Industry balance sheet is becoming more scarce and expensive. Funds need to take a closer look at the entire liquidity provider space - existing, new and alternatives. This perspective addresses many of the issues that prime brokers, funds and the entire industry are currently facing.

1. Norman Feckl
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Perspective
Balance Sheet and Liquidity
By Norman Feckl
09/15/2015
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Is The Fund Space On The Right Pace & Operating From the Right Place?
Industry balance sheet is becoming more scarce and expensive and this trend is set to continue in this direction
for quite some time to come. In addition, a new variable is about to be injected into the mix. Bank regulators are
busy yet again, drafting new rules - BASEL IV. The previous iteration et al has not settled in yet and the industry is
still developing systems, processes and procedures to provide tracking and controls with regard to these rules for
all to follow. Consequently, are any of us truly prepared for yet another impact on liquidity requirements as it
travels down the implementation path?
Whether a prime broker or any fund type of any size (hedge fund, asset manager, family office, proprietary fund,
etc.) that needs liquidity appropriately priced and always there, are we truly ready?
It is important to bring this to the attention of all who rely on liquidity and balance sheet being readily available,
stable and appropriately priced. For all those managing investor and firm monies, for those of us who are
stewards of that highly treasured liquidity, the article below, and many others, serve as a foreshadowing of a
potential dire situation and state in which all the liquidity stakeholders stand - the stakeholders being those who
provide it and for those who depend on it.
The constant process of 'preparedness' must be the action going forward. The regulations march on and over
liquidity and its providers. Prime brokers are already busy mapping this all out and have their plans in order and
on pace.
The fund space, however, requires closer scrutiny. Hedge funds, asset managers, proprietary funds, family offices
and the like, may be more exposed than they realize. They need to take a closer look at what lies ahead, not only
now, but in the future: a 3 to 7 year view is required at a minimum. The results of this analysis may influence the
direction and action that should be taken by all funds, sooner rather than later. In addition, a different approach
with regards to the appropriate tools and resources may be required in order to achieve the end results desired in
establishing the proper control and protection for their balance sheets and liquidity.
Below are testimonial summary bullet points from the referenced article contained herein: “Picky banks play
hardball with hedge fund clients,” and from other articles, outlining the challenges of the industry and where
some points of views were added for reflection and scrutiny:
(Names were removed to allow concentration on the broad principles rather than the specific players)
 One prime broker - is reducing prime business as they do not possess enough ROE. They are perceived to

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be suffering from balance sheet issues and are now, according to some, in survival mode.
 A second prime broker - is significantly scaling back their prime broker business. The investment bank
would rather put capital elsewhere.
 5 prime brokers gaining market share - Hedge Funds have concentrated more business into only 5 prime
brokers - 71% as per one of the articles. Is this too much concentration when viewed in the context of any
future market disruption?
 Less prime broker diversification - This is now becoming the accepted norm by both funds and investors.
Primes (at least 5) win, as they should, as they are about market share; however, should we ask ourselves,
"is this not adding risk and is this not contrary to the true risk mitigation model we all preach and follow?
D-I-V-E-R-S-I-F-I-C-A-T-I-O-N.” Are we putting more risk on our industry by not being as diversified? Could
it suffer when the next disruption hits? Are we concentrating too much in a few places, much like 2008?
Have we not been here before?
 Poorly paying funds - This is front and center for the Primes and they are thoroughly and methodically
reviewing their client base, resulting in the inevitable shedding of funds with AUM of all sizes: $15million
to $40billion plus. ALL are under review, no one fund is immune. The Primes’ ROE model is dictated by
regulations. Liquidity providers have no choice but to continue the retooling of their business models with
the rules that have been mandated to them.
 Primes want more fees - What is the right fee structure for funds to pay? This requires real deep dive
analysis. Who should do it? Do the funds know where the costs are? They appear in fee changes, in
margin changes, in balance sheet shifts and reductions, in fees of other services, and in the shedding of
funds. How is all this pacing with regulators, liquidity providers and liquidity takers? Are they all in sync?
Funds, primes, investors, and the entire market, are all exposed. Each prime will be different, depending
upon where they are in their balance sheet cycle regarding usage and committed capital. Funds of all
types need to understand this. Funds also need to know their slippage and exposure costs. Depending on
the size of the fund, those costs can range from tens of millions to hundreds of millions per year. Think
about that in ten year blocks and you will see that the numbers can be staggering. There are many ways
to capture those costs and turn them into value to the bottom line.
 Hedge Fund launches - are down due to the fact that only a few primes help and those few are rationing
their resources. Going forward, small and even large funds are exposed to new launches so knowing the
right fees, right mix of primes, and seeking the right and new alternative funding facilities are a must.
Knowing how to select and manage a liquidity provider is more important than ever! Having a centralized
platform managing all types of providers is a pre-requisite.
 Banks in charge - "Banks have the control." Funds have no control. The unintended consequence caused
by regulations is that there is no balance of control. This creates risks and places the exposure on the
entire industry itself.
 2016 TLAC – The trend is getting worse. In 2016, Total Loss-Absorbing Capital (TLAC) begins which means
more funds are potentially at risk and even less balance sheet may be available for hedge funds, family
offices, proprietary funds, asset management funds, and any other fund types out there.
 Prime broker profitability falling - ROE is now at 6.3%, down from 2014, which was at 17.2%. Primes will
continue reviewing funds to possibly shed and raise costs to get ROE back in line. Think of this – “Could it
be possible that a major prime drops out of the prime space, leaving more risk, less balance sheet, less
liquidity in the system to fewer primes to help a growing fund space?” Have we seen this before? Is it
possible that less balance sheet will be available in an already tight balance sheet market? Or will price

