Hedge funds will pay Wall Street record fees this year for brokerage services, a business dominated by Morgan Stanley, Bear Stearns and Goldman Sachs Group.

The securities industry's annual revenue from lending shares and cash, clearing and settling trades, and providing risk-analysis software to hedge fund managers will rise to US$7.5 billion (HK$58.5 billion), up 32 percent from 2003, Sanford C Bernstein analyst Brad Hintz estimates. Prime brokerage has become the fastest-growing source of income from trading clients as institutions increasingly diversify their investing with hedge funds.

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Morgan Stanley, the No3 securities firm by market value, Goldman, the second biggest, and Bear Stearns, the fifth largest, have a hammerlock on hedge fund services after spending more than US$200 million a year on trading systems, offering more stock for short sales and courting former employees who left to start their own hedge funds.

Only providing mergers and acquisitions advice generates higher profit margins for securities firms, said Robert Sloan, who ran Credit Suisse First Boston's prime brokerage unit for six years until 2002. "One of the costs of making money is the fees that are charged by prime brokers," said Steven Persky, co-founder of Los-Angeles- based Dalton Investments, with US$1.1 billion in assets.

"There's not a ton of transparency in pricing and they don't go out of their way to highlight how much money they're making."

Prime-brokerage fees may increase by almost a third to US$9.9 billion in 2009, Hintz estimates. A survey by Tremont Capital Management, an industry consulting firm in New York, shows that New York-based Morgan Stanley, Bear Stearns and Goldman are preferred by 60 percent of hedge fund managers.

Dalton Investments uses Morgan Stanley for two Asia funds with US$59 million in assets because of the firm's prowess in the international markets, Persky said. Bear Stearns, which he says is "very, very strong in fixed income," is Dalton's prime broker for a US$367 million fund that invests in the debts of troubled companies.

Goldman's access to securities that can be borrowed to bet on declining stock prices makes it a logical choice for US$86 million in two global equity funds, Persky said.

The US$7.5 billion in fees that Hintz estimates for this year would make prime brokerage an even bigger business for US securities firms than stock underwriting. Wall Street gets the largest share of revenue from trading, which generates about US$43 billion in commissions and gains from proprietary investments.

Morgan Stanley, among the first securities firms to create a prime brokerage in the 1980s, remains the No1 choice for 22 percent of hedge funds, according to Tremont's survey. Hintz said it probably reaped US$2 billion in prime-brokerage fees last year.

"In the early days of this business, we focused on building a scalable model and partnering with our colleagues in operations and technology," said Richard Portogallo, who heads Morgan Stanley's prime brokerage unit. "That created a real advantage for us that we're still capitalizing on today, because the barriers to entry are still very difficult."

Bear Stearns is second at 21 percent and Goldman Sachs is picked by 17 percent of hedge funds. The combined share of the three firms has dropped by just 1 percentage point since 2003, Tremont reported. UBS, Europe's biggest bank, and Merrill Lynch are struggling to close the gap three years after making prime brokerage a priority.

"There are three guys that absolutely dominate that business," said Gerald Hassell, president of Bank of New York, the biggest handler of trades for independent brokerage firms. "Numerous people have tried and failed to crack that."

A decade ago, Wall Street salespeople paid comparatively little heed to hedge fund managers such as George Soros, Michael Steinhardt, or Julian Robertson. Investment banking was the fastest-growing business as the highest stock-market returns in 20 years and low bond yields spurred a boom in equity sales and mergers.

Pension funds, endowments, foundations and other institutional investors account for almost 40 percent of net new flows into hedge funds, compared with less than 5 percent in 2000, according to consultants at Casey, Quirk & Associates in Darien, Connecticut.

The University of Texas System has a quarter of its US$9.5 billion Permanent University Fund in hedge funds. The California Public Employees' Retirement System in Sacramento, the largest US public pension fund, has US$1.2 billion invested.

"Institutions need cash to meet their obligations to future retirees, and hedge funds are a way for them to get a better return," said Patrick Egan, president and chief investment officer of Philadelphia-based Attalus Capital, which has US$1 billion in hedge funds.

Since 1990, hedge fund assets have soared to about US$1.1 trillion from US$40 billion, according to Chicago- based Hedge Fund Research. Hedge fund returns averaged 12 percent a year in the past decade, exceeding the 9.5 percent gain of the Standard & Poor's 500 Index.

The search for novel ways to make money led Ken Griffin, who runs Citadel Investment Group, a US$12.3 billion Chicago-based hedge fund, to start trading natural gas and power in 2001, adding to an array of investments that includes stocks, convertible bonds and the euro.

Most of the largest hedge funds, including David Shaw's US$19.3 billion New York-based DE Shaw and Bruce Kovner's US$12.3 billion Caxton Associates, also based in New York, buy and sell stocks, bonds, currencies and commodities worldwide.

The variety and frequency of hedge fund trades translates into a bonanza for Wall Street. While hedge funds have only one-eighth as much in assets as mutual funds, they account for 40 percent to 50 percent of the daily trading by value on the New York and London stock exchanges, 70 percent of all convertible-bond trading, and 20 percent to 30 percent of all trading in credit- default swaps, a type of debt insurance, according to a report published in March by Credit Suisse First Boston.

Most mutual fund managers, by contrast, are restricted from engaging in short sales and hold on to their stocks and bonds for months or years.

The interest rates that prime brokers charge to lend stocks, typically 0.5 percent, can escalate for shares that are in high demand.

Persky, the Los Angeles hedge fund manager, said he shorted Delta Air Lines shares in the months before the company filed for bankruptcy protection on September 14.

At the time, borrowing the shares from Bear Stearns cost the equivalent of about 10 percent a year in interest, or almost double the prime rate available from commercial banks at the time.

"The profits are huge because the prime brokers haven't committed any of their own capital," said Adam Reed, a finance professor at the University of North Carolina's Kenan-Flagler Business School in Chapel Hill. "It's the short seller's or the hedge fund's capital that is invested."

Because there are no publicly quoted rates for services such as stock loans, hedge funds are at the mercy of their prime brokers for pricing. As a result, the pretax profit margin for prime brokers is 40 percent to 50 percent, said Sloan, the former CSFB executive, who's now a managing partner at S3 Partners, a New York-based firm that provides financing services to hedge funds.

Brokers have "historically made an enormous amount of money from lending securities and money," said Steinhardt, an industry pioneer who closed his hedge fund in 1995 after 28 years in the business.

Persky's Delta bet has returned 84 percent so far because the stock has tumbled to about 65 cents from US$4. He said he doesn't "begrudge" prime brokers the rates they charge because both parties are trying to "maximize their profitability."

BLOOMBERG