BANGALORE - Smaller U.S. brokers are cashing in on the opportunity to provide prime brokerage services to small and mid-sized hedge funds as top players rebuild their crisis-scarred operations by focusing on large money managers.

The collapse of Lehman Brothers (LEHMQ.PK) last year was followed by a virtual breakdown of relationships between hedge funds and prime brokers, who charge fees for providing financing for trading and settlement of trades.

With the bigger players curbing their reach, smaller brokers like FBR Capital Markets (FBCM.O) and TradeStation Group (TRAD.O) launched prime brokerage operations to fill that void.

I think with some of the upheaval with the larger prime brokers (Bear Stearns, Lehman) they might be thinking this is an opportune time, analyst Richard Repetto of Sandler O'Neill said in an e-mail.

More players may be on the way, Repetto said.

There are other people like Interactive Brokers (IBKR.O) working on their prime brokerage operations, he said. Knight (Capital) (NITE.O) is working on self-clearing and they could possibly offer prime brokerage over time.

Top prime brokers are playing it safe by sticking to big names that are considered more likely to withstand losses and repay borrowed funds than their smaller counterparts.

Hedge funds are also choosing their counterparties carefully, since a collapsed broker means frozen accounts and difficulties in closing trades and returning cash to investors.

TradeStation launched its Prime Services division in September for start-up to mid-sized hedge funds, registered investment advisers, professional traders and asset managers.

Over the last 12 to 18 months, it has become increasingly difficult for these types of firms to find providers that meet their needs, TradeStation Chief Executive Salomon Sredni said on a post-earnings conference call last month.

TradeStation also expects to benefit from hedge funds that are seeking multiple prime brokers to reduce counterparty risk.

One thing that we've all learned is that it's best to have multiple prime brokerage providers, and that brings pretty big opportunity for smaller players to move up the food chain, analyst Matthew Snowling of FBR Capital Markets said.

Big hedge funds are now picking three top brokers from a list comprising JPMorgan (JPM.N), Goldman Sachs (GS.N), Credit Suisse (CSGN.VX), Deutsche Bank (DBKGn.DE) and Morgan Stanley (MS.N).

Smaller brokers are waiting for hedge fund launches to gain momentum. The pace of hedge fund launches is expected to accelerate after a year-long hiatus, as markets revive and investors regain interest.

PRIME BROKING: LONG-TERM BET

Prime broking suffered during the financial crisis. Banks reduced prime brokerage lending to cut leverage, hedge funds scurried to banks with diverse sources of funding and brokers were left to make do with hedge funds' dwindling pool of assets.

TradeStation, with its new division, plans to provide execution platforms, clearance and settlement of trades, risk management, portfolio reporting and commission-sharing arrangements to its clients.

TradeStation, however, does not expect the new division to provide immediate boost to results.

All we see is it's a business that takes a little bit of time. It's growing very slowly. The sales cycle is slow in the accounts, CEO Sredni said on the conference call.

Analyst Snowling said switching a prime brokerage provider is a serious investment. It takes a lot of time and effort to convert the back office to a new provider.

Also, as interest rates are low there is not much to be made of client cash and margin relationships.

The economics, because of the interest rate environment, aren't overly exciting right now, Snowling said. It is a bet on the long term.

(Reporting by Ratul Ray Chaudhuri in Bangalore; Editing by Maju Samuel)

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