Talk:Prime brokerage anatomy

If you wanted a simple, JC-endorsed explanation of how an equity prime services business operates, you could do a lot worse than to look at the introduction section of UBS’s “GFS Terms” document, which is the standard terms and conditions for its equity prime brokerage business. It neatly and clearlly sets is out. 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 going to write a set of prime brokerage terms, hypothetically, this is how he might have done it.

But 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.

Three parts of a prime brokerage business

A prime brokerage business is divided into three parts:

1. Operational services: The operational services the broker provides to clients to enable them to transact in the market: Bank accounts to pay and receive cashflows and margin payments relating to Transactions; securities custody accounts to hold customer inventory and settlement and payment services by which the broker accepts customer instructions to settle its transactions in 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 have a view on the transactions: they are meant to be fully collateralised and delta-hedged at all time, so have nothing to gain or lose from ordinary fluctuations in asset prices: they make their money through commissions and financing spreads, so as long as a customer portfolio does not gap through its margin buffer— big if — the main determinants of business success for the prime broker are how well it manages to structural internal costs of providing the business.

Structural internal costs of providing prime brokerage services

As a secured lending business prime services is heavily regulated, and these regulations present themselves 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” — that do not reflect the day-to-day risks of doing business rather they are systemic safeguards designed to leave resources on the table following extreme market situations and as such act as a “tax” on the business that does not directly correspond to its actual risk.
2. Actual funding costs: the actual costs to the business of borrowing the necessary funds to provide the margin loans to customers. There is a bit of a double whammy 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.
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.