Marc Rubinstein has over 25 years experience as an analyst and investor in the financials sector which he distills into a weekly newsletter, Net Interest, which I think is a really great read! Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby).
As with all of our guest contributors, Marc’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.
Last week, under the gaze of a new chairman, Credit Suisse announced a restructuring of its investment bank. After losses racked up through its dealings with Archegos Capital Management, the bank decided to exit prime brokerage, a business it has been in for many years.
At the same time, in another place and another market, a much newer financial services company reaffirmed its commitment to enter the prime brokerage business. Coinbase launched a prime brokerage offering in crypto for its institutional clients midway through the third quarter. On its earnings call, the company’s CEO highlighted it as a key area of investment.
The two businesses aren’t exactly alike. Equities – the substrate for the Credit Suisse model – has a different market structure from crypto. But the structure of the two markets is not a million miles apart and so it’s no surprise that crypto should borrow from models refined in the equities market.
This week, we take a closer look at the prime brokerage business model and its application in crypto. Earlier this week, the aggregate value of the world’s crypto assets flew through $3 trillion for the very first time. Institutional interest is rising and an effective prime brokerage solution could be the way to unlock it.
Hedge Funds and Their Prime Brokers
Most retail investors have a single brokerage account through which they manage their investments. Their broker will usually look after custody for them and offer additional services such as margin lending. If they have more than one account, they are likely to be distinct: funds in one account can’t usually be drawn to cover positions in another.
It’s different in the institutional market. Investment managers will typically have accounts with lots of brokers. Brokers use the term clients, but to the extent that conveys some kind of loyalty, it’s deceptive – institutional money managers are free to roam between all the firms on the Street.
In 1949, Alfred Winslow Jones launched the first “hedged fund”. By employing short-selling (“a little known procedure that scares away users for no good reason”) and leverage, he was able to generate much higher returns than the conventional long-only funds of the day. Because he managed his assets more intensively than traditional firms, he needed accurate reports on all his positions and swift clearance of trades. But keeping track of it all was hard, so he hired a firm, Neuberger and Berman, to help.
Over time, the hedge fund industry grew. At the beginning of 1968, 40 firms operated a similar model to Jones’. By 1969, there were between 200 and 500, managing $11 billion of assets.
In 1971, a clerk at a firm called Furman Selz (later acquired by Dutch bank, ING) realised there was a business here, and began cultivating hedge fund clients. He started off keeping books and records by hand, but soon developed a computerised portfolio tracking system tailored especially for hedge funds. The pitch was simple: why work with 20 to 30 different brokers and try to consolidate all their reports when you could work with a single “prime” broker to keep accurate daily records. In 1982, he took his system to Morgan Stanley, which used it to help Julian Robertson of Tiger and George Soros manage their funds.
Other brokerage firms began to take note. Goldman Sachs was doing a lot of margin lending for Michael Steinhardt, another pioneering hedge fund manager, out of its private clients business. The Steinhardt account required specialised handling because rather than settling margin on each of his positions separately, Steinhardt negotiated for it all to be netted off so it could be settled in one payment on a daily basis. A partner at Goldman saw the same potential that the clerk at Furman Selz had.
Goldman Sachs called it Global Securities Services. It was an operationally exacting business, with high fixed costs associated with installing the right computer systems. For years, it was treated as a back office, lodged on the seventh floor of the firm’s 30-storey headquarters on Broad Street. But its status within the firm grew as it became more profitable. In the full year before it went public, Global Securities Services contributed $730 million of revenue to Goldman Sachs, versus $795 million in the equities sales and trading business.
To this day, the business continues to offer a technology platform and reporting that enables hedge fund and other clients to monitor their security portfolios and manage risk exposures. Alongside that, prime brokers like Goldman offer a range of other services:
- Custody – looking after a hedge fund’s assets.
- Bank accounts – running multi-currency cash accounts on behalf of hedge funds.
- Margin lending – lending on margin to hedge funds against the value of their security holdings.
- Stock lending – lending stock, so that funds can short-sell stocks they don’t own.
- Synthetic prime brokerage – providing funds with derivative exposure on assets via synthetic equity derivatives like single stock swaps or total return swaps.
- So-called “Delta One” services – offering hedging instruments like index swaps. (In some cases, this business sits outside prime brokerage since its client base skews away from hedge funds towards more traditional funds.)
