That was one conclusion of a recent study by Finadium LLC and Pershing LLC, a BNY Mellon company, “Lending and Leverage: The New Securities Finance Model for Hedge Funds.”
One issue, according to the study, is investor demand for greater transparency. “Leveraged investing continues to be seen as a murky area full of risk and unintended consequences,” an announcement of the study said. “Transparency in securities lending pricing creates a more productive relationship between hedge funds and their prime brokers, and it offers hedge funds new opportunities to attract investors.”
It is in the securities lending area where a prime broker can stand out from the crowd. “Securities loans may not be as important to hedge funds today as they were in 2008, however, it is expected that securities lending will return to center stage over the next several years,” the announcement said.
“The major challenge for hedge funds of all sizes continues to be access to hard-to-borrow securities,” said Craig Messinger, managing director of Pershing Prime Services, in the announcement. “A prime broker with access to inventory, whether through electronic markets, retail pools or relationships with institutional lenders, is critical. Forging a strong operational relationship with a prime broker is critical to a hedge fund’s success, regardless of where securities loans are sourced.”
According to the study, market structural changes were prompted by the market turmoil of 2008 and were made more complicated by moves by regulators to suspend short selling that year, which the study announcement said “created major disruptions in the prime brokerage business model.” As the ruling to avoid naked short sales has been made permanent, hedge funds and prime brokers have made the appropriate adjustments in their practices, and they are aware of greater possible changes in market structure.
Going forward, the critical point in choosing a prime broker is ensuring that the fund’s and prime broker’s interests are aligned; if one party looks for transparency while the other does not, regular conflicts will arise.
“Going forward, hedge funds will need to spend more time focusing on the costs and means by which they obtain securities loans,” said Josh Galper, managing partner of Finadium, in the announcement. “As more transparency enters the securities lending market, investors are looking for hedge funds to demonstrate an ability to secure the best financing for their trades. This in turn places a greater emphasis on how funds source securities lending inventory and how they manage their prime brokerage relationships.”
More information about obtaining the study is here.