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Capital Markets

Prime brokers: Under pressure

Big-three providers must face up to new competitors and internalization

The allure of providing prime brokerage services to hedge funds is putting pressure on the three dominant brokers in the industry, says Standard & Poor's.

The ratings agency predicts two trends that could erode the profits from prime brokerage at the three largest US prime brokers, Morgan Stanley, Goldman Sachs and Bear Stearns.

The first is competition from investment and commercial banking groups attracted to prime brokerage for hedge funds because of the earnings potential. "Wide margins and growth in volumes in prime brokerage have attracted new entrants who compete on price and in the conditions of services, including collateral requirements," says Standard & Poor's report, Hedge funds and their counterparties – catching the big one. UBS and Citigroup, for example, are reported to have been pouring money into prime brokerage services such as securities lending and trade execution.

A second trend that might erode the profits to which the large three prime brokers have become accustomed is the internalization of services by some of the largest hedge funds, says the report. A few large hedge funds are bypassing brokers and trading directly with other investors, while others have International Swaps and Derivatives Association agreements with dozens of counterparties.

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