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 listed as under:
Services Offered by Prime Brokerage
The significant advantage of prime brokerage is that these hedge funds can get a suite of services right under one umbrella, which are listed as below:
#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
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#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 sell. 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, bonds, options, 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 fund to enable it to facilitate all trades be it in securities like equity, fixed income securities 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
The prime brokerages also do provide administrative services to the hedge funds so as to reconcile their books on a daily basis and strike a daily NAV (Net Asset Value) 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 take 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 bonds, that were hitherto unknown.
#8 – Authorization to Securitize
When a bank realizes that it has too many toxic assets in its balance sheet 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 accounts and also facilitate clearing and settlements for the hedge funds and other clients
Limitations of Prime Brokerage
- Misuse of Created Products – The prime brokers are bestowed with the ability to create exotic derivative products like credit default swaps and collateralized debt obligations (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 worth, 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 the financial institutions such as hedge funds and other huge traders. These financial institutions help to create better efficiencies in the markets and prime brokerages play an important role in facilitating them.
- However such prime 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 smooth flow of trade, capital, and money between institutions thereby ensuring greater efficiency in the market as a whole.
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