History of Prime Brokerage

The growth in the number of hedge funds as well as the scale of their operations quickly created the need for a special kind of intermediary that would cater to their needs. This intermediary was the “prime broker”. The prime brokerage business quickly caught the attention of many investment banks as it became a significant source of revenue.

Today all major investment banks have a prime brokerage business and it forms a significant chunk of their revenues. Also, hedge funds are almost the only clients that prime brokerages have. An increase in the number of prime brokerage firms while the number of hedge funds has remained constant has caused intense competition in the industry.

Prime brokerages evolved from the ever increasing scale of hedge fund operations. As hedge funds started trading regularly, their operations became complex and difficult to manage. The technology and infrastructure required to manage these operations was expensive and since it was not a part of the hedge fund’s core business, it was not a worthwhile investment.

However, major investment banks already had the infrastructure in place to manage investments worth billions of dollars. They would therefore provide this service to the hedge funds in return for a fee. The services provided were many and varied. It is for this reason that it has been difficult to come to a precise definition of what constitutes a prime brokerage firm. Some of the services provided by prime brokerage firms are mentioned below.

Services Provided By Prime Brokerage

• Funding: Hedge funds, by definition, are highly levered business entities. The money received from investors is further levered by taking loans from prime brokerages. A prime broker provides access to a virtually unlimited pool of money at short notice for reasonable interest rates. In return for providing this service, they get the brokerage business of hedge funds. Hedge funds use the money provided by these brokerage firms to buy securities. Later, they use the same securities as collateral to borrow even more! Leverage ratios of 10:1 are very common and prime brokerage firms are comfortable proving these supposedly risky services for a reasonable fee.

• Settlements: Hedge funds usually have a lot of open positions open across asset classes. Also, the turnover rate is quite high meaning that assets are replaced by other assets quite frequently. Hence, the process of clearing and settlement for these trades has to be highly efficient. Hedge funds do not have the infrastructure required to manage these trades. However, since prime brokerages are investment banks, they do have such infrastructure. Therefore as a value added service, prime brokers provide clearing and settlement services to their clients.

• Reporting: The large and varied portfolio of hedge funds warrants the use of a specialist to track the positions and provide data to the decision makers. The speed and accuracy of this data is crucial since decisions need to be made really quickly. Once again investment banks have the infrastructure to provide such services and allow their prime brokerage units to use it to provide a value added service in order to retain the client.

Since prime brokerages provide these generic services, there is a lot of competition amongst them. This competition is benefitting the hedge fund industry. Many prime brokers go as far as providing some sort of seed fund for the hedge fund to lure a hedge fund to take up their services.

Regulation

The prime brokerage industry is virtually unregulated across the world. However, in the United States there is some amount of regulation. For instance, a prime broker cannot open an account unless there is at least $500000 in equity in the case of an individual or $1000000 in equity in case of an organization. Ambiguity arises when prime brokerages based out of United States fund operations within the United States. The regulation is not quite strong enough and market participants are able to find quite a few loopholes.

Financial market participants are averse to any kind of regulation. This has caused a lot of hedge funds to shift their businesses to offshore locations. For instance, Morgan Stanley has been amongst the first firm to start an international prime brokerage desk at its London office.

Wall Street therefore is not the hub of prime brokerage activity. Instead, such activities are concentrated in locations like Singapore and London.

Selecting a Prime Broker

Hedge funds are rightly very picky when it comes to selecting their prime broker. A prime broker is not just a vendor. Instead, they are business partners and their action or inaction can have grave consequences.

• Hedge funds like to know if the prime brokerage has access to top end technology. This is because hedge funds do not have back office operations of their own.

• The financial position of the prime broker is also verified very closely. Hedge funds do not want to miss out on trades because their broker was cash strapped and could not finance them at a moment’s notice.

• Hedge funds also prefer prime brokers who offer the highest loan to value ratios. This means they give out maximum loans on minimum collateral.

A lot of other factors go into selecting a prime brokerage. Since prime brokerages literally run the operations of these hedge funds, it is essential to understand in order to understand the hedge fund business.