2021: A Surprising Year for Prime Brokerage

2021 should have invigorated prime brokerage as active strategies continued to outperform and hedge funds saw record assets under management (AUM). Instead, 2021 turned out to be a watershed for the sector in a number of surprising ways.

Below are five key themes that defined 2021 and will continue to impact prime in the new year:

1. Increased Demand Side for Prime Solutions

In 2021, episodic volatility has drawn more attention to actively traded strategies. Moreover, positioning for macro strategies like rising rates (for instance, natural gas +93% YoY) and growing inflation expectations (labor market tightness — weekly unemployment claims in October tumbled to a ½ century low) have many institutional investors rethinking investment strategies and increasing their hedge fund allocations. That’s on the back of the best year for hedge funds in a decade in 2020, outperformance in 2021, and reaching an all time high AUM of nearly $4 trillion at mid-year. Ever more sophisticated strategies are emerging that require active management and demand additional risk capital and more nuanced attention. Many primes either don’t want to take on this new risk or cannot increase balance sheet utilization, creating situations where primes and brokers simply stop clients’ access to certain securities. Meeting the demands of sophisticated traders is becoming harder, but interfering with the proper function of markets should not be the answer.

2. Ongoing Supply Restrictions

Despite a veneer of rationality and evidence-based chess moves, each market fluctuation explicitly impacts which investors are deemed “acceptable” to the major primes. And that field is narrowing dramatically. Case in point: Archegos’s failure left family offices wondering if they, too, will soon face access limitation. Even firms that are let into the VIP room need to often wait months or longer just for the onboarding process to be completed. Some firms are shuttering prime services across the board. The pull-out of Credit Suisse, formerly one of the biggest primes, is symptomatic of the larger problem: the risk-taking activities of prime brokerages, and the supply of risk capital, are out of sync with the commercial banks in which they sit. More than ever, the larger primes are focusing their efforts on the same 50 clients, leaving thousands of investors, especially those with bleeding edge strategies and demanding needs, searching for new homes.

3. Costs Are Rising While Service Declines

Costs are rising for both primes and their clients. Regulatory and compliance demands have made the market safer in the wake of the crash of 2008, but at a high cost. Unfortunately, many of these rules are implemented with blunt force across all types of clients, whether justified or not. This results in higher costs and the stifling of investment required to serve growing areas of prime demand for sophisticated players, smaller firms, and those with elaborate technology needs. Clients are seeing higher hurdle rates and minimums even as services fall off. As demand for services picks up, primes continue to create additional manual processes by simply hiring more people, rather than addressing the underlying issues with technological solutions — meaning costs go up, demanding clients are cut, and the industry falls further behind.

4. A Modern Technology Stack for Modern Finance

In an interview in Traders Magazine this quarter, Abigail Johnson, Chairman and CEO of Fidelity Investments pointed to the challenges of working with antiquated technology: “The financial system still runs on a lot of infrastructure that was designed and built in the late 1980s and early 1990s […] we still can’t get everything done that we’d like to get done to be the most competitive company that we want to be.”

Clients are looking for ever increasing levels of differentiated service, and they’re frustrated with what’s available. Despite the over half a trillion dollar global tech spend at banks, modern tech remains a rarity in prime services. Clients want to better leverage data, portfolio analysis, risk assessments, custom reports, and a better clearing experience, yet the industry is not positioned for this. The prime space has become accustomed to its limitations and, since clients have nowhere else to turn, firms are not incentivized to hit the upgrade button. They just continue on with their slow, siloed, legacy technology system, making reactive fixes on top of older mainframe stacks.

5. A Focus on Risk Management

Ask yourself a question: How does your prime rank on a real time risk measurement? The fact is that most prime brokers don’t actually know their own exposure. They’re stuck in a cycle dependent on stale data, accessing millisecond markets from yesterday’s vantage. The future of prime has to be data-driven, in a manner that covers all assets. Firms have to approximate their capital needs in order to measure true risk, P&L, and margin. Such work is currently inefficient, costly, and a tax on the industry across the board.

The fact that bleeding edge technology and its antiquated predecessor can coexist in the markets is a surprise. It is hard to imagine calling your family to share holiday cheer from your new iPhone 13 and they answer using a rotary phone! In our industry, quantum computing coexists with Cobol, and microservices with mainframes.

Prime saw a shot across the bow in 2021: a major failure of risk, data, and technology that surprised, yet happily did not grow into a systemic issue. This time, rather than wait for the next failure, Clear Street has been building the first self-clearing, non-bank prime on a modern, cloud-native technology stack.