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adjust for that shortfall? New ones will take up the slack, though the pace of new liquidity providers needs
to accelerate. This is one positive trend, nonetheless.
 Hedge funds setting up financing desks – Having a better understanding of prime brokers is recognized as
a necessary process by funds on the funding side, but is this keeping pace with the primes as well as the
new and impending banking regulations? Primes have set sail on this matter; are the funds still at anchor?
 Selection of Primes - Lessor known primes and new entrants are being selected and this is a good path
and should be supported and applauded; however, are the funds taking a real in-depth thorough look of
what is available? Is this adding a different undefined risk to hedge funds and to those primes
themselves? Do they in fact have the expertise? Investors accept this. Should they? We have all
experienced 2008; unfortunately, we lost a prime or two and could use them back in the game. It is a fact
that some of the best primes blew up; and blew out hedge funds. The new primes will have their market
disruption exposure and experience soon enough. As they have a shorter prime track record than the
longer established players, we all need to plan for the potential of some new entrant turning off the
liquidity spigot earlier than expected. We need those participants and their balance sheets to support the
industry. The funds need to control the selection process and this must be more rigorous.
 Prime brokers space in flux - Procrastination will cause unexpected and inevitable pain to the fund
market. Primes, themselves, are still sorting through this regulatory mess and they are fighting for survival
for their firms, their prime-brokerage businesses, their jobs, their livelihoods.
 Prime Broker criteria - Meeting and maintaining prime broker criteria is difficult given the pressures of:
BASEL III; Dodd Frank; Federal reserve powers on banks; expansion of government agency authority;
capital reserve requirements; short selling restrictions; balance sheet overhaul; and more; and next: HERE
COMES BASEL IV!
 Increased fees on funding, margins, trading costs - Primes are increasing costs on all fronts. How do
funds understand all the continuous moving parts? Do any of us really know all the costs? And... new
costs are on the way - BASEL IV.
 Higher capital requirements and regulatory risks - are here to stay and will become more burdensome.
Both primes and funds are exposed with regards to liquidity and balance sheet. Balance sheet and
liquidity may not be available to those scrambling for survival when the next market disruption occurs,
while experienced liquidity providers will be ready. The burdensome regulations will actually help the
newly entering liquidity providers. It is the funds that need to ensure they are in a constant state of
preparation to protect their investors but also to support the industry itself.
The funds that are able to provide a strong independent liquidity protection platform for themselves, in
addition, will be providing a stronger foundation for the industry. A stronger foundation that will allow for
continued growth and a stronger foundation for withstanding the constant changes and unexpected market
shocks for their funds and investors. As a result of funds having developed a strong liquidity and financing
platform, liquidity would be available for those who may be less developed and for those who may fall short
during challenging times. Those funds would have access to secure liquidity when they really needed it.
The end result is the industry wins!

