Israeli Hedge Funds Need Prime Brokerage to Succeed

Like Levi’s 501 jeans to the Israeli teen of the 1980s, prime brokerage is that rare commodity in Israel that any knowledgeable Israeli portfolio manager covets. It’s time to import prime brokerage wholesale so that the industry overall can benefit.

What is Prime Brokerage?

Prime brokerage is a suite of vital services that investment banks offer to their hedge fund clients.

Hedge funds typically access the securities markets through a number of executing brokers and settle transactions by instructing their custodian to deliver or receive cash or securities. The prime broker consolidates the clearing and settlement of securities transactions by settling the trade directly with the executing broker and acting as the custodian of the assets. This provides operational efficiencies for the client and consolidates reporting through a single entity, the prime broker. Prime brokers perform a number of additional core functions that contribute significantly to the success of hedge funds, such as cash management, securities and cash lending, and capital introduction.

The Israeli Model.

Prime brokerage services do not exist in the Israeli market. With only five major banks and a small local market, the use case simply is not justified. But what of the Israeli portfolio manager that trades globally? These managers typically access the global markets in one of two ways: either through their local Israeli banks or through Interactive Brokers (“IBKR”), an online digital trading platform.

Using local banks to trade globally has significant disadvantages. The Israeli banks generally charge execution fees on top of the commissions charged to them, so trading in global markets through a local bank can be expensive. Israeli banks provide no added value beyond custody and execution; cash management options are limited, obtaining leverage is complicated, and margin requirements are prohibitive.

Interactive Brokers are an inexpensive alternative, but the offering is also limited.  IBKR’s margin requirements cannot be tailored to a client’s portfolio, and securities lending is constrained. OTC derivatives trading is significantly limited on IBKR making it difficult to execute certain strategies. Most concerning, IBKR does not provide a designated relationship manager. So, during market distress, good luck finding someone to answer your call.

The Opportunity Cost.

The scale and complexity of investments have led over time to a prime brokerage offering that goes far beyond the clearing and settlement of trades and custody of assets. The bundle of services offered by prime brokers today includes:

• Portfolio margining, which allows funds to net collateral requirements across their physical and synthetic (i.e., derivatives) portfolios, often resulting in a reduced margin requirement when compared to collateralization on a per product basis.
• Lending securities or cash to clients with leveraged portfolios seeking to amplify returns, including through “short selling”, where investors sell securities they don’t own by borrowing them from a broker.  Where the prime broker also acts as custodian, the process of borrowing securities and cash is further streamlined since the client’s assets can easily be shifted to the prime broker as collateral.
• Cash management services.  Prime brokers pay interest on G-7 currencies.  They even offer a “cash sweep”, where free credit balances are “swept” into money market mutual funds yielding higher interest on an overnight basis.
• “Concierge” services, such as capital introduction services, where the prime broker introduces the client to new investors by setting up meetings with individuals or institutions who are seeking investment opportunities. The prime broker can also provide risk analytics and metrics that might otherwise be performed in-house or by third-party service providers.

Why it matters.

The bottom line is this: The prime brokerage relationship becomes essential once a fund manages more than $50 million and is seeking institutional capital. Institutional investors in Europe and the US will not consider investing in a fund that does not have a recognized prime broker. Relying on a local bank or IBKR as a fund’s primary prime brokerage relationship creates real constraints around leverage, short book management, cash management, and counterparty perception that become increasingly limiting as a fund grows.

Prime brokerage arrangements have become the staple of a portfolio manager’s book. Prime brokers synthesize core functions that were previously managed by separate brokers, custodians and administrators, and they provide additional services that can help hedge funds and asset managers grow their business.

Just as the Levis 501 imported global fashion wholesale to Israel, international prime brokerage is essential for Israel to grow on the international stage of investment management. Israeli hedge fund managers should take note.