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. These three elements form an integrated whole: operational services enable Transactions, which generate risks that must be managed:

1. Operational services: The operational services the broker provides to customers to enable them to transact in the market: Bank accounts to pay and receive cash flows 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. These operational services may not be glamorous, but they are the interpersonal interface between the prime broker and its customers and May well be what makes prime services business “sticky”. There are significant switching costs for customers so a slick operational interface with experienced subject matter experts will be a competitive advantage. Not that you would know that from systemic 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 have a view 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. They are meant to make their money accretively, through execution commissions and financing spreads. If a customer portfolio does not gap through its margin buffer — that is a big “if” — the main determinant for a prime broker’s success is how well it manages its structural internal costs.

You will hear people say that Prime Services is a simple business, but one where 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 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 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

Prime brokerage businesses often segment their clients into tears based on likely return of allocated capital. Top tier clients may receive preferential pricing, security terms, margin terms and 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. This has never made much sense to JC: if you're prepared to offer preferential pricing and advantageous credit and margin terms to clients who, QED, will be taking more risk with the bank's capital, you should be prepared to offer those terms to smaller clients who on the same theory will not present the same risk. No better example exists than our old friend Archegos. The simple fact of having to manage different tiers of clients with different playbooks creates unnecessary complication and room for operational error in the prime services business. If your pricing and credit terms work for large clients they should work for small ones too if the clients are so small that they do not work, then it makes more sense to not do that business. Lastly, offering premium terms to smaller clients may be a business differentiator and help to build trust with growing clients. And the consistency of credit and margin terms across the platform makes for easier management of the portfolio in stress scenarios.