Definition of Prime brokerage accounting
Prime brokerage accounting refers to dealing with a bunch of services that financial institutions and investment banks offer to large investment clients, private equity firms, wealthy investors and hedge fund that require borrowing of cash or securities to engage in netting for absolute returns.
The services covered under prime brokerage accounting are leveraged trade execution, cash management and securities lending. These services were, therefore, provided by large financial firms like UBS, Credit Suisse, Morgan Stanley and Goldman Sachs(or the prime broker).
Prime Brokerage Services
- Find new investors: Prime brokerage offers capital introduction services. This is done by setting up meetings and making presentations to those who wish to invest in a fund.
- Borrowing cash: Prime brokers aid in amplifying returns by assisting hedge funds to get extra cash and also in short selling. Where investors sell the stocks that they don’t own by borrowing them from the prime broker.
- Serve as a custodian: Prime broker moves faster on trades by having custody of the fund’s assets. It also makes financial reporting easier.
- Access to research: The brokers have departments for research that can nearly find out any data or report required by the fund managers. In a few cases, prime brokers make research available to funds simply for the customer.
- Other services: Some niche services may also be provided depending on the prime broker like lines of credit, performance analytics reports etc. Newer funds get help for administrative tasks like employee training and human resources.
- Aware of regulatory issues: Prime brokerage serves as an advisory body with the complex regulatory environment around finance. Also, the hedge fund cannot update itself with every change in rules due to the lack of resources.
Features of prime brokerage
- Unlike the individuals who sell or buy securities with basic assistance or research reports. Prime brokerage accounting enters when someone needs special services for a large sum of money, is short stocks, and wishes to make money even in down markets etc.
- Offered to hedge funds and similar clients, prime brokerage accounting refers to a group of services by banks and financial institutions which can be complex.
- Hedge fund access aid from the services provided by the prime brokerage accounting like finding new investors, research, borrowing cash and securities etc.
- This accounting process helps large institutions to get a mechanism. That allows them to outsource their investment activities and attain a focus on investment strategy and goals.
- The prime broker needs the minimum account size of the financial institutions to transact with different fees and requirements.
Working of Prime Brokerage accounting
Before understanding prime brokerage, we must take a brief look at the concept of a hedge fund. Regarding services they require and what they do:
A hedge fund is a partnership that together pools money. It uses different investing or risk management methods to earn high returns even though the market is falling. As a result, it often uses borrowing or leverage to boost returns.
Hedge fund manages money from large endowments or pension funds which signifies a higher scale of investing and makes it different from the general investor. As a result, prime brokerage accounting counts more aid to hedge funds rather than simply executing trades.
Regulation in Prime Brokerage Accounting
This must be noted that prime brokerage accounting is virtually unregulated across the globe. Although, The United States has some regulations. The prime broker cannot operate an account unless it has $500000 in the case of individual equity or $1000000 in the case of an organisation. Moreover, the regulation is weak and there are loopholes found by the market participants.
Since there can be any kind of averse regulation in financial market participants, therefore, many hedge funds have shifted their business to offshore locations. For example, Morgan Stanley is the first to start a prime brokerage desk.
Hedge Fund
A hedge fund in prime brokerage accounting refers to the pool/vehicle of investment structure by a registered investment advisor or a money manager and designs to receive a return. The structure briefly recognizes a limited liability company or limited partnership. They are complex and heavily diversified.
It holds both short and long stocks because of which the risk management reduces. As a result, investors make money despite market fluctuations. The funds however serve rich investors due to the fees charged and higher risks involved as compared to other investments.
Also, a hedge fund is not necessary to get registered with SEBI (Securities and Exchange Board of India), with our market regulators or disclose NAVs during the day end. Whereas, the other mutual funds follow the regulatory requirements.
How does a hedge fund work?
Hedge fund (under prime brokerage accounting) invests in debt, bonds, real estate, currencies, convertible securities, derivatives (futures and options) equities because of which they use different types of trading techniques. There are different hedge funds relying on the kind of strategies used to manage them and on the securities they invest in.
