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Definition of Prime Brokerage

How does Prime Brokerage work?

Services provided by Prime Brokerage

How does Prime Brokerage make profits?

What is Prime Brokerage?

Prime brokerage is a set of services provided by major investment firms to their clients in hedge funds. These services include cash management and securities lending to help hedge funds increase their leverage while executing large trades.

How does Prime Brokerage work?

To understand prime brokerage, it helps to first get acquainted with hedge funds and what they do and the services they require.

Hedge funds are partnerships that pool their funds. They employ various investment and risk management techniques in search of substantial returns. They continue to operate even when markets decline. Hedge funds often use leverage (or borrowing) in an attempt to amplify returns.

These funds often manage money from pension funds and large pools. Given the size of the investments and the approach taken, the needs of hedge funds are different from those of the average individual investor. As a result, prime brokerage does more than just help hedge funds execute trades.

The range of services provided by prime brokerage includes:

• Securities or cash borrowing: Prime brokers assist hedge funds in obtaining cash to enhance returns. They also help them with “short selling,” where investors sell stocks they do not own by borrowing them from a broker.
• Assisting them in finding new investors: Prime brokers can provide “capital introduction” services, where they arrange meetings and introductions to those who may be interested in investing in a fund.
• Providing access to research: Prime brokers often have strong research departments that can produce data and reports on anything a fund manager needs. In many cases, the broker makes this research available to funds simply because they are a client.
• Acting as custodians: By holding the fund’s assets, the prime broker can act quickly on trades. This also makes financial reporting much easier.
• Staying updated on regulatory issues: The regulatory environment surrounding finance is complex. Hedge funds might not have the resources to stay informed on every rule change. Prime brokers often serve as advisors in this area.
• Offering other “concierge” services: Some prime brokers may provide specialized services, such as performance analytics reports and lines of credit. New funds may even get assistance with administrative tasks, such as human resources and employee training.

How does Prime Brokerage make profits?

Since prime brokerage can earn money in several ways, prime brokerage units can generate substantial profits for companies. First, brokers charge base fees for custody and other services. Prime brokerage also earns significant amounts from the interest rate spread between borrowing and lending. Most importantly, prime brokers can use client collateral for their own investing. This is known as “rehypothecation.” In many cases, fund partners allow their collateral to be used in this manner in exchange for lower fees.

However, it’s important to note that rehypothecation does carry some risks for the investor. There is always a chance that the broker will lose the investment, even though they did not originally own it.

The practice of rehypothecation was more common before the financial sector collapse in 2008 and 2009.

Source: https://www.thebalancemoney.com/what-is-prime-brokerage-4165497