Definition and Example of Prime Brokerage
"Prime brokerage" is a term that refers to the suite of services offered to hedge fund managers and other similar large investors. It lets them complete major investment transactions.
If you buy or sell stocks, bonds, and other investments for yourself, you may get help from a broker who executes the trades. You may use a discount brokerage firm, such as Fidelity, Charles Schwab,or E-Trade, which allows you to trade stocks online and get some basic research reports and advice.
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? What if you want to borrow large sums of money to maximize returns, sell stocks short, and make money even when the markets are going down? You would likely need some special services and assistance. That's where prime brokerage enters the picture. It serves the needs of hedge funds, which can be complex.
Most of the big-name investment banks serve as prime brokers, including Goldman Sachs, JPMorgan Chase, and Credit Suisse.
How Does Prime Brokerage Work?
To understand prime brokerage, it helps to learn first about hedge funds, what they do, and the services they require.
Hedge funds are partnerships that pool their money. They use various kinds of investing and risk management methods in search of big returns. They keep going even when markets are falling. Hedge funds 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 the investing and the approach, the needs of hedge funds differ from those of the average individual investor. As a result, prime brokerages do more than simply 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 cash to amplify returns. They also aid them in “short selling,” where investors sell stocks they don’t own by borrowing them from a broker.
- Helping them find new investors: Prime brokerages can offer “capital introduction” services, whereby they set up meetings and present to those who 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 having custody of a fund's assets, a prime broker can move quickly on trades. This also makes financial reporting much simpler.
- Staying aware of regulatory issues: The regulatory environment around finance is complex. Hedge funds may not have the resources to stay on top of every change in rules. Prime brokers often serve as advisors in this area.
- Offering other “concierge” services: Some brokers 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 staff training.
Because they can earn money in several ways, prime brokerage units can make a nice profit for firms. First, brokerages charge basic fees for custody, concierge, and other services. Prime brokerages also earn very large sums from the spread in interest rates between their borrowing and lending operations. What's more, prime brokers can use the collateral from clients for their own investments. 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. There is always a chance the brokerage could lose the investment, even though it never owned it in the first place.
The practice of hypothecation 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 help with short-selling, access to research, and keeping hedge funds current on regulatory issues.
- Prime brokers make money through fees, the spread in interest rates between their borrowing and lending operations, and using client funds for investing.