Prime broker
|
Prime Brokerage Anatomy™
|
This article is largely about equity prime brokerage, because that’s mainly what the JC knows about. Those wanting to know more about l’affaire Archegos can go to that article, but here — and the sister article on synthetic prime brokerage, might be a useful backgrounder, though to be honest the Archegos thing, and the Credit Suisse management report into it, is a pretty neat backgrounder all by itself.
Prime brokerage is, first and foremost, a financing business. A prime broker lends money on margin to hedge funds so they can invest in the market. It can do this directly, by making cash or stock loans, or “synthetically”, using swaps, but either way the PB does not have any market risk on its client’s positions. It makes its money through commissions and optimising its cost of funding.
Many legal eagles who really should know better don’t understand this, and it makes for lengthy and pointless negotiations.
Why “prime”?
No idea. Just one of those mysteries of the law, like why all English lawyers hate the Contracts (Rights of Third Parties) Act 1999, and why people insist on counterparts clauses.
Okay, let’s guess: Wikipedia says the term, and concept, dates back to the New York broker Furman Selz which offered a centralised service for money managers in the seventies, the idea being to centralise your back office functions and trade flow into a single place — a “prime” broker, we suppose. But it is a guess. These days large hedge funds have multiple prime brokers (Archegos had seven!!) so the adjective has lost some of its cachet.
What prime brokers do
Supplementary to their core lending operation, prime brokers — fondly known in the trade as PBs — provide the following services:
- Custody: looking after the hedge fund’s “long” investment portfolio much of which they will have financed (this sounds kind, but the PB’s ulterior motive is to have control of and security over all those lovely assets)
- Bank accounts: running a multi-currency cash account - from which they can lend their clients money.
- Margin lending: lending on margin to hedge funds who want to get exposure to securities without funding it (you know: so they can achieve (cough) leveraged alpha);
- Stock lending: lending the hedge fund stocks it needs to settle short sales.
- Synthetic prime brokerage: Providing the hedge fund with derivative exposure to assets through synthetic equity derivatives (also called “CFD”s). This may involve accepting give-ups and give-ins 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 clients money so they can make investments. All going well the client keeps all the profits and losses from their investments, but pays the PB interest and repays principal. Client lets the PB look after the assets so it can monetise them, thereby lowering its costs of providing the funding in the first place.
The PB lends explicitly, through cash margin loans (for long positions) and stock loans (for short positions), or implicitly through equity derivatives (which can be long or short). All this so your fund can generate — ahh — “alpha”[1]
The four basic prime brokerage trades:
- The margin loan: a physical long position;
- The stock loan: a physical short position;
- The long swap: a synthetic long position;
- The short swap: a synthetic short position.
Each of these four trades involves the prime broker funding an asset, and then getting hold of the asset in one form or another. Since the cost of funding to the prime brokerage is critical to its viability, it is worth seeing what the prime broker does in each of these cases.
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.
Margin lending: How do you improve your cost of funding? By taking the shares you hold in your PB business (either your clients’ custody assets, where they are buying the shares outright — this is called “cash prime brokerage” — or the shares you buy to hedges the equity derivatives you write to your clients, where they are taking only economic exposure to shares under a swap and are not buying them outright — this is called “synthetic prime brokerage” — and in either case converting those shares back into cash, or cash-like instruments, that you can use to pay down what you have borrowed from your own treasury department.
So remember these two things:
- Prime brokers are not the other side of the trade to their clients. Even on equity swaps. They are on the same side. All they care about is getting their loans paid back with interest/. The better their clients’s investment returns, the safer is their lending position.
- Prime brokerage is margin lending: The reason the prime broker wants your assets is not just for security, but so it can use them to reduce its own internal cost of funding. The lower its own cost of funding, the less it has to charge you. So it is in your interest to let the prime broker reuse your assets, if you are allowed to.
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)
Prime broker solvency
Cue thundercrack — the Lehman insolvency was a chastening experience for some hedge funds who discovered to their dismay that their assets — which they thought Lehman was holding safely in a little shoebox under its bed for them — were rather harder to get back than they expected. They hadn’t gone awol as such, but were somewhat caught in the gears of the great steampunk machine.
The financial crisis has led to a good deal of focus from both clients and regulators on bank solvency, but fifteen years on the world is a very different place, and our view — coloured by a decade advising prime brokers, granted but still — is that prime brokerage customers should spend a little time managing the extreme tail risk of their prime broker failing during their relationship, and less time obsessing about it in the abstract when they negotiate their master agreements because, frankly, it is all rather tiresome.
It works like this: a customer can unwind its positions, repay its lending and withdraw its assets at will on any day. As long as the prime broker has been paid, it will just give you back your assets, or, at your choice, their money’s worth. Now seeing as fully capitalised regulated financial institutions do not typically collapse over night — Lehman was fast, and it was teetering on the brink for months — its final slide was fairly constant and took about seven months — if you are half-way paying attention there is plenty of time to get your assets out before corkscrewing into a ditch. Hedge fund advisors are meant to understand the equity market. Look at the equity of your prime broker![2]
Since 2008 the FCA has significantly tightened its CASS custody rules, in particular introducing a rule obliging prime brokers to cover any custody shortfall with their own assets, and enhancing customer asset segregation rules. And the worlds financial regulators have introduced broadly similar bail-in and bank resolution regimes, meaning the resolution of failing banks will be a much more managed process than it used to be, with the main goal of protecting the overall financial system from the shock of the failure of a significant credit institution.
Should you be asleep at the switch and miss the pending implosion of your prime broker, then the solvency regime of your prime broker isn’t really the thing that makes recovering your assets hard. It will be (i) unwinding any reuse/rehypothecation arrangements and (ii) satisfying outstanding indebtedness and releasing any security interests over the assets. Neither of these things are a function of the insolvency regime of the broker.
Under an English law reuse arrangement, a prime brokerage customer is an unsecured creditor of the prime broker for the return of equivalent reused assets. To the extent that the return obligation is offset by the customer’s liability under its margin loan portfolio, this is a zero-sum game, but generally the reuse multiplier will be more than 100% and may be as much as 140%. For this balance, the customer has prime broker credit risk. (This is not necessary true under a US rehypothecation arrangement, because under one of those typically alchemical US legal constructs, the prime brokerage customer retains ownership of a rehypothecated asset even while the prime broker sells it outright into the market, so at least inside the PB’s books and records the customer has a preferred claim to the rehypothecated asset over other creditors of the bank. What this means in practice may be quite different (to what a US customer expects, and quite similar to what an English one would get).
Even if you recover all the reused assets and return them to the prime brokerage custody account, there is another obstacle: the security interest. This is likely to delay return of your asset, because the banks administrator will want to make sure that every conceivable debt claim for which the assets are security is recovered first — or applied against the assets — before any security is released. and here the “kitchen-sink” security model that all prime brokers use will gum things up. For prime brokers take security against not just close-out liabilities due under identified maser agreements, but, you know, “any indebtedness, claim, liability, damage or loss, present or future, direct or indirect, contingent or otherwise, that Client or Client’s affiliates, friends or relations, jointly or severally, may owe to Prime Broker, its affiliates and any of its employees, officers directors, agents or advisors however described”. Right?
Not to be confused with
See especially in the context of AIFMD: Prime broker - AIFMD Provision.