Prime broking braced for new era after Archegos collapse
On an overcast morning in early 2016, the then Irish Taoiseach Enda Kenny opened Credit Suisse’s new trading floor in Dublin and declared that the city had joined “a small club of trading locations worldwide”.
The office would serve as the trading hub for the Swiss bank’s global prime broking division, a business that helps grease the wheels of hedge fund clients by lending them money and stock to execute trades.
But almost six years later, hopes that Dublin could grow into a significant outpost in the bank’s global operations have evaporated.
Instead the future of the office and its 90-strong staff have been swept up in the fallout from the collapse of Archegos Capital, an obscure family office whose demise left its prime brokers with $10bn in losses and the wider industry confronting its biggest upheaval since the global financial crisis.
European and US banks have long used prime broking, a business with steady if unspectacular returns, as a way of forging more lucrative relationships with hedge funds and, in smaller numbers, family offices.
Archegos, run by Bill Hwang, an alumnus of legendary hedge fund Tiger Global, was one such client. By the time it was incinerated over a weekend in late March, Archegos counted several of the world’s largest banks, including UBS and Morgan Stanley, as prime brokers.
The $5.5bn trading loss Credit Suisse suffered was the worst in its 165-year history, stinging the bank into action. Last week the lender said that it would all but exit a business it has been in since 1996.
While the bank was the highest-profile casualty, prime broking executives and industry analysts say the consequences of Archegos could yet prove far reaching, with regulators considering tougher rules and smaller players reassessing whether the business is still worth it.
“The immediate impact from Archegos has been much more concentration of business in the hands of the biggest prime brokers,” said Youssef Intabli, research director at Coalition Greenwich, which tracks investment banking trends.
“Hedge funds have chosen banks that are reliable and are good in risk management, offer a range of products and have very strong execution. Smaller and more niche players have lost out,” he added.
Japanese bank Nomura, the second-hardest hit from the Archegos debacle with losses of $2.9bn, has also bid a retreat. The lender decided to pull out of offering cash prime broking in Europe and the US this summer, though it will continue to provide the services in Japan.
“The balances you need to make this business profitable suggest we will be left with just seven or eight global players after Archegos has shaken through the market,” said one investment banker who oversees a prime brokerage.
“There will be the Wall Street giants, plus two or three from Europe, and that will be it. No one else will be able to compete at that scale,” they cautioned.
The three market leaders — JPMorgan, Morgan Stanley and Goldman Sachs — oversee as much prime broking assets as the next nine players combined, according to Coalition data.
The scale of the damage wrought by Archegos sprang from a reckless use of leverage. Hwang persuaded several investment banks to extend billions of dollars in credit to the family office to juice up its concentrated bets on US and Chinese stocks.
Its use of a type of derivative known as total return swaps ensured that none of the prime brokers knew how exposed each other was to Archegos.
It is an area that industry executives expect regulators to home in on. The Federal Reserve and the UK’s Prudential Regulation Authority are assessing whether to introduce more stringent oversight.
Credit Suisse’s prime broking business straddled its headquarters in Zurich, its two main investment bank centres in New York and London, and Dublin, where the bank won Ireland’s first ever “third country branch” licence which enabled it to operate there with limited local supervision.
“Any time you have this kind of thing . . . all the dials get turned up to 10,” said a regulatory expert at one investment bank. “The amount of oversight that goes into this, internal from the board and from the regulator, is going to be high.”
For the banks who offer prime broking, particularly the smaller ones, there is a hard-nosed decision on whether the business is still attractive given the slim revenues it generates.
“You’re not expecting to make a tonne of money directly, but it is supposed to allow you to deepen the relationship with the client,” said the head of another investment bank that has a prime broking division. “It’s the anchor for the relationship, but it doesn’t make sense to offer it by itself.”
Credit Suisse, for example, earned just $16m of revenue in 2020 from its relationship with Archegos. Despite acknowledging that quitting prime broking would hurt its equities capital markets division as hedge fund clients no longer used other services, Credit Suisse said its balance sheet could be more profitably deployed.
Chief financial officer David Mathers said these were sacrifices it was willing to make to focus more squarely on wealth management, which had little overlap with the prime business.
“We are making a very deliberate strategic decision to exit a business which has very high leverage, is highly transactional in nature and has a very high degree of complexity,” he said last week. “I think it’s exactly the right thing to do.”
Credit Suisse said exiting prime broking would cost it $600m in revenues but be offset by $400m of cost savings. Analysts at Berenberg estimate the move will result in a 4 per cent hit to the group’s revenues in 2023.
While the Archegos scandal has cast a shadow over prime broking, some banks are undeterred and trying to capitalise.
French lender BNP Paribas, which has long aspired to be one of the top three in an industry dominated by Wall Street, has been picking up hedge fund clients from Credit Suisse over the past six months, according to bankers at several different lenders.
“If you have a strong prime business, you not only service hedge funds’ equities needs, they can also do credit, rates and foreign exchange trading with you,” said Olivier Osty, head of global markets at BNP Paribas’ investment bank. “This halo effect is really key.”
Credit Suisse this week struck a deal recommending its clients transfer to BNP, which bought Deutsche Bank’s prime finance unit two years ago. The French lender expects to capture up to half of Credit Suisse’s prime assets, enough, it hopes, to overtake Barclays in the rankings.
“A lot of Credit Suisse clients said they already had [relationships with] two US banks, and they needed some diversification. So the biggest beneficiary has been the old Deutsche business that is now owned by BNP, and to a lesser extent UBS,” said a London-based executive at a US bank. “The fallout has really helped the other Europeans.”
If the windfall for some rivals from Credit Suisse’s exit has been sudden, any changes to how the industry is regulated are likely to be slower.
Weeks following the collapse of Archegos, Federal Reserve chair Jay Powell voiced concern at the scale of losses “in a business that is generally thought to present relatively well understood risks”.
Seven months later, the Fed’s examination of the episode is ongoing. In the UK, the PRA said it has been talking to firms and other regulators as “part of our ongoing supervisory approach” since the banks revealed the losses.
Swiss regulators started enforcement proceedings against Credit Suisse over risk management failures and ordered short term fixes, including a capital surcharge. A spokesman for the regulator, Finma, declined to comment on the case.
As regulators in Japan also weigh up changes, industry executives anticipate any new rules will force more transparency in trades, especially when dealing with derivatives.
“It’s a very specific business with a very specific risk, where you don’t exactly know the size of the risk and funding footprint of your client,” said the head of one investment bank. “It’s virtually the only area in banking where you don’t know everything your clients are doing.”
Additional reporting by Sarah White, Stephen Morris, Joshua Franklin and Nicholas Megaw