In addition, prime brokers provide consulting services to help fledgling hedge funds get off the ground – services like finding offices, hiring people, engaging lawyers and capital introduction. Typically, these services are offered for free as a means to onboard new funds early in their life.
Prime brokers make most of their money on the financing side. They lend explicitly through cash margin loans (for long positions) and stock loans (for short positions), or implicitly through equity derivatives (which can be long or short). Like any form of lending, prime brokerage is a spread business: money is made on the spread between what hedge funds pay for financing and what prime brokers pay as the cost of their funding. In 2020, Goldman’s equities financing revenues were down, not because of a lack of hedge fund activity, but because the firm suffered “higher net funding costs”.
Because of high switching costs and barriers to entry given the tech spend, returns in the business can be strong. The industry grew from $10.7 billion in revenue in 2010 to a peak of $18.3 billion in 2018 before falling back to $15.2 billion last year (based on data from Coalition). Typically, prime brokerage contributes around 40% of total equities sales and trading revenue. So far this year, Goldman Sachs has made $3.1 billion of revenue in the business. On his first quarter call with investors, Morgan Stanley’s CEO said, “This is a gem of a business that we’ve probably generated, I don’t know, something close to $40 billion in revenue in a decade. It’s a core part and backbone of the equities business.”
In order to mitigate risk, prime brokers require hedge funds to pledge their underlying positions as collateral and post margin. Given that positions are typically quite liquid, risk should be quite low. After its blow-up on Archegos, Credit Suisse commissioned a report to investigate. The report confirms, “prime brokerage is intended to be a low-risk business”.
And yet, as we discussed in our piece following the blow-up (What Sort of a Business is Investment Banking?), Credit Suisse lost a bucket-load of money in its prime brokerage business financing a single client. The report puts total losses at $5.5 billion on a client who contributed $26 million in revenues in the two full years prior to collapsing.
Credit Suisse’s loss arose not because the business wasn’t low-risk, but because the firm performed it badly. Credit Suisse made the classic error that firms in the lending business are prone to – underwriting on the basis of competitive positioning rather than underlying risk. In 2019, Credit Suisse managers agreed to lower Archegos’ standard swap margin rate after Archegos convinced them that “another prime broker offered lower margin rates.” They lowered it from an average of 20% down to 7.5%, which Archegos confirmed was “pretty good”.
Credit Suisse was also an organisational mess, which didn’t help. The overall prime brokerage business was run by two co-heads – one based in London and one in New York – each of whom thought the other was responsible for the US Prime Financing business which oversaw the Archegos account.
Seven months after disclosing its prime brokerage losses, Credit Suisse decided that it doesn’t have “the competitive advantage required to deliver sustainable returns above our cost of capital in this business.” It is shutting the business to free up $3 billion of capital. Revenues were around $800 million in 2020, so not too bad, but costs were high.
Credit Suisse is not the first to exit the business. Nomura pulled out of the business in Europe and the US earlier in the year, also following losses on Archegos. And Deutsche Bank exited a couple of years ago in an overhaul of its entire equities franchise. The industry is consolidating around its three largest players – Goldman Sachs, Morgan Stanley and JPMorgan. They are characterised by strong balance sheets, modern technology and good client service.
Prime Brokerage in Crypto
The market structure in crypto is different from the market structure in equities. For a start, the market is a lot less mature. Coinbase threw an interesting chart into its shareholder letter this week showing Internet vs. Crypto Adoption. The punchline: we’re back in 1998. A recent survey reveals that around 4% of Americans owned crypto in 2020. That’s up from 1.9% in 2019, but it’s a long way short of equities, where over 15.2% of households directly own stock (that was the number in 2019; it’s likely gone up since then).
But it’s a big market. In the past 24 hours, around $150 billion worth of crypto assets has traded. In recent days, trading volume has been as high as $200 billion which is almost as much as in US equities – with the proviso that crypto trades every minute of a 24-hour cycle, whereas US equities only trade for six and a half hours a day.
However nascent the market, institutional engagement is even more so. Coinbase itself was founded in 2012 focused on providing an onramp for consumers to access crypto. It didn’t turn its attention to the institutional market until 2015. As Jeff John Roberts writes in his book, Kings of Crypto, about the founding of Coinbase, “in a critical move, the company launched a professional exchange. While Coinbase’s original retail product let ordinary individuals buy and sell bitcoin, the exchange was a turbocharged version that let big-time traders swoop in and out of positions worth thousands or millions of dollars … If the exchange caught on, it would mean Coinbase could claim institutional customers in addition to its core base of retail bitcoin buyers.”
