Hedge Funds & 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 , 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.
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”
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
- Prime broker - AIFMD Provision
- Also Law of Property Act 1925
- Editor’s note: actually “vega”.