Prime brokerage economics
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Prime Brokerage Anatomy™
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Bank economics
Before getting onto how, specifically, a prime broker makes money, let’s first consider the basic case: how a traditional bank makes money.
You will hear much disquiet about fractional reserve banking, but that is in essence what a bank does: gathers lots of relatively small deposits from retail customers and pays a small amount of interest on them, and it lends them, in larger “clips”, for fixed periods, to borrowers, who pay a larger interest rate. There are prudential regulations requiring banks to not lend out a portion of their deposit base, but to keep it on hand for a “rainy day”. Hence the label “fractional reserve” banking. Banks have to keep a fraction of their “capital” in reserve. It just sits there, costing them a lot of money.
Exactly how big that fraction is is a matter of ongoing debate, depending as it does on the amount of risk the bank takes on the “asset” side of its balance sheet. There are all kinds of different measures
S On one side it has a loan book, usually in the shape of mortgages, on the other side it accepts customer deposits.[1] 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 GC in a fancy car and so on.
The bank’s treasury department ensures that its 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:
- Minimise credit losses: it must minimise credit losses on its loan portfolio
- Minimise running costs: It must minimise interest costs on its borrowings.[2] It is axiomatic that, for a given loan, the cheaper a bank’s cost of funding, the fatter its margin. This is simple mathematics.
Banks minimise credit losses by taking security and putting in place other credit mitigation techniques — close out netting, guarantees, credit support — which it can use to offset its losses should customers to whom it has lent money default. For example a mortgage, under which the bank may repossess a defaulting customer’s house.
It may seem obvious, but it is worth saying that security interests over customer property may relieve credit risk, but they do not minimise interest or operating costs (and indeed may contribute to them in the form of legal and registration costs).
Once credit mitigation is in place, and since there are natural market limits to the amount of interest a bank can charge on its loans, the key question for the bank is how do I reduce my overall borrowing costs?. This is the way to fatter margins.
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 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 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, 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
The risks and challenges to a prime broker’s business are the same as for a boring bank:
- Avoid credit losses: It needs to avoid credit losses as a result of the implosion of its customers before they can repay its loans. For this it takes security over its customers assets, and may impose netting obligations and — most importantly — margin arrangements.
- Minimise running costs: Once the asset side of its business is taken care of it must minimise its liabilities: by trimming operating costs — you know, offshoring subject matter experts to India, that kind of thing — and in particular minimising as best it can the cost of funding the loans it advances to its customers. Just like a boring mortgage lender, a prime broker must some how get its hands on the money it wants to lend to its customers. Just as with a boring bank, the normal way of doing that is borrowing it from the treasury department. At eye-watering rates.
Margin and loan-to-value
There are all kinds of credit risk mitigation techniques, and your credit officers will wax long and lyrical about the importance of cross default, NAV triggers, key person clauses and so on, but what matters above all else is that your customer keeps the required margin with the PB over the required loan-to-value ratio: if this stays true, then the other credit mitigants don’t matter.
Re-hypothecation
Unlike mortgage lenders, prime brokerage customers tend not to need to live in their investments. If investment is a “have cake or eat it” affair, mortgage customers want to eat their cake; prime brokerage customers just to have theirs.[3] They care about the return their investments bring them, but as long as that is assured they are happy to hand over possession of their investments to the prime broker “for safekeeping” and as collateral for their obligations to repay their loans.
And unlike residential properties in suburban Las Vegas, the investments that prime broker customers make tend to be liquid, transferable securities. The thing about a transferable security is that you can sell it or lend it and thereby raise money against it. If it is liquid you can do this quickly, and quickly get it back if, having lent it out, you find the customer needs it.
Hence the fabulous idea of “re-hypothecation” (as described for Americans) or “reuse” (as described for ordinary people).[4] Under this strategy, the customer permits the prime broker to take assets from its custody accounts and finance them in the market, Usually by borrowing higher quality assets and using the prime brokerage investments as collateral in an agency lending arrangement. The prime broker takes the high-quality assets it has raised and returned them to its Treasury Department for credit on its internal borrowing account.
See also
References
- ↑ And may enter into other forms of term borrowing in the financial markets such as by issuing commercial paper, bonds and so on.
- ↑ It must also minimise its operating costs in terms of personnel, plant and equipment et cetera, needless to say.
- ↑ “Eating” being to make use of an investment; “having” to rent it out and earn a return. This is not a good metaphor, because of course one can have your cake and eat it, if you live in your house and it goes up in value. But you get the point.
- ↑ Legally, re-hypothecation and reuse are very different operations; in practice they amount to exactly the same thing. As usual, form is far more important than substance in the mind of the legal eagle.