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Prime brokerage is the generic name for a bundled package of services offered by
investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance Finance is a term for the management, creati ...
s, wealth management firms, and securities dealers to
hedge fund A hedge fund is a pooled investment fund Image:Financial info.jpg, The values and performance of collective funds are listed in newspapers. An investment fund is a way of investment, investing money alongside other investors in order to benefit ...
s which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an
absolute return The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective "absolute" is used to stress the distinction with the relative return measures often used ...
. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients. The prime broker benefits by earning fees ("spreads") on financing the client's margined long and short cash and security positions, and by charging, in some cases, fees for clearing and other services. It also earns money by rehypothecating the margined portfolios of the hedge funds currently serviced and charging interest on those borrowing securities and other investments.


Services

Each client in the market of a prime broker will have certain technological needs related to the management of its portfolio. These can be as simple as daily statements or as complicated as real-time portfolio reporting, and the client must work closely with the prime broker to ensure that its needs are met. Certain prime brokers offer more specialized services to certain clients. For example, a prime broker may also be in the business of leasing office space to hedge funds, as well as including on-site services as part of the arrangement. Risk management and consulting services may be among these, especially if the hedge fund has just started operations. The following services are typically bundled into the Prime Brokerage package: * Global custody (including clearing, custody, and asset servicing) *
Securities lending In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available ...
*
Financing Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm uses ...
(to facilitate leverage of client assets) *Customized technology (provide
hedge fund A hedge fund is a pooled investment fund Image:Financial info.jpg, The values and performance of collective funds are listed in newspapers. An investment fund is a way of investment, investing money alongside other investors in order to benefit ...
managers with portfolio reporting needed to effectively manage money) *Operational support (prime brokers act as a hedge fund's primary operations contact with all other broker dealers) In addition, certain prime brokers provide additional "value-added" services, which may include some or all of the following: * Capital Introduction – A process whereby the prime broker attempts to introduce its hedge fund clients to qualified hedge fund investors who have an interest in exploring new opportunities to make hedge fund investments. *Office Space Leasing and Servicing – Certain prime brokers
lease A lease is a contractual arrangement calling for the user (referred to as the ''lessee'') to pay the owner (the Lessor (leasing), ''lessor'') for use of an asset. Property, buildings and vehicles are common assets that are leased. Industrial o ...

lease
commercial
real estate Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more genera ...

real estate
, and then sublease blocks of space to hedge fund tenants. These prime brokers typically provide a suite of on-site services for clients who utilize their space. This is typically called a "hedge fund hotel". *
Risk Management Risk management is the identification, evaluation, and prioritization of risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty Uncertainty refers to Epistemology, epistemic situations involving ...

Risk Management
Advisory Services – The provision of risk analytic technology, sometimes supplemented by consulting by senior risk professionals. *Consulting Services – A range of consulting / advisory services, typically provided to "start-up" hedge funds, and focused on issues associated with regulatory establishment requirements in the jurisdiction where the hedge fund manager will be resident, as well as in the jurisdiction(s) where the fund itself will be domiciled.


History

The basic services offered by a prime broker give a money manager the ability to trade with multiple brokerage houses while maintaining, in a centralized master account at their prime broker, all of the hedge fund's cash and securities. Additionally, the prime broker offers stock loan services, portfolio reporting, consolidated cash management and other services. Fundamentally, the advent of the prime broker freed the money manager from the more time consuming and expensive aspects of running a fund. These services worked because they also allowed the money manager to maintain relationships with multiple brokerage houses for IPO allocations, research, best execution, conference access and other products. The concept and term "prime brokerage" is generally attributed to the U.S.
broker-dealerIn financial services Financial services are the economic services provided by the finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation a ...
Furman Selz in the late 1970s. However, the first hedge fund operation is attributed to
Alfred Winslow Jones Alfred Winslow Jones (9 September 1900 – 2 June 1989) was an Australians, Australian investor, Hedge fund, hedge fund manager, and sociologist. He is credited with forming the first modern hedge fund and is widely regarded as the "father of the h ...
in 1949. In the pre-prime brokerage marketplace, portfolio management was a significant challenge; money managers had to keep track of all of their own trades, consolidate their positions and calculate their performance regardless of which brokerage firms executed those trades or maintained those positions. The concept was immediately seen to be successful, and was quickly copied by the dominant
bulge bracket The group of bulge bracket banks comprises the world's largest multi-national investment banks An investment bank is a financial services Financial services are the Service (economics), economic services provided by the finance industry, which ...
brokerage firms such as
Morgan Stanley Morgan Stanley is an American multinational investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effo ...
,
Bear Stearns The Bear Stearns Companies, Inc. was a New York-based global investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, ...