Today, institutional customers make up 72% of Coinbase trading volume (as per third quarter). That share has been growing. In the third quarter, Coinbase won market share in institutional volumes while its retail volumes performed in line with the industry. It picked up new institutional clients including Pimco. A survey conducted by Fidelity reveals that the share of institutional investors in the US with exposure to digital assets will increase to 90% within five years, from 27% in 2020.
In order to service these institutional clients, Coinbase rolled out a prime services product that combines trading, custody, analytics and financing in a single solution – the kind of thing Goldman and Furman Selz did in equities many years ago. The demand is potentially greater in crypto because custody is a harder problem to solve.
Others in the industry are also developing their prime brokerage activities. We discussed Galaxy here in Net Interest a few months ago. Founded by ex-Goldman partner Mike Novogratz, it is set up as a ‘merchant bank’ for crypto, focussed on the institutional market. It began offering prime services to select clients during the second quarter, taking in $150 million of customer funds onto its balance sheet by quarter end. Other providers include Copper, which provides some core prime services, notably custody. FTX is a leading crypto exchange that began by targeting large, active traders and is making inroads on the institutional side.
Way behind in their immersion of this market though are the traditional prime brokers. There are a number of reasons for this. The first is regulation. Goldman’s President and Chief Operating Officer has said that, “As a regulated bank, we are limited in what we can and can’t do. So we could custody, but we can’t principal bitcoin as an example. So those distinctions, maybe not as well understood, but that’s something that we’ll have to navigate through.”
Other firms take more of a paternalistic approach. On his recent earnings call with investors, the CEO of UBS said, “I still feel that … not many players understand the true value of crypto, what determines the value of crypto, what the uses of crypto. And therefore, I think it is not something that one can regard as an investment but it’s much more – it’s more about speculation. We don’t advise on speculation. That’s what it is, and that’s why we don’t go there.” (Wait till he see what goes on in some of his institutional clients’ portfolios.)
The final reason is client demand. Morgan Stanley’s CEO said on his recent earnings call, “for us, honestly, it’s just not a huge part of the business demand from our clients, and that may evolve, and we’ll evolve with it. But right now, it’s not – it’s certainly not what’s driving our economics one way or the other. But we’re watchful of it. We’re respectful, and we’ll wait and see how the regulators handle it.”
Tackling the institutional market is important because, as the equities business has demonstrated, there’s a lot of money there. Right now, Coinbase makes much more money in retail. Although retail contributes 28% to its trading volume, it makes up 94% of its trading revenues. But it wouldn’t be as efficient in that business without its institutional clients to provide liquidity. It is also likely that trading commissions in the segments converge, as they have done in equities. If, as Coinbase suggests, we are only in 1998 in terms of crypto adoption, it is worth remembering that retail trading commissions averaged $19.50 per trade back then (E*Trade) versus zero today. Coinbase retail fee rates have already fallen from 1.35% in the first quarter of 2020 to 1.10% in the most recent quarter.
There are various differences in the economic model of intermediaries in crypto versus those in equities. Coinbase operates a vertically integrated model, combining order management, execution, clearing and custody, in a way few equities providers do. It’s like E*Trade, the New York Stock Exchange and the DTCC rolled into one. Equities brokers tried to replicate this model in the past when the likes of Goldman Sachs looked to bypass the New York Stock Exchange but it didn’t stick, not least due to regulation. The difference here is that crypto trading data is freely available, while a lot of the value in equities exchanges is captured via the data they collect.
The legacy equities brokers aren’t out of the game yet. Commodities markets evolved around a group of specialist players – as Javier Blas and Jack Farchy describe in their book, The World for Sale – but Morgan Stanley and Goldman Sachs eventually muscled in (before regulation turned against them). There can also be convergence. One specialist player, Philipp Brothers, acquired Salomon Brothers, one of Wall Street’s most storied investment banks. In this iteration, Sam Bankman-Fried, the founder of FTX, has said (joked?) that he may one day buy Goldman Sachs and CME.
As crypto institutionalises, its market structure will likely evolve. There’s a place for prime brokerage within that.