LONDON, 15 September 2003 — Hedge fund managers are demanding a more specialist service from prime brokers, providing opportunities for existing and new entrants to the market. Prime brokers handle the back-office operations for hedge funds, including stock lending, execution and clearing of trades, advice on regulation and reporting and balance sheet management.

The market has traditionally been dominated by US investment banks Goldman Sachs and Morgan Stanley. But a new generation of hedge fund products means the two market leaders aren’t necessarily the best-suited for the job.

“In the past, hedge funds mainly used equity long/short strategies which relied on prime brokers’ stock-lending and capital introductions to investors,” says Nick Cavalla, associate director of Man Group PLC (U.EMG), the world’s largest hedge fund manager, with $30 billion under management. “But the increase in fixed income and credit strategies and the use of derivatives has resulted in a new generation of hedge fund product.” Large investment banks have historically kept their different operations separate, making simultaneous direct access across a number of assets for multi-strategy purposes difficult.

For example, a global macro strategy, which involves betting on macroeconomic trends, would involve access to an investment bank’s bond and fixed-income desk. This will be in a different part of the bank to its main equity financing unit, and cross-fertilization is costly, says Cavalla.

Dresdner Kleinwort Wasserstein spotted its chance and launched a prime brokerage business in July last year with the aim of catering to a more diversified hedge fund business. “We wanted to build a more flexible platform that can cover all asset classes and deliver a more integrated product efficiently - and of course we are also able to tap the group’s stock-loan resources for more traditional equity trading,” says Martin Keller, managing director of DrKW’s international prime brokerage business.

DrKW has just over 20 people dedicated to its prime brokerage unit, compared with hundreds working at the more-established houses. But it’s managed to grow its client base from six at the start to 25 hedge funds currently. The client base is predominantly European, though this includes US hedge funds with European offices, and is a more or less equal mix of fund of hedge funds and single fund managers, says Keller.

DrKW provides execution, clearance, financing and reporting and account management directly and other services offered by the full-service prime brokers such as legal and accountancy advice through third-party specialists. This means it can concentrate on the numerous different strategies used by today’s hedge funds and the equivalent number of different risk profiles that this entails. Global macro is one of the strategies that has returned to favor recently and relies predominantly on the execution and clearing capabilities of a prime broker, says Keller. The largest percentage of global macro trading is done in the forex market, and the weakening of the dollar against the euro for a prolonged period of time has boosted interest in this strategy. In the second quarter of this year, global macro funds alone pulled in $2.48 billion of the total $13.83 billion new money in hedge funds, according to TASS Research, part of Tremont Capital Management. Prime brokers have also traditionally dealt with counterparties on behalf of the hedge funds and have cleared the final trades. But Man’s Cavalla says that this isn’t necessary in some strategies, such as those based on the fixed-income market.

Fixed-income arbitrage involves the purchase and simultaneous short sale of fixed-income or debt securities such as government bonds and mortgage-backed securities of the same term, and can involve dealing with up to 20 different counterparties.

“It is much more efficient to deal direct with the banks with whom you are doing the trades and to net the positions direct, rather than clearing all positions back through a prime broker,” Cavalla says.

These strategies don’t rely on the large-scale trading and financing of equities — the traditional domain of the likes of Goldman Sachs and Morgan Stanley.