PRIME BROKING: BofAMLS COMEBACK PLAY

THE NEW WATCH

In a market that remains ultra-sensitive to counterparty credit risk and the safety of client assets, all but two of the leading prime brokers are now owned by major universal banking groups. They include Barclays Capital (which acquired the American equity finance franchise of Lehman Brothers), JP Morgan (which bought Bear Stearns in the spring of 2008) and Merrill Lynch, which has recovered strongly since its acquisition by Bank of America. Sylvan Chackman, co-head of global markets financing & futures at BofA Merrill Lynch (BofAML), explains how the bank has established a global, one-touch shop for its prime brokerage services that is now itching to flex its muscles whenever hedge funds regain their taste for leverage; and how the bank intends to give top rated prime brokerage operations such as Deutsche Bank and Credit Suisse a run for their money. Neil OHara reports.

to Beijing and Sao Paolo to ANK OF AMERICA Sydney. The secret of its phoenix(BofA) tripped up in 2008 like success lies in an integrated when it sold its prime approach that offers clients onebrokerage business to BNP stop shopping for all their Paribas, a transaction that could financing needs. After the not have been timed worse. The merger, we combined all the deal closed in October, just financing businessesrepo, after the Lehman Brothers futures, prime brokerage in bankruptcy lit the touch paper equity, fixed income and foreign on a wholesale redistribution of exchange, swaps, securities market share among prime lending and clearing of OTC brokers. BofA could only watch derivatives,says Chackman. We from the sidelines as hedge have one touch point in terms funds abandoned long-time of sales and client service, and market leaders, Morgan Stanley we look at risk globally across and Goldman Sachs, in a mad multiple asset classes. scramble to diversify their At many prime brokers, these sources of financing. By the time various functions are separate BofAs shotgun marriage with lines of business with their own Merrill Lynch was consummated income statements, which can in January 2009, leading prime foster in fighting rather than brokersespecially Credit co-operation for the firms Suisse, Deutsche Bank and JP overall benefit. With that in Morganhad signed up scores Photograph Paul Fleet / Dreamstime.com, mind, BofAML lumps them of new clients. supplied September 2010 together for internal financial BofA then went on to inherit reporting purposesand Merrill Lynchs prime broker compensation calculations. book, which had also suffered client defections as the brokerage giant stumbled at the height Our competitors are not getting the economies of scale, of the financial crisis. Luck comes in many guises; and so it the ability to price and win new business the way we can, has proved as Merrill Lynchs prime broking business has claims Chackman. We avoid internal turf battles. Hedge funds make up the bulk of BofAMLs clients, of provided the combined entity with a solid foundation upon which to rebuild market share. Today, the business has bounced course, but it also services long-only institutions that need back under the Bank of America Merrill Lynch (BofAML) financing for their futures and foreign exchange investments. banner and picked up enough market share to be a major The sales effort targets entities based on their overall league contender, alongside the five other big prime brokers. relationshipactual or potentialwith the entire bank. For Based in BofAMLs airy and eco-friendly new offices in mid- example, while Chackman may accept a hedge fund with town Manhattan, Sylvan Chackman, managing director and co- less than $50m in assets if it is affiliated with an existing head of global markets financing and futures, runs a BofAML client from whom the bank derives other revenues, the division that has employees scattered far and wide, from London minimum size will be higher for a standalone relationship.

FTSE GLOBAL MARKETS OCTOBER 2010

77

78

PRIME BROKING: BofAMLS COMEBACK PLAY

Steve Keller, managing director and head of Americas financing sales at Bank of America Merrill Lynch. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Mike Stewart, co-head of Global Equities at Bank of America Merrill Lynch. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Steve Keller, managing director and head of Americas financing sales, points out that the merger allowed BofAML to tap the vast Merrill Lynch equity franchise for client prospects. It helped that the taint that may have attached to the Merrill Lynch name in 2008 has since evaporated. Indeed, the fact that the prime broker is part of a commercial bank is a huge advantage in snagging new business. Every single hedge fund we see is thrilled to market BofAML as counterparty to an investor base that is increasingly interested in business risk, holds Keller. Many entities that left us during the financial crisis have come back. BofAML may have missed out on the easy pickings in late 2008 but it has taken full advantage of a secondary shake-out among prime brokers over the past 18 months. Moreover, since 2008 a number of major prime brokers have also shown a willingness to shed some of the smaller funds; though these were not the only trends in play. The relationship between prime brokers and hedge funds has changed irrevocably as pressure on hedge fund managers to diversify their counterparty credit risk exposure by appointing more than one prime broker continues, for instance. Any which way, BofAML has not been slow to spot and leverage opportunity. Chackman says small hedge funds that used to have only one prime broker now have two or three, while the biggest funds that may once have had eight or more have cut back to four or five as assets under management tumbled and trading volumes declined. We have benefited from both sides, he says. We have seen hedge funds who only had one add us as a second or third, and we have seen big hedge funds cut two or three other prime brokers and add us. Year to date, BofAMLs client roster has expanded by an estimated 300 hedge funds run by 100 different managers, some of which were new customers to the bank as well as to the equity division. Financing balances have jumped, and although low interest rates have squeezed profit margins, BofAMLs prime broker revenue is almost flat at a time when its major competitors have reported sharp declines. In 2009, for example, Goldman Sachs securities services revenue (which includes prime brokerage) slumped 41%, while

Morgan Stanleys prime broker revenue fell 20%. Chackman sees BofAMLs revenue poised to surge when hedge funds appetite for leverage returns. The gains wont come only from its existing client base, either. Even though Morgan Stanley and Goldman Sachs are now bank holding companies, they dont have the balance sheet power that established commercial banks can bring to bear. The monoline broker model is outdated, says Chackman. They are holding on pretty well in a low leverage environment, but when that turns they could have trouble deploying balance sheet at a competitive price. He expects those banks that signed up so many new clients in 2008such as Credit Suisse, Deutsche Bank and JP Morgan might in future struggle to retain them all, too. Wishful thinking? No, says Chackman. Its about underlying business dynamics; and the global BofAML footprint appeals to hedge funds that want to borrow stock in Japan, do a swap in Brazil and repo in New York under a cross-margin arrangement that minimises the collateral they have to put up, holds Chackman. Hedge funds want simplicity today, he says.They want to execute, clear and finance with one firm.