Bear Stearns
,
Merrill Lynch Merrill (officially Merrill Lynch, Pierce, Fenner & Smith Incorporated), previously branded Merrill Lynch, is an American investment management Investment management is the professional asset management Asset management refers to a system ...
,
Credit Suisse Credit Suisse Group AG is a global investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In f ...

Credit Suisse
,
Citigroup Citigroup Inc. or Citi (stylized File:Les Demoiselles d'Avignon.jpg, ''Les Demoiselles d'Avignon'' (1907), also by Picasso in a different style ("Picasso's African Period") four years later.In the visual arts, style is a "...distinctive mann ...

Citigroup
, and
Goldman Sachs The Goldman Sachs Group, Inc. () is an American multinational investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as tim ...

Goldman Sachs
. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domestic
Long / short equity Long/short equity is an investment strategy generally associated with hedge funds. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. This is different from the ris ...
funds. The first non-U.S. prime brokerage business was created by Merrill Lynch's London office in the late 1980s. After the
financial crisis of 2007–2008 The financial crisis of 2007–2008, or global financial crisis (GFC), was a severe worldwide economic crisis An economy (from Greek οίκος – "household" and νέμoμαι – "manage") is an area of the production, distribution and ...
, new entrants came to the market with custody-based prime brokerage offerings.


1980s to 2000s

Through the 1980s and 1990s, prime brokerage was largely an
equities In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities i ...

equities
-based product, although various prime brokers did supplement their core equities capabilities with basic bond clearing and custody. In addition, prime brokers supplemented their operational function by providing portfolio reporting; initially by messenger, then by fax and today over the web. Over the years, prime brokers have expanded their product and service offerings to include some or all of the full range of fixed income and derivative products, as well as foreign exchange and futures products. As hedge funds proliferated globally through the 1990s and the 2000s, prime brokerage became an increasingly competitive field and an important contributor to the overall profitability of the investment banking business. As of 2006, the most successful investment banks each report over US$2 billion in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).


Financial crisis of 2007–08

The
financial crisis of 2007–2008 The financial crisis of 2007–2008, or global financial crisis (GFC), was a severe worldwide economic crisis An economy (from Greek οίκος – "household" and νέμoμαι – "manage") is an area of the production, distribution and ...
brought substantial change to the marketplace for prime brokerage services, as numerous brokers and banks restructured, and customers, worried about their credit risk to their prime brokers, sought to diversify their counter-party exposure away from many of their historic sole or dual prime broker relationships. Restructuring transactions in 2008 included the absorption of
Bear Stearns The Bear Stearns Companies, Inc. was a New York-based global investment bank Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, ...

Bear Stearns
into JP Morgan, the acquisition of the assets of
Lehman Brothers Lehman Brothers Holdings Inc. () was a global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank Investment is the dedication of an asset to attain an increase in val ...

Lehman Brothers
in the US by
Barclays Barclays plc () is a British multinational Investment banking, investment bank and financial services company, headquartered in London, England. Apart from investment banking, Barclays is organised into four core businesses: Retail banking, pe ...

Barclays
, the acquisition of
Merrill Lynch Merrill (officially Merrill Lynch, Pierce, Fenner & Smith Incorporated), previously branded Merrill Lynch, is an American investment management Investment management is the professional asset management Asset management refers to a system ...
by Bank of America, and the acquisition of certain Lehman Brothers assets in Europe and Asia by Nomura. Counter-party diversification saw the largest flows of client assets out of Morgan Stanley and Goldman Sachs (the two firms who had historically had the largest share of the business, and therefore had the most exposure to the diversification process), and into firms which were perceived, at the time, to be the most creditworthy. The banks which captured these flows to the greatest degree were Credit Suisse, JP Morgan, and Deutsche Bank. During these market changes, HSBC launched a prime brokerage business in 2009 called "HSBC Prime Services", which built its prime brokerage platform out of its custody business.