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Article: “Picky banks play hardball with hedge fund clients”
Funds | Tue Sep 15, 2015 8:16am
Picky banks play hardball with hedge fund clients
* New rules make banks more choosy on hedge fund clients
* Some banks scaling back prime brokerage, others joining
* New funds launch with fewer brokers
By Simon Jessop and Nishant Kumar
LONDON, Sept 15 (Reuters) - For Jonathan Kinlay, no novice at setting up a hedge fund, this time round was much
harder.
In the traditional Grand Tour of investment banks looking for help to finance his trading, he was politely turned
down by no less than six for being too small.
The response, says Kinlay, chief investment officer of New York-based Systematic Strategies LLC, was the same at
each of them: "We'd love to help you. We know you. Give us a call as soon as you've got $50 million."
Kinlay's experience highlights sweeping changes underway in banks' prime brokerage units, which provide funds
with services such as lending money or securities and settling trades.
Mounting regulatory pressure since the financial crisis is prompting banks to cull smaller and poorly paying clients.
Many of the funds which do make the cut are being asked to pay more in fees or pump higher-quality business
through the bank.
"You're seeing large funds look to consolidate their activity with fewer large primes so they are relevant enough in
terms of wallet," said the head of prime brokerage for Europe at a leading investment bank.
But even that is not enough for some.
Credit Suisse Group is reportedly set to scale back its prime brokerage activities after a wide-ranging review by
new Chief Executive Tidjane Thaim, who would rather use the capital elsewhere.
As well as raising the bar for hedge fund launches, the changes are also leaving funds open to greater
counterparty risk as they are forced to use fewer banks - a sharp reversal of the trend seen in the industry just
after the 2008 crisis.
Then, hedge funds - spooked by the collapse of Lehman Brothers - had sought to diversify away from the
dominance of Goldman Sachs and Morgan Stanley, giving a chance to rivals such as Deutsche Bank and Credit

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Suisse to boost market share.
This year, less than 3 percent of hedge funds launched with the help of three or more prime brokers, down from
11.4 percent in 2014 and a high of 14.5 percent in 2008, data from industry tracker Eurekahedge showed.
More than 70 percent of the launches used just one bank, up from 61 percent in 2014 and a low of 55 percent in
2012.
BANKS IN CHARGE
That change mirrors the changing power relationship between the funds and their banks.
For many years, funds received the red-carpet treatment from brokers. Pre-crisis, funds often picked brokers on
the basis of a bank's specialism and service offering, while post-crisis there has been a greater focus on
diversifying credit risk.
Now, though, the banks are in charge.
"The industry is now in the third phase of the evolution of the prime brokerage-hedge fund relationship, which is
about regulatory capital, balance-sheet and liquidity," said Dan Thomas, head of Wells Fargo Securities' client
trade services.
Since Basel III rules on leverage began to go live, crimping the amount of balance sheet they could extend to
funds, banks have seen the profitability of their prime units slide.
While most just give high-level revenue figures, data from other industry watchers shows the scale of the hit to
banks' bottom line by the rule changes.
Data from industry tracker Coalition showed average 2014 return on equity for nine of the top brokers based on
risk-weighted asset-based capital was 17.2 percent. Using new leverage rules, the profitability fell to 6.3 percent.
And that trend is likely to get worse as banks brace for the onset in 2016 of Total Loss-Absorbing Capital (TLAC)
rules, designed to bullet-proof the industry against future shocks and which will see big banks hit more than their
smaller peers.
That flux is proving a boon to cash-rich investment banks such as Wells Fargo, which is ramping up its prime
offering and attracting funds rejected or asked to pay more by industry leaders.
ATTRACTIVE FUNDS
Determining which fund is attractive to which bank and at what price is complex. It hinges on a host of factors
including the size of the bank, its geographic footprint, the trading flow of both fund and bank and the fund's
growth plans.
Among the most attractive fund strategies, in theory, would be those which do not take up much balance-sheet,
such as equity market neutral funds or long-short, where a fund bets on stock prices rising and falling.
Less attractive strategies could include less liquid debt markets, or ones which require a bank to take the opposite
side of a complex derivatives trade, but it is possible for a fund that looks 'good' for one bank to look 'bad' for

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another.
"You're seeing hedge funds set up financing desks equivalent to a PB (prime brokerage) house so that they
understand how we evaluate the clients, so they can help optimise their activity," the Europe prime brokerage
chief said. "Because every prime has a slightly different sweetspot across markets."
While return on equity calculations would differ at each bank, as would where the return came from - financing,
execution or custody, for example - most brokers would be "broadly happy" with a return on assets of at least 100
to 125 basis points.
Data from hedge fund tracker Eurekahedge also shows the impact of the shake-up, with traditional prime brokers
attracting more assets from bigger hedge funds and second-tier primes building up their business.
Eurekahedge estimates top-5 banks have captured 71 percent of the market, up from 67 percent before the crisis.
The next five prime brokers have also increased market share to nearly 20 percent, up from 17 percent before the
crisis.
The Europe prime brokerage chief said he thought most big firms - those with more than $5 billion in assets -
would likely settle at four or five prime brokers.
The wide-ranging nature of the changes in the industry mean investors are also showing more forbearance, said
Graham Rodford, chief operating officer at London-based Omni Partners, which has cut its prime brokers to four
from six.
"Investors are also aware that there's pressure on prime brokers and if you tell them that you are consolidating
prime brokers, they see it as less of an issue than they did in the past," he said.
"Before, managers were reluctant to appoint a lesser known prime broker. Now investors understand." (Editing by
Gareth Jones)