What Are Prime Brokers and How Do They Work?

Key Points

• Prime brokers are financial institutions that provide a range of services to hedge funds, enabling them to execute large transactions, manage leverage by borrowing securities and cash, and navigate complex investment strategies.

• There are three types of prime brokers: Standard Prime Brokers dealing with traditional financial instruments, Synthetic Prime Brokers specializing in derivatives, and Full-service Prime Brokers, often part of large investment banks, offering a mix of both services.

• Prime brokerages facilitate hedge funds in various ways, including lending securities for short selling, introducing capital from investors, providing research, managing assets as custodians, advising on regulatory changes, and offering additional services like credit lines and performance analytics.

Prime Brokerage Explained: What it Entails and How it Works

The term “Prime brokerage” refers to the bundle of services offered to large investors such as hedge fund managers. These services allow them to complete large investment transactions.  

Prime brokerage is a pivotal part of the financial services landscape, providing institutional clients like hedge funds with comprehensive resources to execute large-scale and complex investment strategies. These financial services are typically provided by industry giants such as Morgan Stanley and Bank of America, who play a crucial role in offering prime brokerage agreements that set the framework for margin financing, credit risk management, and capital efficiency.

If you’re simply buying investments such as stocks and bonds for yourself, you may enlist the services of brokers who execute the trades. For instance, you may use brokerage firms which allow you to trade stocks or bonds online and provide you with some advice or basic research reports.

However, people who own or represent big hedge funds that manage billions of dollars and do more than simply buying shares of index funds, usually require some special assistance and services. These services may include borrowing large sums of money to increase trade sizes, selling stocks short, and making the most of opportunities even when the market is going down. This is where prime brokers enter the picture. They serve the needs of large hedge funds, which are usually complex. ^[1] 

Most big investment banks such as Credit Suisse, Goldman Sachs, and JP Morgan Chase serve as prime brokers. 

Types of Prime Brokers

Prime brokers have been around for a few decades and the business has evolved over time. Now there are 3 types of prime brokers in the financial market.

1. Standard Prime Brokers

   1. These brokers facilitate borrowing of funds using conventional financial instruments such as bonds and stocks. Their size of operation is often limited because they don’t deal with derivatives, instruments, or structures.

2. Synthetic Prime Brokers

   1. Just as the name suggests, this type of prime brokerage deals with structured derivatives and other types of synthetic financial instruments. 
   2. Many synthetic prime brokers also deal with exchange-traded derivatives and over the counter derivatives, or a combination of both. The huge size of the global derivatives market enables prime brokers to provide their clients with more liquidity.

3. Full-service Prime Brokers

   1. These brokerage firms are usually owned by big-name investment banks, allowing them to provide a combination of standard and synthetic prime brokerage services. [2]

How Do Prime Brokers Work?

To understand how prime brokers work, it is essential to first learn about hedge funds and the services they need.

Hedge funds are big partnerships that pool money and use a variety of risk and investment management methods in a bid to create trading opportunities. They often borrow or use leverage in an attempt to maximise such opportunities.

In most cases, hedge funds manage money in large endowments and pension funds. Because of the approach and scale of investing, their needs differ from those of individual investors. Therefore, prime brokers over a wider range of services than simply helping their clients execute trades.

Services Offered by Prime Brokers

Prime brokerages offer a wide array of services, including: [3]

1. Borrowing cash or stocks

   1. Prime brokers help hedge funds get cash to maximise trading opportunities. Moreover, they assist them in “short selling” where hedge funds sell stocks they don’t actually own, by borrowing cash or stocks from brokers.

2. Helping clients find investors

   1. Prime brokers can provide “capital introduction” services by setting up meetings and presenting to investors who are looking to invest in funds.

3. Access to relevant research

   1. Prime brokerages typically have access to extensive research, allowing them to churn out reports on just about anything fund managers may need. In most cases, brokers will make the research available to all their fund manager clients.

4. Serving as Custodians

   1. In addition to making financial reporting much easier, being a custodian to a fund’s assets also allows prime brokers to move swiftly on trades.

5. Staying Up-to-Date with Regulatory Issues

   1. The complex regulatory environment surrounding finance can make it quite difficult for hedge funds to stay up-to-date with changes in rules. Prime brokers have the resources to stay in the know of every change in the industry, putting them in a better position to serve as their clients’ advisors.

6. Providing Other Caretaker Services

   1. Some prime brokers offer other services, such as lines of credit and performance analytics reports. Some may even offer newer clients help with other tasks, such as staff training and human resources.
   2. Because prime brokers can benefit in various ways, such as by charging basic custody fees and concierge fees among other services, brokerage units can also make tidy returns for firms. Prime brokers also benefit from the spreads in interest rates between their lending and borrowing operators.

7. Prime Brokerage Credit Risk Management

   1. Prime brokerages typically structure transactions in a way where all the client’s transactions are routed through them. This effectively makes them intermediaries in all transactions. 
   2. For instance, a transaction between a hedge fund and a broker will be structured as two different transactions; one between the hedge fund and the broker, and another between the broker and the prime brokerage. As a result, prime brokerages accumulate considerable credit risk.
   3. However, since most prime brokers are backed by big investment banks, it’s highly unlikely that they will default. Nevertheless, the collapse of investment banks such as Lehman Brokers has exposed flaws in the model. As a result, it is becoming a common trend for investment banks and hedge funds to hedge their bets in a bid to protect their interests from credit risks.

What is Netting?

Netting is a risk management strategy whereby a financial institution or investment bank takes multiple positions that can be combined into one obligation position. This helps reduce risk in situations where investment institutions take on multiple financial contracts.

Remuneration

Prime brokers typically make returns through a variety of ways such as standard fees (retainers), ticket charges, interest, spreads on loans, etc. The different sources of remuneration makes it hard to calculate the real amount being paid to prime brokers. 

However, the reality is that they have become an important part of investment banking as one of the biggest sources of revenue.

References