In February of this year, Goldman Sachs invited a group of top hedge fund executives to a 500-acre resort estate on the outskirts of London. The Wall Street investment bank sent a clear message: you are no longer our competitors, but our most core client group.

This meeting highlighted an unavoidable reality on Wall Street: major U.S. banks are posting record profits in their trading businesses, but the banks themselves are not the ones actually running the trades. Institutions like Jane Street Capital and Citadel Securities have aggressively pushed into banks' traditional territory, monopolizing the core market-making business while making massive bets on market movements. Their enormous appetite for financing has made them clients that lenders cannot refuse, and a powerful engine for bank profits.

Mike Webb, Barclays' global head of liquidity financing, said that in market-making, "banks find it very hard to compete," but "financing is a bank's traditional strength, and this business has a very deep moat."

This moat is built on the credit lines banks extend to trading giants, with credit scales reaching into the trillions of dollars. Since 2020, the scale of borrowing hedge funds obtain from banks has tripled; the revenue generated by financing has made prime brokerage one of Wall Street's fastest-growing segments. Analysis from industry data firm Coalition Greenwich shows that revenue from equities and fixed income prime brokerage — the two main forms of bank lending to hedge funds — is expected to reach $47.9 billion this year.

However, as banks embrace this trading boom, their fortunes have become deeply tied to their largest clients: giant multi-manager hedge funds like Citadel, Millennium Management, and Point72, as well as proprietary trading firms like Jane Street Capital and Hudson River Trading. The massive risk exposure has already sounded regulatory alarm bells. Data from the Bank of England in July showed that in just the past year, prime brokerage asset balances grew by about 40%. One regulatory official said: "The scale keeps expanding. Has it grown too big to control? When you see a continuously upward curve, that question naturally arises."

For a long time, prime brokerage was regarded as an inconspicuous, back-office support business in banking. But the 2008 financial crisis and subsequent regulatory reforms changed this. New rules restricted banks from using their own balance sheets to take on risk. Speculative trading that was once largely conducted on banks' proprietary trading desks shifted to the hedge fund industry; relatively low-risk businesses like market-making fell to high-frequency trading firms, and later to specialized market makers. Post-crisis regulation produced an unexpected result: although policymakers succeeded in moving a great deal of risky activity out of the banking system, Wall Street lenders became more dependent than ever on trading-related revenue.

The core appeal of serving hedge funds and trading institutions lies in recurring income. An investment bank may spend years courting a corporate executive like Musk just to win a one-time fee for IPO advisory. But serving as prime broker for Citadel, Millennium, or Jane Street Capital can bring stable cash flow. Executives at three top investment banks said that after deducting trading costs, this business can generate up to $200 million in annual revenue. Martin Moloney, deputy secretary general of the Financial Stability Board, said: "If anyone thinks that as long as banks are adequately capitalized, the problem will disappear... that idea is far too naive."

Coalition Greenwich data shows that prime brokerage revenue as a share of investment banks' total equities business revenue jumped from 10% in 2005 to about 38% this year, and that figure does not yet include banks' enormous derivatives services business. He added: "There is growing awareness that when non-bank institutions build positions, they actually rely on supporting services provided by banks."

Hedge fund executives say Goldman Sachs and Morgan Stanley are the two leaders in this business, with JPMorgan Chase in third place. As prime brokerage revenue explodes, they face fierce competition from Wall Street peers Citigroup and Bank of America, as well as European challengers BNP Paribas, Barclays, and ABN AMRO.

Beyond the overall expansion of the hedge fund industry, one of the biggest growth drivers is the rise of a handful of giant hedge funds and trading institutions. Goldman Sachs data shows that large multi-manager funds manage less than one-tenth of the industry's total assets, but last year contributed more than one-third of the entire industry's trading activity. These institutions are sophisticated professional participants, with hundreds of trading teams covering various asset classes, bringing built-in diversification and mature risk control systems, which also gives banks a reason to keep expanding lending.

Webb said: "Institutional-grade hedge funds or asset managers are mature organizations with liquidity management departments that report directly to the founders." A smaller number of clients, each larger in size, also simplifies bank management. Webb added: "It is easier to deeply understand a small group of core clients."

Scale also brings benefits to banks. The greater the trading flow, the easier it is for a bank to match one client's long position with another client's short position — a key balancing operation known as internal matching. This means banks can provide financing to both sides of a trade at the same time without borrowing in the public market or borrowing securities, eliminating the most costly part of the business and lifting profit margins.

But according to people familiar with industry practices, the continued growth of a small number of top clients has also shifted the balance of power: clients are able to negotiate more favorable lending terms. Lock-up periods — the period during which a prime broker promises to continue providing financing and cannot withdraw credit midway — have gradually lengthened. What was usually a two-week commitment has been extended to 30 days, then to three months; for some of the industry's most sought-after top clients, the period has been extended to six months. In other words, unless extremely long notice is given in advance, banks cannot cut financing or demand additional margin beyond what the contract stipulates.

Some regulators believe fierce competition is steadily eroding risk safeguards. In particular, banks often struggle to fully grasp all of a client's business activities and true risk profile. Large trading institutions and hedge funds typically disclose as little as possible about their cooperation with other prime brokers, saying this protects intellectual property and prevents strategy leakage. A senior executive at a top investment bank said that large counterparties generally provide only their overall leverage ratio on a combined basis across multiple prime brokers; but the bank has no way of knowing how that leverage is allocated, or how concentrated the positions are.

Prime brokerage institutions insist that standards have tightened in recent years, with stricter leverage reviews and more complete risk control systems. But some regulators question whether banks have truly learned the deeper liquidity-related lessons, despite previous blow-up events. Moloney of the Financial Stability Board said: "I understand that many major participants will say we have built sophisticated collateral and risk control systems. As long as this system continues to work, of course that is good." "But competitive pressure will erode risk control defenses, and we must remain highly vigilant about this, because risk has cross-border transmission characteristics and could trigger a larger crisis across the entire financial system."