Prime brokerage economics
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Hedge Funds & Prime Brokerage Anatomy™
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Consider how a traditional bank makes money: 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 interest revenue on its loans (after credit losses) exceeds its total interest costs on its deposits and borrowings, and the total amount it must pay to keep the organisation running.
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 promise treasury department may be high, especially for a 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 interest and 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 the cashflows it was secured upon. 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 securisation market in the mid-2000s, But we can see the idea here is to optimise the banks financial position.
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,