Prime broker
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Prime Brokerage Anatomy™
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Brokerage Anatomy™
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This article is largely about equity prime brokerage, because that’s mainly what the JC knows about.
A prime broker is the business division of an investment bank that looks after hedge funds.
What prime brokers do
Prime brokers — fondly known in the trade as PBs — provide the following services:
- Custody: looking after the hedge fund’s “long” investment portfolio - (but this is because they like to reuse all those lovely assets)
- Bank accounts: running a multi-currency cash account - from which they can lend money.
- Margin lending: lending on margin to hedge funds who want to own securities without paying for them (you know - leverage).
- Stock lending: lending the hedge fund the assets it needs to settle short sales, and lending it the money it needs to buy assets.
- Synthetic prime brokerage: providing the hedge fund with derivative exposure to assets as an alternative to the hedge fund buying them outright). Often in the trade called “CFD”s. This may involve accepting give-ups from other executing brokers.
- Swaps and ETD: Providing general exposure to swaps, futures, options and that sort of thing.
Prime brokers often also have a consulting arm which helps a nascent hedge funds get off the ground: setting it up, finding offices, hiring people, engaging lawyers, recommending (cough) prime brokers, and capital introduction.
Why prime brokers do it
Prime brokerage is a financing business. This is the key to it: to lend your clients money so they can make investments. All going well the client keeps all the profits and losses from their investments, but pays you interest and repays your principal.
You can lend them money — explicitly, through cash margin loans, or implicitly through equity derivatives, and you can lend them securities so they can short-sell (also explicitly, through an outright stock loan or implicitly through equity derivatives). All this so your fund can generate — ahh — “alpha”[1]
You make your money charging a financing rate to your clients on the money you lend them. the challenge is that your business will have to pay a financing rate, to your treasury department, for all the cash you are using in your business to lend to your customers. The trick is to organise your operation be as efficient as possible, to reduce that cost the treasury department charges you. The lower your cost of funding, the better your margins.
How do you improve your cost of funding? By taking the assets you hold in your PB business (largely your clients’ custody assets and your own hedge positions for your clients’ equity derivatives) and converting them into cash, or cash-like instruments, that you can give back to your treasury department.
What prime brokers don’t do
- Act as PB administrator: While they look after assets, prime brokers don’t calculate NAV (that’s the PB administrator’s job)
- Act as depositary: PBs, which tend to be situated in London, or New York, generally cannot act an official depositary for AIFMD purposes (though they may get delegated the safekeeping role and may act as a depo-lite)
- Act as an executing broker: They don’t themselves work equity orders for their clients (though their compadres across the Chinese wall in the equities trading division at the same investment bank almost certainly will)
Not to be confused with
See especially in the context of AIFMD: Prime broker - AIFMD Provision.