Prime brokerage anatomy

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The home on earth for all things you need to know about prime brokerage. And some things you’d like to know — such as why a working knowledge of singer-songwriters is just as valuable as one of classics — and some things you might not, such as the kinds of people hedge fund managers like to hang out with. A good set of resources over to the right there (where else?).

Big picture: UBS’s cool GFS terms

If you wanted a simple, JC-endorsed explanation of how an equity Prime Services business operates, generally you would not look at a PrimeBrokerage Agreement.

As is true of most finance contracts, it will leave you none the wiser. Usually PB documents are designed to be comprehensible only to financing lawyers, and only then allegedly. There is one exception to this, and the happy news is it is publicly available: UBS’s “GFS Terms”, which sets out the bank’s standard terms and conditions for its equity Prime Services business, and apply to all customers, great or small.

Seeing as it is a publicly available document (www.ubs.com/gfsterms), and seeing as it does such a nice job, we will use it as a skeleton for our discussion of how prime services work.

Professional courtesy (and the need to maintain plausible deniability, for UBS as much as JC) recommends we say no more, but suffice to say that if JC was, hypothetically, going to write a set of prime brokerage terms, this is how he might have done it.

Three parts of a prime brokerage business

You could divide, as the GFS Terms do, a Prime Services business into three basic parts: “operational services”, “transactions”, and “risk and cost management”. These parts are not functionally distinct in the hurly-burly of daily life in the business — operational services enable transactions which generate risks and costs that the bank must manage — but as a practitioner, it is always worth bearing in mind which of these functions is “in play” at a given time.

1. Operational services: A prime broker provides customers with certain operational services to enable them to transact in the market: an interdealer network who will “give up” transactions to the broker; a set of bank accounts to pay and receive transaction cashflows and margin payments; securities accounts to hold customer inventory in safe custody and settlement and payment services by which the broker accepts customer instructions to settle its transactions in the market. These operational services may not seem glamorous, but they are the interface and main point or interpersonal contact between the prime broker and its customers. Even in our technology-infatuated world, human relationships are important and they help make prime services business “sticky”. A slick operational interface overlaid with experienced subject matter experts to manage accounts will be a competitive advantage — not that you would know it from unerring redundancy practices across the market.
2. Transactions: actual brokerage transactions where the prime broker provides exposure to the customers: these may include margin loans, synthetic equity derivatives, exchange-traded derivatives, and securities financing arrangements.
3. Risk and cost management: The various tools and mechanisms by which the broker optimises its funding, capital and balance sheet costs and manages the market and credit risks associated with customer Transactions. These include the broker’s rights to raise money against customers’ custody assets, call for initial and variation margin, and to close out and cross-net open positions to a single exposure.

Looking at it this way makes plain that Prime Services is primarily a financing business: prime brokers do not take a position on customer Transactions: they should always be fully collateralised and delta-hedged, so have nothing to gain or lose from ordinary fluctuations in asset prices. Prime brokers make their money accretively, through execution commissions and financing spreads. If a customer portfolio does not gap through its margin buffer — and, yes, that is a big “if” — the main determinant for a prime broker’s success is how well it manages and optimises its internal structural costs.

You will hear people say that Prime Services is “a simple business on which it is easy to lose your shirt”: the Archegos situation is as good an illustration of that as anyone could ask for.

Structural internal costs of providing prime brokerage services

As a secured lending business, Prime Services is heavily regulated, and these regulations present largely in additional costs.

1. Regulatory capital costs: The protective costs of entering into risk businesses: risk weighting of assets, leverage ratios, liquidity buffers and large exposure charges. These are broadly preventative measures — Finbarr Saunders might call them “prophylactic” Hwoop! Hwoop! — in that they do not address or reflect the day-to-day risks of doing business, nor really help if they come about: rather they are systemic safeguards designed to ensure the bank can ride through those risks if they come about, leaving sufficient resources on the table in extreme market situations. As such they act as a “tax” on the business without directly corresponding to its actual risks.
2. Actual funding costs: The actual costs to the business of borrowing the funds it needs to provide margin loans to customers in the first place. There is a bit of a double-whammy here related to actual funding costs: the more a business can reduce its funding costs, the less balance sheet it will use and the lower its risk-weighted assets and leverage ratio will be. One one hand this creates a virtuous cycle: more business means better netting opportunities means lower costs means better pricing, means more business — but there’s a balance to be struck, as more business means more operational complexity. As Archegos again illustrates (we will come back over and over to Archegos as the Horcrux of the prime services universe) it is one thing to sharpen your pricing thanks to better risk management; it is quite another to sharpen your pricing because you are desperate not to lose what seems to you to be good business.
3. Regulatory compliance costs: There are regulatory costs of onboarding, AML, and client asset protection and so on. In the scheme of things , manageable, however they may lead to minimum thresholds and hurdle rates for client transactional business to make the business worthwhile for the prime broker to undertake.

The main takeaway here, though, is that a prime services business is not market directional: whereas a hedge fund or prime services customer is in the business of trying to beat the market benchmark, a prime broker is interested only in providing perfectly hedged exposure to customers and then minimising its costs of execution and risk management. Its profitability rises as a result of efficiency. As it becomes more efficient, it is able to price its services more keenly, and can win more business.

Customer tiering

See also: customer tiering

Prime brokerage businesses often segment their clients into “tiers” based on the likely return of allocated capital. “Top-tier” clients — often, but not necessarily, “platinum clients” — receive preferential pricing, laxer security and margin terms as well as better service levels in anticipation of greater deal flow and better revenues, while smaller clients may be stuck with standard pricing and standard, more robust, security and margin terms.

Per the customer tiering article this has never made much sense to JC: if you’re prepared to give better pricing, credit and margin terms to customers who, QED, will be taking more risk with your own capital, it stands to reason you should be okay doing the same with smaller, lower risk clients— who are less likely to blow up, and less apt to create such a big hole if they do.

No better example exists than our old friend Archegos. Yes, it represented an annual revenue wallet for Credit Suisse of $20m [Er, once. Ed]. But was that really worth the four-and-a-half billion dollar hole it left in Credit Suisse’s balance sheet? Unless you wouldn’t bank on that sort of loss happening more often than once in a quarter of a millennium, then, no. (It happened once in five years).

Simply having to manage different tiers of clients with different playbooks, thresholds, triggers and terms creates unnecessary complication in your risk management, and opens the door to confusion, weakness, discoordination and operational error in your risk management operation.

Essentially, it boils down to this: if your pricing and credit terms work for top-tier clients, they will work for small ones too. If the clients are so small that they don’t work, the problem is not with your risk terms, but your client. Exit it: it makes more sense to do that business.

Lastly, offering “premium terms” to small clients may be a business differentiator — every other bugger will be tiering — and it may build trust with growing clients: tomorrow’s top-tier clients.

Key topics

Capital introduction
Cross marginin
Custody, custodians
Depositaries
Give ups and give ins
Initial margin
Margin
Margin lending
Margin lockup
Rehypothecation (aka reuse)
Synthetic prime brokerage
Variation margin