Global reach
The demand for global reach could put even JP Morgan at a disadvantage. The old Bear Stearns prime broker business it acquired was a domestic US franchise, a focus it retains under the JP Morgan umbrella. That leaves Credit Suisse and Deutsche as BofAMLs primary competitors on the international stage, a contest in which Chackman and Keller reckon BofAML is gaining an upper hand. We have a world-class prime broker that we can scale globally, says Keller. Merrill had not only a leading position in the US but also a strong presence in the Pacific Rim and the former Smith New Court business in London. BofAML offers execution and financing in more than 60 countries around the world, they boast. In todays marketplace, our global distribution and reach, combined with research and equity, state of the art infrastructure, pricing and margining, make us an interesting counterparty for a hedge fund,says Mike Stewart, co-head of Global Equities at BofAML.

OCTOBER 2010 FTSE GLOBAL MARKETS

For all the emphasis on creative financing solutions for clients, Chackman admits that prime brokers make relatively little money from margin loans and other long position financing. Stock lending has always been the critical driver in prime brokerage, accounting for more than half the revenue at most firms. From the borrowers perspective, the key is not just the ability to find hard-to-borrow stocks, but securities that will not be called away. Thats where BofAMLs unmatched retail presence comes into play: an enormous pool of stable assets only its clients can tap.Every prime broker has access to the other big custodian banks, says Chackman.We have access to $2trn in total client assets handled by our nearly 20,000 financial advisers. It is a huge differentiator. Even though stock loan demand is depressed at the momentthe specials to general collateral ratio today is about 3%, a far cry from the normal 15%BofAMLs retail assets served its clients well last year when demand for stocks such as Citi and General Motors soared. Prime brokers who source from the custodian banks have to play the game by their rules. For every dollar of general collateral taken, they will get an allocation of specials, typically 10% to 15%. The retail box gives BofAML a proprietary pool that is cheaper and does not require a quid pro quo, an edge that the bank thinks will pay dividends when stock loan balances bounce back. Retail assets also play a part in capital introduction, an area in which BofAML excels: hedge funds gave the firm top rank in two recent surveys. Its a critical function for hedge fund managers. If BofAML can add 20 basis points (20bps) to a funds annual return through its processing and financing services, the manager earns 4 bps in its 20% incentive fee. On every new dollar invested, however, the manager makes a 2% management fee50 times as much.

Sylvan Chackman, co-head of global markets financing & futures at Bank of America Merrill Lynch. After the merger, we combined all the financing businessesrepo, futures, prime brokerage in equity, fixed income and foreign exchange, swaps, securities lending and clearing of OTC derivatives, says Chackman. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Low-risk business
Its a low-risk business for BofAML too; better to be on the same side providing services to the people who run hedge funds than committing capital to take the other side of their trades. With six participants vying for leadership, the securities financing business is more competitive than ever. Hedge funds have cut their leverage dramatically, and while many delivered robust performance in 2009 gains have been elusive in this years choppy markets.If you are a hedge fund chief finance officer or chief operating officer, how do you help maximise returns?asks Chackman. In the last six months, we have seen more negotiations around pricing and terms. The smart funds dont push for every last nickel and dime, however. They know that at some point they will need more leverage and resourcesand prime brokers will be more accommodating to funds that didnt press too hard when times were tough. You dont want to be transactional about this business,says Chackman. The bigger funds understand that. They want strategic partnerships. Those relationships have helped BofAML ride the crest of the UCITS wave in Europe, where even before the merger Merrill Lynch had staked a claim to market leadership. The UCITS framework permits money managers to sell funds registered in a single country throughout the European Union

without having to meet onerous requirements for a local offering in each jurisdiction. Keller says BofAML has already launched UCITS vehicles for six big hedge funds and expects to sign up another dozen or so clients before year endwith more to follow in 2011. The UCITS franchise we have in Europe is unmatched,he says. The big hedge funds are likely to get bigger over the next couple of years, too. The new US regulations that require broker-dealers to scale back their proprietary tradingthe Volcker rulewill be good for hedge funds because it will free up investment bank capital and resources to service clients rather than in-house proprietary trading desks. Traders are likely to jump ship as well, either to join existing hedge funds or to start their own operations. Meanwhile, the barriers to entry keep going up, as does the minimum economic size for an existing fund. I see a massive consolidation among hedge funds, says Chackman. Many funds that are below their high-water mark may be forced to fold.He believes the 7,000 hedge funds that exist today could shrink to 4,500 or 5,000 in two years timebut does not expect assets under management to shrink. He explains: The tail is so long, 14% of the hedge funds control 85% of the assets. Its the small funds that are at greatest risk. In fact, some large funds have taken in so much money that they are already closed to new investors.Many hedge funds are having a very difficult time raising money, but the biggest are now so successful they are closing, says Keller. The trend will play to BofAMLs strength among hedge funds with assets in excess of $10bn, another survey category in which it topped the bill. I

FTSE GLOBAL MARKETS OCTOBER 2010

79