Sunday, September 09, 2007

Why are there no independent prime brokers?

After seeing the recent article on conflicts between hedge funds and prime brokers, I started thinking about what would be required to build an independent prime brokerage.

There's been a lot of noise about prime brokers front running their clients, hedge funds, and otherwise trading off information that funds would prefer was a secret. Considering that the prime brokers are just divisions of global investment banks, that shouldn't surprise anyone. There's also the competition between the trading desks at the banks and the fundamental business of many (most?) hedge funds -- trading. What kind of sense does it make to use someone who may be on the other side of a trade with you as your lender, clearing house and possibly an administrative services vendor. (Prop research has also been cited as a benefit for some of the larger primes.)

The smaller funds don't have much choice with this arrangement, obviously. At the other end of the spectrum you have Citadel, which is reported to be pursuing a broker-dealer license and is known to make a pretty penny lending shares to other funds (for short sales). However, I imagine that even a player like Citadel would like to see more autonomy and less competition with its primes (until it can settle its own trades anyway).

Now, the crossing networks and dark pools probably take some of the edge off of these potentially volatile relationships, because there are multiple options (besides having 2+ primes) for trading, and with anonymity and less market impact to boot. However, the primes do provide some services that most hedge funds can use on some level, or so it appears. So my question is "why not?" What are the upsides or downsides of an independent prime brokerage operation that was not competitive with its clients? Does the potential exist for this to be a viable business model? Why hasn't it already been done? Is it because of the "need" for a balance sheet to support customers? Or is the reason that it hasn't been done merely along the lines of "its never been done like that"?

Inquiring minds want to know. Ok, maybe not really, but I do...dammit.

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