Prime brokerage
Encyclopedia
Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge fund
s and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return. The business advantage to a hedge fund of using a Prime Broker is that the Prime Broker provides a centralized securities clearing facility for the hedge fund, and the hedge fund's collateral requirements are netted across all deals handled by the Prime Broker.
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/or other services. It also earns money by rehypothecating the margined portfolios of the hedge funds currently serviced and charging interest to those borrowing securities and other investments.
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:
In addition, certain prime brokers provide additional "value-added" services, which may include some or all of the following:
The concept and term "prime brokerage" is generally attributed to the U.S. broker-dealer
Furman Selz in the late 1970s. However, the first hedge fund operation is attributed to Alfred Winslow Jones
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
brokerage firms such as Morgan Stanley
, Bear Stearns
, Merrill Lynch
, Credit Suisse
, and Goldman Sachs
. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domestic long-short equities funds
. The first non-U.S. prime brokerage business was created by Merrill Lynch's London office in the late 1980s. Post the 2007 - 09 financial crisis new entrants came to the market, such as HSBC
with a custody-based prime brokerage offering.
-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 have proliferated globally through the 1990s and the current decade, prime brokerage has become 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 two billion dollars in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).
Restructuring transactions in 2008 included the absorption of Bear Stearns
into JP Morgan, the acquisition of the assets of Lehman Brothers
in the US by Barclays, the acquisition of Merrill Lynch
by Bank of America, and the acquisition of certain Lehman Brothers assets in Europe and Asia by Nomura
. Counterparty 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.
Upon Lehman's collapse, investors realized that no prime broker was too big to fail and spread their counterparty risk 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.
), 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
-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.
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
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:
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return. The business advantage to a hedge fund of using a Prime Broker is that the Prime Broker provides a centralized securities clearing facility for the hedge fund, and the hedge fund's collateral requirements are netted across all deals handled by the Prime Broker.
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/or other services. It also earns money by rehypothecating the margined portfolios of the hedge funds currently serviced and charging interest to 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 custodyCustodian bankA Custodian bank, or simply custodian, is a specialized financial institution responsible for safeguarding a firm's or individual's financial assets and is not likely to engage in "traditional" commercial or consumer/retail banking such as mortgage or personal lending, branch banking, personal...
(including clearing, custody, and asset servicing) - Securities lendingSecurities lendingIn finance, securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan will be governed by a "Securities Lending Agreement", which requires that the borrower provides the lender with collateral, in the form of cash, government securities,...
- Financing (to facilitate leverage of client assets)
- Customized technology (provide hedge fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
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 leaseLeaseA lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...
commercial real estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "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; an item of real property; buildings or...
, 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. - Risk ManagementRisk managementRisk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
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-dealer
Broker-dealer
A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers....
Furman Selz in the late 1970s. However, the first hedge fund operation is attributed to Alfred Winslow Jones
Alfred Winslow Jones
Alfred Winslow Jones , a sociologist, author, and financial journalist, is credited with forming the first modern hedge fund and is widely regarded as the father of the hedge fund industry.-Background:...
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
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
brokerage firms such as Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
, Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
, Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
, Credit Suisse
Credit Suisse
The Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:...
, and Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domestic long-short equities funds
Long / short equity
Long/short equity is an investment strategy generally associated with hedge funds, and more recently certain progressive traditional asset managers. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value...
. The first non-U.S. prime brokerage business was created by Merrill Lynch's London office in the late 1980s. Post the 2007 - 09 financial crisis new entrants came to the market, such as HSBC
HSBC
HSBC Holdings plc is a global banking and financial services company headquartered in Canary Wharf, London, United Kingdom. it is the world's second-largest banking and financial services group and second-largest public company according to a composite measure by Forbes magazine...
with a custody-based prime brokerage offering.
1980s and 1990s
Through the 1980s and 1990s, prime brokerage was largely an equitiesStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
-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 have proliferated globally through the 1990s and the current decade, prime brokerage has become 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 two billion dollars in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).
Financial crisis of 2007-09
The financial crisis of 2007-09 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 counterparty exposure away from many of their historic sole or dual prime broker relationships.Restructuring transactions in 2008 included the absorption of Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
into JP Morgan, the acquisition of the assets of Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
in the US by Barclays, the acquisition of Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
by Bank of America, and the acquisition of certain Lehman Brothers assets in Europe and Asia by Nomura
Nomura
Nomura Nomura Nomura (野村 (field village), 埜村 (wilderness field) is a Japanese surname. It can refer to:-Finance:*Nomura Holdings, part of the Nomura Group (also including Nomura Securities Co.)-People:*Don Nomura (born 1957), Japanese-American baseball agent...
. Counterparty 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 declared bankruptcy 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 deleveraging of capital markets during the Financial Crisis of 2008.Upon Lehman's collapse, investors realized that no prime broker was too big to fail and spread their counterparty risk 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 differenceContract for difference
In finance, a contract for difference is a contract between two parties, typically described as "buyer" and "seller", stipulating that the buyer will pay to the seller the difference between the current value of an asset and its value at contract time...
), 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
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
-oriented will generally produce less prime brokerage revenue, but may still present significant economic opportunity in the repo
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
, 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
Stress testing is a form of testing that is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results...
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 MarginPortfolio marginPortfolio margin is a risk-based margin policy. Portfolio margin usually results in significantly lower margin requirements on hedged positions than under traditional rules...
Margin methodologies
- House Methodologies
- Rules-Based
- Stress Tests
- Risk Based Haircuts (RBH)
- Self-regulatory Organizations
- Portfolio marginPortfolio marginPortfolio margin is a risk-based margin policy. Portfolio margin usually results in significantly lower margin requirements on hedged positions than under traditional rules...
- Portfolio margin
- US Regulatory
- Regulation TRegulation TFederal Reserve Board Regulation T is 12 CFR §220 - Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 ....
- Special memorandum accountSpecial Memorandum AccountSMA is a margin credit account used for calculating US Regulation T requirements on brokerage accounts. In addition to Initial Margin and Maintenance Margin requirements, the SMA ledger is used to lock in unrealized gains that augment the clients buying power....
- Arranged Financing
- Regulation T