Prime brokerage denotes a bundle of related services presented to money managers or hedge funds. These services are generally offered by broking houses or investment banks. These institutes cater to investors looking to trade on margin basis for achieving higher returns. The prime brokerage institute can offer centralized services such as combined clearing facility and custodial functions. Hedge funds and money managers can get the facility of netting all their deals with a prime broker and to avail requisite collateral.
Prime brokers charge various fees to their clients for generating revenue. These charges include clearing fees and other such levies. Prime brokers also make money on spreads and by charging finance charges on short and long positions. It also rehypothecates the portfolios of its clients for generating additional revenue. Other sources of revenue include levying interest on margin securities and cash.
Prime brokers offer a large number of services to their clients. These brokers offer custodial services and clearing services, and typically also lend securities to clients on margin basis. These brokers also provide financing facility to its clients. Their portfolio of services may also include providing technological expertise to hedge funds and money managers. Different clients may have different technological requirements and the prime broker may be required to customize its offerings to its clients. Some clients may require simple technology solutions to generate daily reports, while others may require more sophisticated programs for real time updates. Many prime brokers may offer additional services to its key clients based on their requirement.
Prime brokers may also assist its client hedge funds in obtaining capital investments. These brokers may introduce their customers to capital investors and can facilitate the process of obtaining funds for the firm. Additionally, these brokers may also assist their clients in entering real estate transactions. In some cases, these brokers act as realtors by leasing commercial estates. These estates are then divided and sub leased to their hedge fund and investment bank clients. The broker may provide allied real estate services as well. Prime brokers may also offer analytical and risk management services to its clients.
These brokers also let their clients deal with various broking houses through a centralized account. This service can help hedge fund clients in saving money and effort required for maintaining multiple accounts. With the help of a prime broker, the client may also consolidate their cash management function and reporting requirements.
Prime broking gained prominence in the 1970s, though the services existed since 1949. Alfred Winslow Jones offered the first prime brokerage service account to hedge funds in 1949. It solved the major problem faced by the money managers and portfolio managers. Prime broking service helped them in maintaining proper account of their trades, positions and performance. Prime broker let them consolidate their trades across various broking houses. The service portfolio gained popularity and soon major bulge bracket firms like Bear Stearns, Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley and Credit Suisse were offering these services. Since then, the service scope of prime brokers have increased manifold. Prime brokers also expanded their services beyond the United States. The first prime broking service outside of the US was started by Merrill Lynch in London. Major pioneer in the field of prime broking include Furman Selz, which popularized the concept in the 1970s. Lately, many other international firms like HSBC have made foray into this area.
In the beginning, prime broking services were mainly focused on long short equity funds. Prime brokers helped fund managers and hedge funds to maintain diverse relationships through one hub. This helped the clients in saving money on operational expenses. It also reduced the requirement to design multi-layer organizational structures. In this way, prime brokers helped their clients to save money and effort that would have been incurred on the administrative functions. This also let clients divert their scarce resources towards more important functions such as product development and marketing.
However, lately, prime brokers have extended the scope of their services. Prime brokers now also offer custody service. Additionally, they have also started to provide services for bond custody and clearing. However, equities still maintain the core business for prime brokers. These brokers may also extend reporting services to its clients. Prime brokers now also deal in derivatives and fixed income products. Over the years, prime brokers have also added futures and foreign exchange products to its portfolio.
With the advent of hedge funds in the 1990s, prime broking has become an important division of investment banks and broking houses. As in 2006, most major investment banks reported to generate annual revenue in excess of two billion dollars from their prime broking business. This unit now also contributes greatly to the banks’ bottom line. In this era, prime broking business became an instant success and proved to be a cash cow for investments banks and broking houses. These success stories also helped to attract new participants in the market and thereby increasing competition. Presently, several financial institutions from outside of the US are enjoying prominent position in prime brokerage segment.
