What is Prime Brokerage?
Prime brokerage is referred generally to the suite of services that financial institutions such as investment banks offer to clients, usually with more complex financial needs like securities lending, custodian services, cash management, leveraged trade executions. Most commonly, such services are by Investment banks to hedge funds.
Examples of Prime Brokerages
Some of the examples of prime brokers in the financial industry are as under:
- Goldman Sachs
- Morgan Stanley
- UBS
- Bank of America Merril Lynch
- Credit Suisse
- Deutsche Bank
- JP Morgan Chase
- Barclays
- Nomura
- HSBC
- Citi
Services Offered by Prime Brokerage
#1 – Securities Lending
A financial institute may desire to go short on a particular society (meaning to sell the security) but realizes it does not own it. It is in such instances that a prime brokerage serves to create efficiency in the market by lending stocks or shares that the client wants to go short on. This will facilitate efficiency in the markets
#2 – Rebate Income
Similarly, it may also borrow securities from a hedge fund and lend to other clients in need, who would want to short sellShort SellShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more. Thus this mechanism helps the clients to have rebate income on the securities they have lent by capitalizing on the spreads
#3 – Custodian Services
A prime broker may also take custody of all the securities that the client owns, be it equity, bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more, optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more, futures, swaps, etc. A systematic count of all securities are maintained and provided through reports to the clients on a daily basis
#4 – Trading Services
A prime broker may act as an intermediary to the client or hedge fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more to enable it to facilitate all trades, be it in securities like equity, fixed income securitiesFixed Income SecuritiesFixed income investment is a type of investment in which the investor receives a fixed and relatively stable stream of income in the form of dividends or interest over a period of time. Companies and governments typically issue fixed investments in the form of debt securities.read more like bonds, exotic derivatives like credit default swaps, etc. Thus they act as the intermediary to ensure the smooth facilitation of trades between the client and the other counterparty
#5 – Administrative Services
They also provide administrative services to the hedge funds so as to reconcile their books on a daily basis and strike a daily NAV (Net Asset ValueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity's liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more) for these hedge funds. Thus they stand as accountable bodies for all of the assets held by the firm, thereby ensuring that there is no fraudulent basis for any trades and for reporting of numbers and values.
#6 – Analytical Services
Within the houses of the prime brokers, they tend to provide ancillary services to clients, such as analytical services. They tend to record the performance attribution and then give a classification of exposure, be it in products like equities, stocks, FX, etc. They also perform various statistical runs and scenario stimulations so as to enable the client to gauge and access the exposure of the portfolios and thus thereby make the right decision.
#7 – Ability to Create Products
Suppose a hedge fund manager spots a new opportunity but lacks the financial product in the market to capitalize on the opportunity, it is the prime brokers that tend to fill in the void by engineering the product desired by the clients. Periods before the housing bubble of 2008, few hedge fund managers wanted to purchase a credit default swap on the securitized bonds with underlying mortgages. It is the prime brokers or investment banks that went on to create such exotic products like CDS (Credit Default Swaps) on the mortgage bondsMortgage BondsA mortgage bond refers to a debt instrument backed by mortgaged assets such as equipment or real estate such as property, building, etc. It is a secured bond since the bondholders can recover their funds by selling the underlying collateral.read more that were hitherto unknown.
#8 – Authorization to Securitize
When a bank realizes that it has too many toxic assets in its balance sheetIts Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, it approaches a prime broker to help it take it off by converting them into securities, through the securitization process, that can now be traded. Thus there is now a whole new market for such loans and is now off the books of the banks.
#9 – Cash and Trade Settlement Services
The prime brokers also provide certain cash holding and also facilitate clearing accounts and settlements for the hedge funds and other clients
Limitations
- Misuse of Created Products – The prime brokers, are bestowed with the ability to create exotic derivative products like credit default swaps and collateralized debt obligationsCollateralized Debt ObligationsCollateralized debt obligation (CDO) refers to a finance product offered by the banks to the institutional investors. Such tranches have a complex structure and derive their value from the various underlying assets like loans, mortgages and corporate bonds, which also serve as collaterals in case of default.read more (CDOs). However, during the housing bubble of 2008, these products were quite misused and miss-sold excessively by prime brokerages and investment banks. It is when the defaults rose; these banks faced a liquidity crunch.
- Serve only Large Clients – These prime brokerages go on to take on only large clients such as hedge funds with sufficient net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more, for all of its suite of services, whereas small trading and investment business may not be able to deal directly with such prime brokers.
Important Points
- Deutsche Bank had announced that they would be closing down their trading business, and this may involve job cuts of around 18000
Conclusion
- Prime brokerage serves as an important financial intermediary by providing trading, custodian, settlement, and investment services to financial institutions such as hedge funds and other huge traders. These financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more help to create better efficiencies in the markets, and prime brokerages play an important role in facilitating them.
- However, such brokerages have been allegedly responsible for the fall of the economy owing to exotic products and moral hazards that used to exist in the financial services industry. Several checks and regulations are now in place to ensure the activities are monitored.
- Nonetheless, these prime brokerages play an important role in creating a market that would ensure a smooth flow of trade, capital, and money between institutions, thereby ensuring greater efficiency in the market as a whole.
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