Definition of a prime broker
Prime broker can be explained by referring to it as an investment company or large bank that provides a variety of services to hedge funds relating 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 is also termed a prime broker. It acts 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, they makes money by a fee in return for providing a transaction, they obtain a premium on the loan from commercial banks or rehypothecation.
Role of a Prime Broker
It has a role to facilitate investment on behalf of a hedge fund with capital borrowed against the hedge fund. Prime brokers enable greater visibility on performance as all are settled via a prime broker.
As a result, their responsibilities depend upon what is right for clients and the hedge fund. Responsibilities of a prime broker include the following:
- Client Services
- Clearing and giving up services
- Risk management and financing
- Capital introduction
- Hedge fund consulting services
- Bank credit lines
- Online and voice trade execution
- Reporting and portfolio technology
- Research and market timing advice
- Securities lending
Prime brokerage agreement
A prime brokerage agreement depicts a contract between a large client (like hedge funds) and an investment bank or prime brokers. The bank provides services as mentioned above to the client in exchange for fees through this agreement.
This offer is not available to all investors. Large clients need a wide spectrum for their financial services and therefore, at this moment the prime brokerage agreement becomes a part.
Who offers prime brokerage services?
Counting the depth of prime brokerage services, there is not a variety of companies that provide them. They are the domain of big investment banks. They like to get paid for everything, and as a result, companies charge clients pricey rates.
The high-profile players in this field have well-established names in the world of finance. Following are a few financiers that provide prime brokerage services (along with traditional brokerage services for individuals):
- Bank of America Merrill Lynch
- Morgan Stanley
- Charles Schwab
- Goldman Sachs
- Citigroup (owner of Citibank)
- J.P. Morgan (part of JPMorgan Chase)
Services by Prime Broker Account
Although the services under prime brokerage accounting are provided by them themselves with no difference. But there can be other services as well;
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 they comfortably provide these risk management services at reasonable fees.
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 account enters into the image and provides value-added services.
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, they helps with reporting and retaining their client.
Online and trade execution:
Prime broker experience dealers for managing online trade with more complex order brokerage services. they provide clients with dedicated lines an online trading platform as well as the facility over the phones to execute orders(voice dealing).
Clearing gives up services:
Their clients may spread across multiple execution brokers and trade through small brokers, then they have to give up to the main clearing prime broker to exercise execution anonymity.
When traders and hedge funds hold short positions, the underlying shares are required to be borrowed. As a result, prime broker securities lending departments enable clients to directly borrow from the prime broker to reduce the risk of holding a long-term short-position and financing costs.
Prime broker has a client services department for back-offline support to handle clearing issues, general account management, and complex corporate actions.
Risk management and financing:
Clients could manage cross-exchange positions with SPAN margin facilities to ensure minimum margin requirements on offset positions and hedged funds with portfolio risk management.
Reporting and portfolio technology:
A hedge fund might outsource regulatory processes and compliance needed to run a hedge fund to its prime broker through risk management technology and consultancy services.
Prime brokers’ main value is their network of clients. As a result, hedge funds take advantage of their network to generate new business, and increase visibility and inflow of capital.
Fees from a prime broker
Prime broker does not charge fees for package bundled services that they provide to hedge funds. As a result, revenues are derived from three sources i.e trading commissions, spreads on financing including the stock loan, and fees for the settlement of transactions operated away from them.
The lending and financing spreads, charged in basis points on the value of client deposits(credit balances), client loans(debit balances), synthetic financings products like CFDs(contract of difference) or swaps, and client short sales(short balances) holds a large majority of their revenue.
Moreover, it must be noted that clients who choose short selling or leverage showcase more lucrative opportunities than clients who undertake less short selling or utilize minimum leverage.
As a result, the clients having fixed income-oriented market activities produce less of their revenue. However, they might present economic opportunities in the foreign exchange futures, repo, and flow business areas of an investment bank.
Selection of a prime broker
A prime broker not only plays the role of a vendor but of which the hedge fund becomes choosy while its selection. They are business partners whose inaction or actions can lead to great consequences.
- Hedge funds note their access to end technologies 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 or inability to finance them at a moment’s notice.
- The prime broker offering the highest loan to a hedge fund to value ratios are preferred. 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 prime brokers (under prime brokerage accounting) but the major and corresponding hedge funds are mentioned above.
