those mechanisms in place for good?
RM: Yes I think so. Certainly our view at Credit Suisse is that a small number of hedge funds are going to be driving most of the revenues. So it depends what strategy you wish to adopt, how you want to scale your business and what you're targeting. I think whether you're going for smaller clients, with a high turnover or larger clients and being a full service broker, the counterparty risk element is very clear for everybody now. Whichever way you look at it, you're going to have to make sure that you've got scalability. You must handle not just counterparty risk but operational risk, hedging risk and FX risk in synthetics and swap products. If people forget the lessons learnt then it's going to be at their peril, there will be counterparty defaults in the future as we all know.
Chair: I know we're coming into the summer which is typically slow, but I want to know how business is right now?
EG: Leverage balances are certainly down but there are a lot more specials in the market – there's a lot more cash in the market – so for us revenues have been healthy. In particular the high turnover, high velocity accounts have actually fared very well – CTAs and macro funds have done quite well.
RM: I agree. There certainly are many high velocity accounts. Although there may not be certain types of deals out there, such as many takeovers and risk arbitrage deals. There's certainly been much more corporate capital raising and opportunities for clients to get involved. As I mentioned before, we've taken on new clients, so certainly from our perspective we think we have a more balanced model than we had twelve months ago and we see our revenues ahead of where we were at the half year within prime services this time last year.
PL: Yes I would say that many prop desks have closed down and that has clearly created a lot of market opportunity for hedge funds, even though the overall activity has been lower.
Chair: Geographically where do you see demand for synthetic financing coming from?
PL: The major trend after what happened was for most investors to go back to their domestic markets and we saw emerging markets drying up quite dramatically as people focused on credit risk, market risk and political risk. I would say that this is probably still the case.
EG: I agree. There's definitely been a retreat back to domestic markets; in Asia we certainly saw an outflow of risk as well as people. Having said that the emerging markets have done extremely well this year and investors have their eyes open and are keen not to miss opportunities there.
RM: We've also seen renewed interest in the Middle East – countries like Qatar and Saudi – as well as South Africa and Brazil. Certainly those markets have continued to be active this year.
RB: Given the Benelux and more European focus to the bank at the moment we're looking for clients that invest in or trade these markets. We see the bounce in Eastern Europe: on the back of other products like equity brokerage, offering trading IDs and short solutions. But our product is so new that we're not actively targeting clients in emerging markets.
Chair: How did the global hedge fund contraction affect hedge fund interest in Asia?
EG: I think a lot of the margin calls that were needed to be met in the US and Europe were made by selling assets in Asia that had performed well over a period of time. There were publicised retrenchments or downsizing from global funds closing offices or reducing staff in the region, and yes we felt that. A lot of the money managed by the domestic Asian hedge funds has always come from overseas, so again they suffered as the European fund of funds and some of the US investors redeemed, even if they had good performance in 2008. And because you don't have a large number of Asian domestic investors in hedge funds it was difficult to replace. We're just now starting to see inflows, but there was a long period of outflows.
Chair: Were you surprised by the absence of a short selling ban in Hong Kong?
EG: The disclosure regime is very good there, the rules themselves are very tight, and they were put in place at a time, in 97/98, that for Asia was as bad as 2008 was for the US and Europe, so they had confidence in the short selling rules. But Hong Kong definitely won points and praise for not putting in something very quickly without a lot of foresight.
Chair: What are your thoughts on the short selling bans?
PL: Empirical evidence shows that, short selling provides liquidity to the market and that there is no negative correlation between price movement and short selling. This was proven once again on this occasion. Bans make market making in derivatives and other instruments extremely difficult, liquidity is therefore diminished. So hopefully now the regulators will accept that short selling should be viewed as a positive, providing liquidity to the markets and reducing volatility.
RM: I completely agree with that opinion, in particular the point about the associated derivatives. I think it's easy for someone who's not in financial services to perceive a short selling trade as being one that's taking an outright short view rather than one that actually hedges. Whether that is a hedge on a pairs trade, it may hedge a convertible bond or an option. I think the reason why a number of securities were under pressure was because their accounts and revenues, risks and strategies were not fundamentally sound. And I think that there may have been political and regulatory reasons that governments had to be seen to be doing something at that particular time. But I agree, if you look at the studies historically they show that it doesn't effectively change the market – it doesn't make it more secure. It's really an easy temporary rule to come out with to silence some critics.
RB: I think politically the ban shows that the governments are actually taking action, whether or not it's the right action.
PL: Regulators were under tremendous pressure to take action to be seen as being proactive
Chair: Some funds were pulling their free cash out of their prime broker, buying CDS and shorting the stock. There's nothing wrong with any of those things, but all funds doing it together was creating tremendous pressure on banks. And let's face it in many cases these were CEOs, or former CEOs, making the case to keep the short sell ban on. So as a temporary measure it was political and you could see why perhaps it made sense.
RM: The FSA are now very much concentrating on the fact that, as a prime broker or a finance provider you shouldn't have to rely upon the cash of your clients. If you are taking all the assets in and pushing all the assets out and you're reliant on the cash and something breaks in that model then you're completely exposed. Hence if you take the CDS market issues plus reliance on the cash then potentially you do have a serious problem.
EG: And banks have had to right-size their prime brokerage business to suit the size of their balance sheet and their ability to fund during a crisis.