Counterparty risks

The prime brokerage landscape has dramatically changed since the collapse of Lehman Brothers in September 2008. Hedge funds who received margin financing from Lehman Brothers could not withdraw their collateral when Lehman filed for
Chapter 11 Chapter 11 of the United States Bankruptcy Code ( Title 11 of the United States Code The Code of Laws of the United States of America (variously abbreviated to Code of Laws of the United States, United States Code, U.S. Code, U.S.C., or USC) ...
bankruptcy protection Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debt ...
due to a lack of asset protection rules (such as 15c3 in the United States) in the United Kingdom. This was one of many factors that led to the massive
deleveragingAt the microeconomics, micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leverage (financ ...
of capital markets during the
financial crisis of 2007–2008 The financial crisis of 2007–2008, or global financial crisis (GFC), was a severe worldwide economic crisis An economy (from Greek οίκος – "household" and νέμoμαι – "manage") is an area of the production, distribution and ...
. Upon Lehman's collapse, investors realized that no prime broker was too big to fail and spread their
counterparty risk A credit risk is risk of default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
across several prime brokerages, especially those with strong capital reserves. This trend towards multi-prime brokerage is also not without its problems. From an operational standpoint, it is adding some complexity and hedge funds have to invest in technologies and extra resources to manage the different relationships. Also, from the investors' point of view, the multi-prime brokerage is adding some complexity to the due diligence as it becomes very complicated to perform proper assets reconciliation between the fund's administrator and its counterparties.


Fees

Prime brokers do not charge a fee for the bundled package of services they provide to hedge funds. Rather, revenues are typically derived from three sources: spreads on financing (including stock loan), trading commissions and fees for the settlement of transactions done away from the prime broker. The financing and lending spreads, which are charged in basis points on the value of client loans (debit balances), client deposits (credit balances), client short sales (short balances), and synthetic financing products such as swaps and CFDs (
Contract for difference In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...

Contract for difference
), make up the vast majority of prime brokerage revenue. Therefore, clients who undertake substantial short selling or leverage represent more lucrative opportunity than clients who do less short selling and/or utilize minimal leverage. Clients whose market activities are principally
fixed income Fixed income refers to any type of investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance ...
-oriented will generally produce less prime brokerage revenue, but may still present significant economic opportunity in the repo, foreign exchange (fx), futures, and flow business areas of the investment bank.


Risks

Prime Brokers facilitate hedge fund leverage, primarily through loans secured by the long positions of their clients. In this regard, the Prime Broker is exposed to the risk of loss in the event that the value of collateral held as security declines below the loan value, and the client is unable to repay the deficit. Other forms of risk inherent in Prime Brokerage include operational risk and reputational risk. Large prime brokerage firms today typically monitor the risk within client portfolios through house-designed "risk based" margin methodologies that consider the worst case loss of a portfolio based on liquidity, concentration, ownership, macroeconomic, investing strategies, and other risks of the portfolio. These risk scenarios usually involve a defined set of stress test scenarios, rules allowing risk offsets between the theoretical profit and losses (P&Ls) of these stress test scenarios for products of a common underlier, and offsets between groups of theoretical P&Ls based on correlations. Liquidity penalties may be established using a rule-of-thumb for days-to-liquidate that 10% of the daily trading volume can be liquidated without overdue influence on the price. Therefore, a position 1x the daily trading volume would be assumed to take 10 business days to liquidate.
Stress testing Stress testing (sometimes called torture testing) is a form of deliberately intense or thorough testing used to determine the stability of a given system, critical infrastructure or entity. It involves testing beyond normal operational capacity, of ...
entails running a series of what-if scenarios that identify the theoretical profits or losses for each position due to adverse market events. Examples of stress test scenarios include: * Flight to Quality * 3%–15% up or down price movements used in Portfolio margin


Margin methodologies

* House Methodologies ** Rules-Based ** Stress Tests ** Risk Based Haircuts (RBH) * Self-regulatory Organizations ** Portfolio margin * US Regulatory **
Regulation TFederal Reserve Board Regulation T (also referred to as Reg T) is 12 CFR §220 – Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 (Credit by Brokers and Dealers). Regulation T governs the extension of credit by securitie ...
** Special memorandum account ** Arranged Financing


See also

*
Securities market participants (United States) Securities market participants in the United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It c ...


References

{{DEFAULTSORT:Prime Brokerage Brokerage firms