Hedge Fund Borrowing Boom Lifts Wall Street Prime Brokerage

Hedge fund borrowing from banks has tripled since 2020, lifting Wall Street’s prime brokerage revenue to an estimated $47.9 billion this year. Firms including Citadel, Millennium Management and Point72 are using more bank financing for their trading strategies, according to Coalition Greenwich.

Prime brokerage provides hedge funds and proprietary trading firms with loans, securities lending, derivatives and other services. Banks earn recurring fees from financing and servicing large trading clients.

Prime services are expected to account for about 38% of banks’ equity revenue this year, up from 10% in 2005, Coalition Greenwich estimates. The figure excludes the wider derivatives business banks conduct with hedge funds and other trading firms.

The growth follows changes in financial markets after the 2008 financial crisis. New regulations restricted banks from taking large speculative positions on their own balance sheets. Market-making activity also shifted toward firms such as Jane Street and Citadel. Banks continued to provide these firms with financing, securities and risk-management services.

Servicing a major hedge fund or proprietary trading firm can generate as much as $200 million a year after trading costs, according to banking executives. The largest multi-manager hedge funds accounted for more than one-third of industry trading activity last year, while managing less than one-tenth of total assets, Goldman Sachs estimates.

Large trading firms are attractive bank clients because they operate across many markets and have systems for managing liquidity and risk. Their size allows banks to match one client’s long position with another client’s short position, reducing the need to find securities elsewhere.

Goldman Sachs and Morgan Stanley are the largest prime brokerage providers, followed by JPMorgan Chase, according to hedge fund executives. Citigroup and Bank of America are expanding in the business. BNP Paribas, Barclays and ABN Amro are seeking larger market shares.

The concentration of financing among a small number of large firms has drawn regulatory attention. The Bank of England reported in July that prime brokerage balances had risen by about 40% over the previous year. Regulators are examining whether banks’ growing exposure to nonbank financial firms could create wider risks during a sharp market decline.

Federal Reserve data shows that the 50 largest hedge funds borrow about $3 for every $1 of assets under management. Among the 15 largest firms, borrowing is about $11 for every dollar of assets. The figures exclude leverage created through derivatives.

One banking executive estimated that the largest hedge funds could have effective leverage of 20 to 25 times when derivatives are included. Market makers may operate with leverage of as much as 40 times, according to another executive.

The largest hedge funds have gained more negotiating power as their importance to banks has increased. Financing commitments that once lasted about two weeks now run for one, three or six months for some preferred clients. Longer commitments can limit banks’ ability to reduce lending or demand more collateral when markets deteriorate.

Banks also have limited information about a client’s total leverage because large trading firms divide their business among several prime brokers and keep their positions confidential. The risk was highlighted by the 2021 collapse of Archegos Capital Management, which used leveraged derivatives across several banks without disclosing the full size of its positions. Credit Suisse lost $5.5 billion before being taken over by UBS.

Banks avoided another large loss after AI-focused hedge fund Situational Awareness encountered trouble following a market reversal. Banks had provided billions of dollars in financing before Citadel acquired the fund’s public-equity portfolio, helping prevent a disorderly sale.

Prime brokers have strengthened controls on leverage, collateral and liquidity. Regulators continue to examine whether competition for large clients could lead banks to weaken lending standards.