Prime brokerage economics: Difference between revisions
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===Prologue: ''bank'' economics=== | ===Prologue: ''bank'' economics=== | ||
Consider how a traditional bank makes money: on one side it has a loan book, usually in the shape of mortgages, on the other side it accepts customer deposits.<ref>And may enter into other forms of term borrowing in the financial markets such as by issuing commercial paper, bonds and so on.</ref> To make money it must ensure its total | Consider how a traditional bank makes money: on one side it has a loan book, usually in the shape of mortgages, on the other side it accepts customer deposits.<ref>And may enter into other forms of term borrowing in the financial markets such as by issuing commercial paper, bonds and so on.</ref> To make money it must ensure its total ''income'' on its loans (interest, after credit losses) exceeds its total ''costs'' of running the business: paying interest on its borrowings, keeping the lights on, the organisation running, the [[General counsel|GC]] in a fancy car and so on. | ||
The bank’s [[Chief financial officer|treasury department]] ensures that its [[Regulatory capital|capital]] requirements — its lending and borrowing needs — are suitably matched. The internal cost that a lending business incurs | The bank’s [[Chief financial officer|treasury department]] ensures that its [[Regulatory capital|capital]] requirements — its lending and borrowing needs — are suitably matched. The internal cost that a lending business incurs from its treasury department may be high, especially if the business that is perceived to be high-risk or for which the cost of capital is great. | ||
The bank has two challenges in managing its business and ensuring it stays profitable: | The bank has two challenges in managing its business and ensuring it stays profitable: | ||
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If only it could take the houses it has lent against and raise money against them somehow! But customers have an inconvenient habit of occupying their houses, which makes it harder to repurpose them. Customers do not usually give vacant possession to the bank. But there is a proxy here: the value of a house is reflected in the value of the loan: the bank’s asset is not the house itself, but the present and future cashflows the customer pays the bank to repay its loan and continue living in the house. These too have a present value. | If only it could take the houses it has lent against and raise money against them somehow! But customers have an inconvenient habit of occupying their houses, which makes it harder to repurpose them. Customers do not usually give vacant possession to the bank. But there is a proxy here: the value of a house is reflected in the value of the loan: the bank’s asset is not the house itself, but the present and future cashflows the customer pays the bank to repay its loan and continue living in the house. These too have a present value. | ||
In the 1980’s some resourceful bankers hit upon the idea of monetising the value of a mortgage portfolio not by reusing the property itself, but rather the cashflows | In the 1980’s some resourceful bankers hit upon the idea of monetising the value of a mortgage portfolio not by reusing the property itself, but rather by raising cash against the value of the future cashflows the property was securing. They did this through [[securitisation]]: they repackaged future cashflows due on the mortgage loans into secured bonds which they sold at par on the open market. That the banks were less dependent on expensive customer deposits to fund their Lending operations. | ||
This all may have ended badly for the mortgage backed | This all may have ended badly for the mortgage backed securitsation market in the mid-2000s, but we can see the idea here is to optimise the bank's financial position. This is not of itself a bad idea. But it does expose you to tail risks in a difficult market. | ||
=== Prime brokerage economics === | |||
Exactly the same economic drivers are behind the prime brokerage business. The prime broker is essentially margin lending to its customers, either in the form of physical margin loans or or synthetic prime brokerage transactions in the form of swaps. It's facing similar risks: credit losses should its customers default; financing costs which its incurs from its own Treasury Department when it provides financing to its customers, | Exactly the same economic drivers are behind the prime brokerage business. The prime broker is essentially margin lending to its customers, either in the form of physical margin loans or or synthetic prime brokerage transactions in the form of swaps. It's facing similar risks: credit losses should its customers default; financing costs which its incurs from its own Treasury Department when it provides financing to its customers, | ||
For all the excitement, the [[hedge fund]] offices in Mayfair, the hookers, the parties, the [[leverage]], the exotic strategies, and all the buzzwords with which the business overflows, prime brokerage is at its heart a ''lending'' business. The prime broker makes money by lending money and earning interest in return. | |||
====Business dynamics==== | ====Business dynamics==== | ||
The risks and challenges to a prime broker’s business are the same as for a boring bank: | The risks and challenges to a prime broker’s business are the same as for a boring bank: | ||