Prime Brokers List
They splits by asset and size class. The large prime broker only accepts large clients. As a result, start-ups and smaller hedge funds, traders, and brokers should use a specific type of prime brokers list appropriate to their kind of trading which are as follows:
Mini Prime Broker
Firstly discussing from the prime broker’s list, mini brokers accept small institutional accounts. This kind is useful for start-ups and new hedge funds. A client can switch to a mini prime brokers list that offers the type of investment that the investor needs for the hedge fund.
Boutique Prime Broker
Prime brokers list, for the second category, provide reading infrastructure and operational framework for start-up or small hedge funds that become too small for tier 1 prime broker. They have direct relationships with large prime brokers and resell services on a wholesale basis to their clients.
Start-up hedge funds
The top-tier prime broker’s list might shut down all their smaller accounts. As a result, start-up hedge funds need a mini broker or mid-tier prime broker. Therefore, they finder tool helps to find the top prime broker list for the client’s investment strategy.
Small hedge funds
There is a best prime broker list for small to medium-sized hedge funds that assist the client’s trading and fund strategy including regulatory umbrellas, analysis, outsourced back-office systems, custodian services, and research.
Prime of prime brokers
Prime of prime broker explains retail brokers with market access. This concept is common with forex platforms and CFD. Where they provides the platform, administration of accounts, and liquidity back office, and forex brokers act as marketing matching.
There is often a misunderstanding between various brokers and prime brokers. Therefore here are a few comparisons to give a clear image:
Prime broker vs Executing broker
In the concept of prime broker vs executing broker, the executing broker deal with large institutional clients. This kind of broker submits the order on behalf of the client. In brief, it takes care of trading, and carrying out the order.
The hedge fund managers work with the prime brokerage house as prime brokers. That offers to consolidate services whereas executing brokers buy or sell with them. Executing brokers earn from commissions or conflicts of interest that occur from time to time.
Therefore in prime broker vs executing broker, where they deals with trading on the other hand executing ones for clearing.
Prime Broker vs Custodian
In the case of prime broker vs custodian, also termed as custody provider, keeps possession of the assets according to pilotage. It acts as a safe box to which only they have access but only with the client’s express consent.
At the time when stock certificates were printed on paper, the custodians used to store them. However, today almost everything is stored and handled electronically. When the client sells a stock, for prime broker vs custodian transfers electronic entry depicting stock certificates to the buyer account and accepts cash on the client’s behalf from the seller.
Prime broker vs broker
Comparing prime broker v/s broker, the broker is an independent party who serves different industries. Their key responsibility is to bring buyers and sellers together where the broker acts as a third-person facilitator between them.
An example can be a stockbroker and real estate who facilitates the sale of a property. They can furnish market data and research.
In prime broker v/s broker, he is expected to have the resources and tools to reach the largest possible base of sellers and buyers. Then they screen this potential research for a perfect match. Moreover, an individual producer will not have access to customers as brokers do. Another benefit that counts is that they are cheaper in smaller markets with a limited line of products and smaller accounts.
Synthetic Prime brokerage
The prime broker’s traditional service that they provide to hedge funds is the provision of leverage or loans extended to hedge funds to pursue their investing activities and enhance returns.
One common form is margin loan while another strategy through which hedge funds obtain leverage is by the use of OTC services( over the counter) including total return swaps(TRS). Usually, in such forms, the prime brokers pay hedge funds the total return on a reference asset(for example capital gains, dividends, etc).
While the hedge funds give their fees, interest on any embedded leverage, and capital losses. Therefore, the prime broker hedges its position by purchasing a reference asset. So. synthetic prime brokerage, is a means of institutionalizing the TRS-based delivery of leverage hedge funds from prime brokers.
The overall explanation gives us an idea of what is prime broker, an intermediary between hedge funds and two counterparties that provides a variety of additional services discussed. Moreover, there is a difference between custodian, executing, and prime broker. Where only a few players are providing these services in the market by using a prime brokerage agreement.
Frequently Asked Questions (FAQs)
what is prime brokerage?
A prime brokerage is a bundled group of services that investment banks and other financial institutions offer to hedge funds and other large investment clients that need to be able to borrow securities or cash in order to engage in netting to achieve absolute returns.
what is a prime brokers?
The role served by a prime brokerage is that of facilitating large, active trading operations such as hedge funds.