83,209
edits
Prime brokerage economics: Difference between revisions
Jump to navigation
Jump to search
no edit summary
Amwelladmin (talk | contribs) (Created page with "{{a|pb|}}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.<ref>An...") |
Amwelladmin (talk | contribs) No edit summary |
||
| Line 1: | Line 1: | ||
{{a|pb|}}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.<ref>And may enter into other forms of term borrowing in the financial markets such as by issuing commercial paper, bonds and so on.</ref> 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. | {{a|pb|}} | ||
===Prologue: ''bank'' economics=== | |||
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.<ref>And may enter into other forms of term borrowing in the financial markets such as by issuing commercial paper, bonds and so on.</ref> 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 [[Chief financial officer|treasury department]] ensures that its [[Regulatory capital|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’s [[Chief financial officer|treasury department]] ensures that its [[Regulatory capital|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. | ||
| Line 20: | Line 22: | ||
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, | 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, | ||
==Prime brokerage economics=== | |||
Apply all that to the business of [[prime brokerage]]. For all the excitement, the [[hedge fund]] offices in Mayfair, the hookers, the parties, the [[leverage]], the exotic strategies, and all the buzzwords with which the business overflows, prime brokerage is at its heart a ''lending'' business. The prime broker makes money by lending money and earning interest in return. The risks and challenges to its business are the same: It needs to avoid credit losses as a result of the implosion of its customers before they can repay its loans. For this it takes security over its customers assets, and may impose netting obligations and other margin arrangements. Once the side of its business is taken care of it must minimise its liabilities: by trimming operating costs and in particular offsetting as best it can the cost of funding the loans it advances to its customers. Just like a mortgage lender, a prime brokerage business must borrow these funds from its treasury department. | |||
Unlike [[mortgage]] lenders, [[prime brokerage]] customers tend not to need to live in the investments they bought with their loan proceeds. They care about the ''return'' their investments bring them, but as long as that is assured they are happy to hand over possession of their investments to the prime broker “for safekeeping” and as collateral for their obligations to repay their loans. | |||
{{sa}} | And unlike residential properties in suburban Las Vegas, the investments that prime broker customers make tend to be liquid, transferable securities. The thing about a ''transferable'' security is that you can sell it or lend it and raise money against it. If it is liquid you can do this quickly, and quickly get it back if the customer needs it. | ||
Hence the fabulous idea of [[re-hypothecation]] (as described for Americans) or [[reuse]] (as described for ordinary people).<ref>Legally, re-hypothecation and reuse are very different operations; in practice they amount to exactly the same thing. As usual, form is far more important than substance in the mind of the legal eagle.</ref> Under this strategy, the customer permits the prime broker to take assets from its custody accounts and finance them in the market, Usually by borrowing higher quality assets and using the prime brokerage investments as collateral in an agency lending arrangement. The prime broker takes the high-quality assets it has raised and returned them to its Treasury Department for credit on its internal borrowing account. | |||
{{sa}} | |||
*[[Prime brokerage charging]] | *[[Prime brokerage charging]] | ||
{{ref}} | {{ref}} | ||