For example, to trade with debt and equity share, the trading technique can be to operate in the stock market or purchase directly in a private placement from the company. However, in the case of derivatives with futures, there lies an obligation to purchase or sell an underlying stock at a predetermined rate. Whereas, with options, the scenario remains the same just without an obligation. As a result, securities investment of such kind diversifies trading methods.
Types of Hedge Fund
There are 3 types of the hedge fund in prime brokerage accounting:
- Fund of funds: These are majorly the mutual funds that invest in another hedge fund rather than individual securities.
- Offshore hedge fund: Preferably established in a low-taxation country, an offshore hedge fund is formulated outside our own country.
- Domestic hedge fund: As the name suggests, a domestic hedge fund is only open for investors that are subject to the taxation of the origin’s country.
Different Strategies for investing Hedge Funds
A hedge fund can also be differentiated by the strategies adopted by its fund managers to maintain funds which sometimes makes it higher on the risk management rack.
- Market neutral: Market-neutral funds often seek to minimize market risks. Moreover, it includes long and short equity funds, convertible bonds and fixed-income arbitrage.
- Event-driven: It refers to the situation where investment is done to take advantage of corporate events’ price movements. For example, distressed asset funds and merger arbitrage funds
- Arbitrage: The word defines purchasing security from the security market trading at a low price and selling it in a higher price market for some profit. However, exchanging very highly correlated securities( asset class or multiple ones) simultaneously when markets move sideways for some profits is known as relative value arbitrage.
- Short/Long selling: By literal meaning, short selling refers to the selling of security without actually buying it but with a notion to purchase it at a predetermined future price and date. The investor expects the share price to drop on the future date and book profits.
- Market-driven: These funds also advantage of global market trends. Hedge fund under prime brokerage accounting notes the global macros and the way it impacts equities, interest rates, currencies and commodities.
Note: The fees include profit sharing ( varying from 10-15%) and management fees, generally less than 2%. The minimum amount to invest in a hedge fund is 1 crore per investor while the entire fund has to be at least a corpus of 20 crores.
Prime Brokers
A prime broker commonly an investment company or large bank provides a variety of services to hedge funds. They can be related to operational support, clearing, risk management and settlement of transactions. Moreover, an operational office, a trading office, a brokerage company or a managing company. That helps to resolve various tasks are also termed as a prime broker.
The prime broker act as an intermediary between a hedge fund and two counterparties ( the first being large investors and the second the commercial banks). The prime broker enables hedge funds to borrow bonds and stocks from large investors to engage in large-scale short selling. Moreover, they maximize hedge fund investments through leverage by receiving margins from commercial banks. Also, the prime broker makes money by fee like, in return for providing transactions, they obtain a premium on the loan from commercial banks (noted in prime brokerage accounting) or rehypothecation.
Services provided by prime brokers
Although the services under prime brokerage accounting are provided by the prime broker themselves with no difference. But there can be majorly 3 services;
- Funding: The prime broker virtually provides access to an unlimited pool of money for reasonable interest rates at short notice. The leverage ratios can commonly reach 10:1 while the prime broker comfortably provides these risk management services at reasonable fees.
- Settlements: The hedge funds have high open positions where assets can be replaced frequently. As a result, the clearing and settlement procedure of the trades needs to be precise and efficient. For which the hedge funds do not have an infrastructure. Therefore, the prime broker enters into the image and provide value-added services.
- Reporting: the varied and large portfolios of hedge funds need specialists to provide information to the decision-makers. Along with this, there needs to be accuracy and speed since the decisions are made quickly. As a result, the prime brokers help with reporting and retaining their clients.
Selection of a prime broker
A prime broker not only plays the role of a vendor. As a result, the hedge fund becomes choosy while its selection. They are business partners whose inaction or actions can lead to great consequences.
- Hedge fund notes the prime broker access to end technologies. This happens because the hedge fund does not have a back office on its own.
- The prime broker’s financial position is also verified. This step becomes important since hedge funds do not want to miss trades due to the broker’s cash strap. Moreover, the inability to finance them at a moment’s notice.
- The prime brokers offering the highest loan to a hedge fund to value ratios prefer. This states that prime brokers on minimum collateral can give out maximum loans to hedge funds.
However, there are other factors also which count in the selection of a prime broker. But the major and corresponding hedge fund prevails above.