What Is Prime Brokerage?
It is more than just buying and selling stocks
People who buy or sell stocks, bonds, and other investments usually get assistance from a broker who actually executes the trades. Many investors may use discount brokerage firms such as Fidelity, Charles Schwab, and E-Trade, which allow you to trade stocks online and get some basic research reports and advice.
But what if you represent a big hedge fund that manages billions of dollars and does more than buy a few shares of an index fund? And what if you want to borrow large sums of money to maximize returns, short stocks, and make money even when the markets are going down? Well, then you probably need some special services and assistance. That's where prime brokerage enters the picture.
What Is a Prime Broker?
Prime brokerage is a term that refers to the suite of services offered to hedge fund managers and other similar large investors that enables them to complete major investment transactions. Most of the big-name investment banks, including Goldman Sachs, JPMorgan Chase, and Credit Suisse often serve as prime brokers. While prime brokerage once represented a very small portion of revenue for these firms, it became an increasing part of their business between 2010 and 2015. Many firms continue to add prime brokerage customers.
The Needs of Hedge Funds
To understand prime brokerage, it helps to first get your head around hedge funds, what they do, and what services they require.
Hedge funds are partnerships that pool money together and use various kinds of investing and risk management techniques to try and earn big returns, even when markets are falling. They often use leverage (or borrowing) in an attempt to boost returns. These funds often manage money from pension funds and large endowments. Because of the scale of their investing and their approach, the needs of hedge funds differ from the average individual investment.
Prime brokerages do more than help hedge funds execute trades. The array of services offered by prime brokerages includes:
- Borrowing stocks or cash: Prime brokers assist hedge funds in getting extra cash to amplify returns but also aid them in “short selling,” in which investors sell stocks they don’t own by borrowing from a broker.
- Helping them find new investors: Prime brokerages can offer “capital introduction” services, in which they set up meetings and make presentations to those that may be interested in investing in a fund.
- Providing access to research: Prime brokers usually have robust research departments that can churn out data and reports on nearly anything a fund manager may need. In many cases, the broker makes this research available to funds simply for being a customer.
- Serving as a custodian: By actually having custody of a fund's assets, a prime broker can move quickly on trades, which also makes financial reporting much simpler.
- Staying aware of regulatory issues: The regulatory environment around finance is complex, and hedge funds may not have the resources to stay on top of every potential change in rules. Prime brokers often serve as advisors in this area.
- Offering other “concierge” services: Depending on the broker, they may offer niche services, such as performance analytics reports and lines of credit. Newer funds may even get help with administrative tasks, such as human resources and employee training.
How Prime Brokers Make Money
Because they can earn money in several ways, prime brokerage units can be rather profitable for firms. First, brokerages charge basic fees for custody, concierge, and other services. Prime brokerages also earn substantial sums from the spread in interest rates between their borrowing and lending operations.
Additionally, prime brokers can use the collateral from clients for their own investing purposes. This is known as rehypothecation. In many cases, the fund partners permit their collateral to be used this way in exchange for a reduction in fees. Rehypothecation comes with some risk to the investor, as there is always the potential that the brokerage could lose the investment even though it never owned it in the first place. This practice was much more common prior to the collapse of the financial sector in 2008 and 2009.
- Brokers are for individuals; prime brokers are for hedge funds.
- Prime brokers help hedge funds handle large investment transactions.
- Prime brokers offer special services such as helping with short-selling, providing access to research, and keeping hedge funds up to date on regulatory issues.
- Prime brokers make money through fees, the spread in interest rates between their borrowing and lending operations, and by using client funds for investing.