The rapid expansion of hedge fund borrowing has become a major source of revenue for Wall Street banks, as firms including Citadel, Millennium Management, and Point72 increasingly rely on lenders to finance their trading strategies, according to a report by the Financial Times.

Hedge fund borrowing from banks has tripled since 2020, helping turn prime brokerage into one of the fastest-growing areas of the banking industry. Revenues from equity and fixed-income prime brokerage are expected to reach $47.9bn this year, according to Coalition Greenwich.

The growth reflects a major shift in the financial system since the 2008 crisis. Regulations introduced after the financial crisis restricted banks from taking large speculative positions on their own balance sheets, pushing much of the risk-taking into hedge funds and specialist trading firms.

At the same time, market making has increasingly moved towards firms such as Jane Street and Citadel. While banks have ceded ground in some areas of trading, they have retained a critical role by providing the financing, securities lending and other services required by these increasingly powerful non-bank market participants.

The attraction for banks is the recurring nature of prime brokerage revenues. Servicing a major hedge fund or proprietary trading firm can generate as much as $200m a year after trading costs, according to banking executives.

Prime services are expected to account for about 38% of banks’ equities revenues this year, compared with 10% in 2005, according to Coalition Greenwich. The figures exclude the substantial derivatives business provided by banks to hedge funds and other trading firms.

The growth has been concentrated among a relatively small group of large multi-manager hedge funds and proprietary trading firms. The largest multi-managers accounted for more than a third of industry trading activity last year despite managing less than a tenth of total assets, according to Goldman Sachs.

These firms are attractive counterparties because of their scale, diversified trading operations and sophisticated liquidity and risk-management systems. Their size also enables banks to offset trades internally, matching one client’s long position with another client’s short position and reducing the need to source securities externally.

But the concentration of financing among a handful of very large clients is also raising concerns among regulators.

The Bank of England said in July that prime brokerage balances had risen by about 40% over the previous year. Regulators are increasingly questioning whether the growth in exposures to non-bank financial institutions could create vulnerabilities for the wider financial system.

The scale of hedge fund leverage is substantial. US Federal Reserve data shows that the 50 largest hedge funds borrow about $3 for every $1 of assets under management, while the figure rises to roughly $11 for every dollar among the 15 largest firms. Those figures do not capture leverage embedded in derivatives.

One banking executive estimated that the largest hedge funds could have effective leverage of 20 to 25 times when derivatives exposures are included. Market makers can operate with even higher leverage, potentially reaching 40 times, according to another executive.

Goldman Sachs and Morgan Stanley are the largest players in prime brokerage, followed by JPMorgan Chase, according to hedge fund executives. Competition has intensified as Citigroup and Bank of America expand their operations, while European banks including BNP Paribas, Barclays and ABN Amro also seek a larger share of the business.

The bargaining power of the largest hedge funds has increased alongside their importance to banks. Financing commitments that once lasted around two weeks have expanded to a month, three months and, in some cases, six months for the most sought-after clients.

Longer commitments can limit a bank’s ability to reduce financing or demand additional collateral if market conditions deteriorate. Regulators have raised concerns that intense competition for lucrative clients could gradually weaken safeguards designed to protect banks against sudden losses.

Banks also have limited visibility into the full extent of a hedge fund’s leverage because large trading firms typically spread their business among several prime brokers and closely guard information about their positions.

The risks were highlighted by the collapse of Long-Term Capital Management in 1998 and Archegos Capital Management in 2021. Archegos used highly leveraged derivatives across several prime brokers while withholding the full scale of its positions from individual banks. Credit Suisse ultimately suffered a $5.5bn loss from the collapse, contributing to the bank’s eventual takeover by UBS.

More recently, banks narrowly avoided another major loss when AI-focused hedge fund Situational Awareness ran into trouble following a reversal in markets. Banks had provided billions of dollars of financing before Citadel stepped in to acquire the fund’s portfolio of public equities, helping prevent a disorderly unwinding.

Prime brokers argue that risk controls have strengthened since previous failures, with greater scrutiny of leverage, collateral and liquidity. But regulators continue to warn that competitive pressure can encourage banks to loosen standards as they compete for the industry's largest and most profitable clients.