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 look at the introduction to UBS’s “GFS Terms”, which is the bank’s standard terms and conditions for its equity Prime Services business. 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.

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, hypothetically, going to write a set of prime brokerage terms, this is how he might have done it.

Three parts of a prime brokerage business

You could divide, as this document does, a Prime Services business into three basic parts: “operational services”, “transactions”, and “risk and cost management”. These parts are not functionally distinct in the hurly-burly of daily life in the business — operational services enable transactions which generate risks and costs that the bank must manage — but as a practitioner, it is always worth bearing in mind which of these functions is “in play” at a given time.

1. Operational services: A prime broker provides customers with certain operational services to enable them to transact in the market: an interdealer network who will “give up” transactions to the broker; a set of bank accounts to pay and receive transaction cashflows and margin payments; securities accounts to hold customer inventory in safe custody and settlement and payment services by which the broker accepts customer instructions to settle its transactions in the market. These operational services may not seem glamorous, but they are the interface and main point or interpersonal contact between the prime broker and its customers. Even in our technology-infatuated world, human relationships are important and they help make prime services business “sticky”. A slick operational interface overlaid with experienced subject matter experts to manage accounts will be a competitive advantage — not that you would know it from unerring 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 take a position 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. Prime brokers make their money accretively, through execution commissions and financing spreads. If a customer portfolio does not gap through its margin buffer — and, yes, that is a big “if” — the main determinant for a prime broker’s success is how well it manages and optimises its internal structural costs.

You will hear people say that Prime Services is “a simple business on which 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 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” Hwoop! Hwoop! — in that they do not address or reflect the day-to-day risks of doing business, nor really help if they come about: rather they are systemic safeguards designed to ensure the bank can ride through those risks if they come about, leaving sufficient resources on the table in extreme market situations. As such they act as a “tax” on the business without directly corresponding to its actual risks.
2. Actual funding costs: The actual costs to the business of borrowing the funds it needs to provide margin loans to customers in the first place. 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.