is the generic name for a bundled package of services offered byinvestment bankswealth management firms, andsecurities dealerstohedge fundswhich need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve anabsolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge funds collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.

The prime broker benefits by earning fees (spreads) on financing the clients margined long and short cash and security positions, and by charging, in some cases, fees for clearing and other services. It also earns money byrehypothecatingthe margined portfolios of the hedge funds currently serviced and charging interest on those borrowing securities and other investments.1

Each client in the market of a prime broker will have certain technological needs related to the management of its portfolio. These can be as simple as daily statements or as complicated as real-time portfolio reporting, and the client must work closely with the prime broker to ensure that its needs are met. Certain prime brokers offer more specialized services to certain clients.

For example, a prime broker may also be in the business of leasing office space to hedge funds, as well as including on-site services as part of the arrangement. Risk management and consulting services may be among these, especially if the hedge fund has just started operations.

The following services are typically bundled into the Prime Brokerage package:

Global custody(including clearing, custody, and asset servicing)

Financing(to facilitate leverage of client assets)

Customized technology (providehedge fundmanagers with portfolio reporting needed to effectively manage money)

Operational support (prime brokers act as a hedge funds primary operations contact with all other broker dealers)

In addition, certain prime brokers provide additional value-added services, which may include some or all of the following:

Capital Introduction A process whereby the prime broker attempts to introduce its hedge fund clients to qualified hedge fund investors who have an interest in exploring new opportunities to make hedge fund investments.

Office Space Leasing and Servicing Certain prime brokersleasecommercialreal estate, and then sublease blocks of space to hedge fund tenants. These prime brokers typically provide a suite of on-site services for clients who utilize their space. This is typically called a hedge fund hotel.

Risk ManagementAdvisory Services The provision of risk analytic technology, sometimes supplemented by consulting by senior risk professionals.

Consulting Services A range of consulting / advisory services, typically provided to start-up hedge funds, and focused on issues associated with regulatory establishment requirements in the jurisdiction where the hedge fund manager will be resident, as well as in the jurisdiction(s) where the fund itself will be domiciled.

The basic services offered by a prime broker give a money manager the ability to trade with multiple brokerage houses while maintaining, in a centralized master account at their prime broker, all of the hedge funds cash and securities. Additionally, the prime broker offers stock loan services, portfolio reporting, consolidated cash management and other services. Fundamentally, the advent of the prime broker freed the money manager from the more time consuming and expensive aspects of running a fund. These services worked because they also allowed the money manager to maintain relationships with multiple brokerage houses for IPO allocations, research, best execution, conference access and other products.

The concept and term prime brokerage is generally attributed to the Selz in the late 1970s. However, the first hedge fund operation is attributed toAlfred Winslow Jonesin 1949. In the pre-prime brokerage marketplace, portfolio management was a significant challenge; money managers had to keep track of all of their own trades, consolidate their positions and calculate their performance regardless of which brokerage firms executed those trades or maintained those positions. The concept was immediately seen to be successful, and was quickly copied by the dominantbulge bracketbrokerage firms such asMorgan StanleyBear StearnsMerrill LynchCredit SuisseCitigroup, andGoldman Sachs. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domesticLong / short equityfunds. The first non-U.S. prime brokerage business was created by Merrill Lynchs London office in the late 1980s. After thefinancial crisis of 20072008, new entrants came to the market with custody-based prime brokerage offerings.2

Through the 1980s and 1990s, prime brokerage was largely anequities-based product, although various prime brokers did supplement their core equities capabilities with basic bond clearing and custody. In addition, prime brokers supplemented their operational function by providing portfolio reporting; initially by messenger, then by fax and today over the web. Over the years, prime brokers have expanded their product and service offerings to include some or all of the full range of fixed income and derivative products, as well as foreign exchange and futures products.

As hedge funds proliferated globally through the 1990s and the 2000s, prime brokerage became an increasingly competitive field and an important contributor to the overall profitability of the investment banking business. As of 2006, the most successful investment banks each report over US$2 billion in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).

Thefinancial crisis of 20072008brought substantial change to the marketplace for prime brokerage services, as numerous brokers and banks restructured, and customers, worried about their credit risk to their prime brokers, sought to diversify their counter-party exposure away from many of their historic sole or dual prime broker relationships.