Chair: What are your thoughts and what have your clients said to you about the proposed EU hedge fund legislation?
RB: I think it could well cause a flight by managers to elsewhere in the EU – Switzerland and Malta have been mentioned. Obviously it may have an impact on how things are run in the UK.
Chair: Do you think it'll get that far? Do you think that funds will just leave the UK?
PL: My belief is that the hedge fund industry is quite a portable industry in terms of location and hedge funds being entrepreneurs will figure out a way to opt out.
RB: I think leverage is more of an issue. I've no idea how they want to measure it but if they want to set limits to the amount of leverage a fund is going to have it would have a fairly dramatic impact on the UK hedge fund industry.
RM: Given the complexity of strategies – multi-strategy across asset classes that a lot of clients use – how would leverage be measured? The FSA have always been able to look at the leverage we're providing to funds. The recent HMT White Paper highlights the need for the FSA to have further powers covering the gathering of information and enforcement powers which could include requiring funds to reduce their leverage. Also if you look at some of the offshore options in Europe – Ireland and Luxembourg for example – some of the allies of the UK aren't in such a strong position at the moment either. There is certainly a need for everyone to believe that the legislation that comes out is proportionate and suitable for a global business.
EG: I spent an hour today at a client event with Andrew Baker from AIMA and he explained AIMA's lobbying efforts. It's alarming for all the reasons that you mentioned and because it's closer to happening than we might think. I think we all feel that it goes too far and it misses the target; the lobbying efforts are trying to highlight those points. People don't have a problem with disclosure as long as it's not given to the public. And people don't mind registration. So if you're worried about systemic risk then you should be focused on aggregating positions and providing disclosure at aggregate levels, not an individual level. One thing that doesn't seem to be getting a lot of air time in the US is that investment managers with funds that are not compliant with the EU regulations may not be able to do business in the EU. It'll be difficult once it has gone through the European Parliament because then it'll be difficult to change. Now UCITS 3 is an example of how if you're offering a regulated fund you can distribute onshore in Europe, so we're spending a lot of time with clients talking them through how UCITS 3 works, both for institutions and hedge funds. So yes people will find a way to work within the rules but it will be expensive and time consuming.
RM: It means that you can't just have a US master feeder structure, you have to look at your various options, whether it be UCITS depending on your client base or whether it be European onshore. There is enough time, as you said, for people to adjust their structure in order to cope with the legislation but it will still be painful. I think if you are an asset manager and you do have that distribution network then UCITS allows you to fulfil some of the regulations that are due. But I think unless you are an asset manager and you are looking for those retail clients then maybe UCITS isn't the solution for you.
RB: Like you said, you need to have the distribution machine and you need to have the administrative capabilities for reporting and informing your investors so you need obviously a very high developed infrastructure to cope with that, and I think that's quite a big hurdle. I believe there will become a clear separation between the bigger managers and the smaller players not present in that space.
Chair: Has there been a flight towards the UCITS 3 structure recently or is it just commanding more attention now?
EG: We are definitely seeing a flight to this type of product. We've seen our first fund of funds dedicated to UCITS 3 strategies and demand from the more institutional type hedge funds who want to look at whether they can use this as a distribution channel. The questions they want to know are: How much does it cost? What's the benefit? Is it really something that people want? One interesting fact that we heard was that 50% of the revenue raised last year actually came from Asian investors.
RB: I think we can agree that the hurdle for becoming a UCITS fund or distributing it is high. But investors are difficult to find at the moment and many people want to diversify their investor base as much as possible. The added advantage of the retail channel is that it comprises lot of very small investors which dampens the effects of redemptions.
EG: A lot of institutions want UCITS though too; they want to know that your fund meets those standards. And it's institutional money that hedge funds really want.
RM: I think what will happen, as always in the securities industries solutions will evolve towards a structure that's as good a fit as possible. But there's a lot of uncertainty out there still, so that's why that refinement is really not taking place yet.
PL: But if you look at the history it's very interesting because originally UCITS 3 was perceived by institutions as a way to get into the hedge fund space by creating the long and short strategies through130/30 funds. Nevertheless the assets under management never materialised. I think today fund investors want liquidity, with a regulatory framework that is safe and allows for risk management. So I think it will get a lot more traction within the hedge fund world.
EG: Investors will always chase performance and the reason why I think the 130/30 product suite never took off is because the performance of those funds was poor relative to other funds.
PL: Yes and the timing was horrible.
RM: But another fundamental issue is you've got to have the ability to pick the right shorts. It's a very basic premise but there are many hedge funds that have not performed over history because they are predominantly long only and they don't hedge, they haven't got the right hedging mechanisms.
EG: That's right and UCITS is surprising in that as long as you have a liquid strategy you can do a lot of different things, it's not just equity long and short, and it's all done synthetically. So this will drive some of the synthetic bounces going forward.
RB: Also if it is a fund launched by institutional investors the performance focus is not so aggressive as what you see with hedge funds. Hedge funds promise 12% annually and they will do it every year, and if they don't then their investors walk away – it's very volatile. But these other 130/30 funds are much more institutionalised and obviously a bad year is not immediately the end of the fund. So it's not a product that is here now and gone tomorrow; I think it will be much more sustainable than that.
Chair: I'd like to thank you for coming and I appreciate your time.