Prime broking landscape underwent a drastic change in the wake of economic crisis in 2007 to 2009. The main change brought about by the crisis pertained to prime broker and client relationship. Major hedge funds decided to diversify their holdings and sought to reduce their reliance on one or two prime brokers. Instead, they now decided to go for multiple prime brokers to diversify their risk. Prime brokers also restructured their businesses to meet new requirements. The industry saw many prominent mergers and acquisitions. JPMorgan acquired Bear Stearns in 2008 and Barclays bought Lehman Brothers. Nomura also acquired several Lehman businesses in Asia and Europe to consolidate its position. Merrill Lynch was absorbed in Bank of America. The two most prominent prime brokers Goldman Sachs and Morgan Stanley saw major outflow of the business following the crisis. Most of such business went to other bulge bracket banks such as JPMorgan, Deutsche Bank and Credit Suisse. Due to the turmoil in the market, new entrants set foot in the segment. HSBC set up its prime broking business under “HSBC Prime Services” brand in 2009. HSBC carved its business from its custodial division.
Prime brokers help hedge funds and money managers in managing their risks. However, the industry itself felt the tremors in 2008, when Lehman Brothers, a major player in the segment, collapsed in 2008. The collapse was so sudden that Lehman clients did not enough time to pull out their collateral securities. These securities further sank when Lehman filed for bankruptcy. These hedge funds also suffered due to the absence of asset protection laws in the United Kingdom. The United States have provisions such as 15c3 for protection of assets. These happenings led to large scale of deleveraging in the market.
The collapse of a major player like Lehman cautioned hedge funds against relying upon sole or dual prime brokers. Hedge funds now seek to diversify the counterparty risks by engaging with various prime brokers. These funds now favored brokers with robust capital reserves in place. The new trend led to various new problems. Clients such as money managers and hedge funds now need to invest more to manage multiple prime brokers. They also need to invest more in new technology and resources for managing various relationships. Such multiple relations have also added to operational complexities faced by hedge funds. It also causes problems related to asset reconciliation procedures. These problems can be solved to some extent by proper coordination between fund administrators and counterparties.
Prime brokers tend to value clients with more leverage positions higher than the ones with smaller leveraged positions, since prime brokers derive a major portion of their revenue from spread and money or securities loaned to hedge funds. However, even the clients with lower leverage position can generate income for prime brokers in the form of foreign exchange fees and repo funds. These clients generally belong to fixed income schemes.
The major function of prime brokers is to provide leverage and liquidity to its clients. Prime brokers carry out this function by giving out loans on the guarantee of long positions held by their clients. Consequently, prime brokers are susceptible to major losses if the value of collateral securities fall below the value of loans granted to the clients. For mitigating these losses, prime brokers constantly monitor the risk profile of their clients and loan portfolios. Most of the prime brokers use their in-house methodologies for determining the risk profile. These strategies involve monitoring of various factors such as ownership, liquidity, macroeconomics, investments and concentration.
Prime brokers also face reputational and operational risks. Prime brokers generally impose liquidity stipulations. These stipulations generally assume that 10 percent of the average daily security trading volume may be liquidated without causing any undue stress to the prevailing price level. According to this principle, a trading position of the size of the average trading volume will require 10 trading days for liquidation. Prime brokers also carry out stress test for measuring feasibility and risk profiles. These tests include the use of what-if functionality. These tests determine the paper loss or profit for various combinations of trades. These tests may include Portfolio margin and flight to quality techniques.
Prime brokers generally develop their own risk measurement methodologies. However, these customized tests use one of the various popular underlying techniques for determining risk profiles. These in-house techniques may be rules based or may employ Risk Based Haircuts methodology. Some brokers also use stress tests, some self regulated firms may also use portfolio margin techniques. The US government recommends use of Regulation T, Arranged Financing and Special memorandum account.
A prime brokerage is constantly reinventing itself and adds various new functions over the course of the time. Prime brokers now also provide advisory services to its clients, especially to “start up” firms. These start up firms may require various services such as regulatory compliance, capital funding and working capital funding. These brokers can provide specialized services pertaining to the jurisdictions where the fund has to be situated.
Prime brokers may also offer tailor made technological solutions. In this way, prime brokers can help their clients save funds on developing in-house technologies. Prime brokers also have the advantage of having latest know how required for developing such technologies.