Restructuring transactions in 2008 included the absorption ofBear Stearnsinto JP Morgan, the acquisition of the assets ofLehman Brothersin the US byBarclays, the acquisition ofMerrill Lynchby Bank of America, and the acquisition of certain Lehman Brothers assets in Europe and Asia byNomura. Counter-party diversification saw the largest flows of client assets out of Morgan Stanley and Goldman Sachs (the two firms who had historically had the largest share of the business, and therefore had the most exposure to the diversification process), and into firms which were perceived, at the time, to be the most creditworthy. The banks which captured these flows to the greatest degree were Credit Suisse, JP Morgan, and Deutsche Bank. During these market changes, HSBC launched a prime brokerage business in 2009 called HSBC Prime Services, which built its prime brokerage platform out of its custody business.

The prime brokerage landscape has dramatically changed since the collapse of Lehman Brothers in September 2008. Hedge funds who received margin financing from Lehman Brothers could not withdraw their collateral when Lehman filed fordue to a lack of asset protection rules (such as 15c3 in the United States) in the United Kingdom. This was one of many factors that led to the massivedeleveragingof capital markets during thefinancial crisis of 20072008.

Upon Lehmans collapse, investors realized that no prime broker was too big to fail and spread theircounterparty riskacross several prime brokerages, especially those with strong capital reserves. This trend towards multi-prime brokerage is also not without its problems. From an operational standpoint, it is adding some complexity and hedge funds have to invest in technologies and extra resources to manage the different relationships. Also, from the investors point of view, the multi-prime brokerage is adding some complexity to the due diligence as it becomes very complicated to perform proper assets reconciliation between the funds administrator and its counterparties.3

Prime brokers do not charge a fee for the bundled package of services they provide to hedge funds. Rather, revenues are typically derived from three sources: spreads on financing (including stock loan), trading commissions and fees for the settlement of transactions done away from the prime broker. The financing and lending spreads, which are charged in basis points on the value of client loans (debit balances), client deposits (credit balances), client short sales (short balances), and synthetic financing products such as swaps and CFDs (Contract for difference), make up the vast majority of prime brokerage revenue.

Therefore, clients who undertake substantial short selling or leverage represent more lucrative opportunity than clients who do less short selling and/or utilize minimal leverage. Clients whose market activities are principallyfixed income-oriented will generally produce less prime brokerage revenue, but may still present significant economic opportunity in therepo, foreign exchange (fx), futures, and flow business areas of the investment bank.

Prime Brokers facilitate hedge fund leverage, primarily through loans secured by the long positions of their clients. In this regard, the Prime Broker is exposed to the risk of loss in the event that the value of collateral held as security declines below the loan value, and the client is unable to repay the deficit. Other forms of risk inherent in Prime Brokerage include operational risk and reputational risk.

Large prime brokerage firms today typically monitor the risk within client portfolios through house-designed risk based margin methodologies that consider the worst case loss of a portfolio based on liquidity, concentration, ownership, macroeconomic, investing strategies, and other risks of the portfolio. These risk scenarios usually involve a defined set of stress test scenarios, rules allowing risk offsets between the theoretical profit and losses (P&Ls) of these stress test scenarios for products of a common underlier, and offsets between groups of theoretical P&Ls based on correlations.

Liquidity penalties may be established using a rule-of-thumb for days-to-liquidate that 10% of the daily trading volume can be liquidated without overdue influence on the price. Therefore, a position 1x the daily trading volume would be assumed to take 10 business days to liquidate.

Stress testingentails running a series of what-if scenarios that identify the theoretical profits or losses for each position due to adverse market events.

3%15% up or down price movements used inPortfolio margin

Securities market participants (United States)

What prime custody is doing to prime brokerage. COO Connect. December 2011.

Opalesque (10 September 2009).Opalesque Exclusive: The reshaping of the prime brokerage industry.

Capital asset pricing modelalphabetasecurity characteristic line)

Articles needing additional references from September 2009

Wikipedia articles in need of updating from November 2010

This page was last edited on 11 August 2019, at 20:55

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