The role served by a prime brokerage is that of facilitating large, active trading operations such as hedge funds. A prime broker can be thought of as a sort of central broker, facilitating and coordinating extensive, complex trading in a variety of financial instruments.
Prime brokerage services are provided to institutional clients by major investment banks such as Merrill Lynch and Goldman Sachs.
- Prime brokerage refers to a bundle of services that investment banks and other major financial institutions offer to hedge funds and similar clients.
- Services included within a prime brokerage bundle may include cash management, securities lending, and more.
- The services of a prime brokerage aid hedge funds in accessing research, finding new investors, borrowing securities or cash, and more.
- A prime brokerage service gives large institutions a mechanism allowing them to outsource many of their investment activities and shift focus onto investment goals and strategy.
- Financial institutions need a minimum account size to be able to transact with prime brokers and all prime brokers have different requirements and fees.
Core Prime Brokerage Services
Prime brokers provide a wide variety of custodial and financial services to their hedge fund clients, including acting as an intermediary between hedge funds and two key counterparties. The first of these important counterparties are large institutional investors, such as pension funds, that have massive equity holdings and, therefore, serve as a source of securities to lend for short-selling purposes.
The second group of important counterparties is commercial banks that have adequate funds available to make large loans for margin purposes. These two counterparties, with the aid of the prime brokerage, enable hedge funds to engage in large-scale short selling through borrowing stocks and bonds from the large institutional investors, and to maximize their investments through leverage by obtaining margin financing from commercial banks. The prime brokerage makes money by charging a fee, such as a spread or premium on the loan from a commercial bank, in return for facilitating the transaction.
Another core service provided by prime brokers is that of trade clearing and settlement. While a hedge fund traditionally operates through accounts at a number of brokerage firms, it commonly instructs these executing brokers to clear all trades through its designated prime broker. This simplifies reporting and operations for the hedge fund since the prime broker also typically serves as the custodian for the hedge fund’s assets. It further simplifies and streamlines the process of borrowing investment securities and capital since the hedge fund’s assets can quickly and easily be shifted to the prime broker as collateral.
What is the difference between a broker and a prime broker? A broker facilitates the trading of securities, such as the buying or selling of stocks for an investment account. A prime broker, instead, is a large institution that provides a multitude of services, from cash management to securities lending to risk management for other large institutions.
Additional Prime Broker Services
In addition to the core lending services they provide, prime brokers offer their hedge fund clients other services, sometimes referred to as “concierge services,” designed to ease and enhance the operation of a hedge fund. One important additional service is offering risk and performance analytics. A number of prime brokers have partnerships or other arrangements with risk management service providers, such as RiskMetrics Group, that enable them to provide hedge fund clients with daily risk and performance analysis services.
Another important service is capital introduction for the fund manager. Capital introduction is essentially the process of connecting hedge fund managers to potential investors in the form of the prime broker’s asset management and private banking clients. Prime brokers further serve their hedge fund clients, who frequently engage in trading derivative financial instruments, by offering them access to their derivatives trading desks, along with risk management suggestions from their own derivatives trading operations.
Prime brokers also typically offer their hedge fund clients private access to the prime broker’s research services, thus enhancing and reducing research costs for the hedge fund. Outsourced administration and trustee services, along with enhanced leverage enabled by offering lines of credit, are additional features offered by many prime brokerage firms.
Considerations for Hedge Fund Managers in Selecting a Prime Broker
Because of the fact that a prime brokerage provides so many essential services that are crucial to the efficient and hopefully profitable operation of a hedge fund, the selection of a prime broker is a major decision for a hedge fund manager. Among the primary considerations in selecting a prime broker are the price of the various services offered, easy access to large holders of securities, including holders of less liquid and more difficult-to-borrow securities, and trading confidentiality.
Additionally, potential investors in a hedge fund may be influenced, positively or negatively, by the selection of a particular prime broker. This can be an important factor in the decision, especially for a new fund that is just starting up and actively seeking major investors.
Frequently Asked Questions
What are the largest prime brokerages?
The relative size or success of prime brokerages can be measured in several ways. Based on the number of hedge funds served, Goldman Sachs, JP Morgan, Morgan Stanley, Credit Suisse, and UBS make up the top five.
Are prime brokers just for hedge funds?
While hedge funds are important to prime brokers’ business, other large investment clients that need clearing services, or to be able to borrow securities or cash in order to engage in trading would also need a prime broker. These could include mutual funds, market maker firms, proprietary trading desks, and inter-dealer brokers.
What is the difference between a prime broker and a custodian?
A custodian is a financial firm that holds financial assets for safekeeping to minimize the risk of theft or loss. While a prime broker may offer custody services, they also offer additional services including credit facility, clearing, execution, and so on.
What is a prime brokerage agreement?
Clients sign a prime brokerage agreement detailing what responsibilities the prime broker will assume in providing their services, along with their applicable fee structure.
The Bottom Line
Prime brokerage is an important service that is provided to large institutions to help them facilitate their business and outsource activities that allow them to focus on their core responsibilities.
Prime brokerage is an important part of the financial sector that creates jobs for thousands of peoples and contributes significantly to the economy. For many large institutions, a prime broker can be a one-stop shop that makes doing business much easier.