What it means
A hedge fund may trade through many different banks, buy and sell in several markets and borrow to increase its positions. Keeping track of all of this would be a heavy administrative job.
A prime broker acts as the fund's central base, settling trades, holding the assets and providing a single view of positions and cash. The main services are custody (safe-keeping of the fund's securities and cash), securities lending so the fund can sell shares it does not own, margin financing so it can borrow to buy more, and consolidated reporting.
Many prime brokers also offer trade execution, research, capital introduction to potential investors and office support for start-up funds. Financing is the big earner.
When a fund borrows to buy investments, the prime broker lends the money and holds the securities as collateral (assets pledged to secure the loan). It charges interest at a benchmark rate plus a spread, and it can demand extra collateral if the value of the investments falls.
The arrangement carries risks. A fund concentrated with one prime broker is exposed if that bank fails or restricts credit, and assets can be re-used by the broker under certain conditions, which creates counterparty risk.
Since the 2008 financial crisis many funds have spread their business across several prime brokers for that reason. For non-specialists, prime brokerage explains how modestly sized investment firms can run large, leveraged strategies.
It also explains why a sudden loss of credit from a prime broker can force a fund to sell holdings quickly, which can move markets. Fees and terms are negotiated between the fund and the broker, and larger funds usually get better pricing.
A small start-up fund may need to meet minimum asset levels and accept higher charges. Comparing offers on financing spreads, lending fees and service quality is an important early decision for any new fund.
In practice
Real-world examples.
Example
A newly launched hedge fund signs with a prime broker for custody, trade settlement and daily reporting. The fund's small team can then focus on investment decisions and not on back-office administration. The prime broker also introduces the fund to potential investors at industry events.
Example
A fund wants to sell short a retailer's shares, which means selling shares it has borrowed in the hope of buying them back cheaper. The prime broker locates the shares, lends them and charges a fee for the loan. When the shares are returned, the fund pays any dividends that were due on them in the meantime.
Example
A fund's portfolio falls sharply and the prime broker issues a margin call, asking for more cash or collateral. The manager sells some positions to raise cash and keep the account within the broker's limits. Meeting the call promptly keeps the relationship with the broker intact.
Formula
Calculation
Financing charge = Amount borrowed x (Benchmark rate + Spread) x Days / 360, and Leverage = Total positions / Fund equity.
A hedge fund has $20,000,000 of its own equity and buys $50,000,000 of securities, borrowing $30,000,000 from its prime broker. Assume the benchmark rate is 4% and the spread is 1%, so the rate is 5%. For a 30-day period the financing charge is $30,000,000 x 0.05 x 30 / 360 = $1,500,000 x 30 / 360 = $125,000.
Leverage is $50,000,000 / $20,000,000 = 2.5 times. If the portfolio loses 10%, that is $5,000,000, which is 25% of the fund's $20,000,000 equity, showing how borrowing magnifies losses as well as gains.Case study
Seen in the real world.
Tidewater Capital is a fictional hedge fund with $100,000,000 of equity that relied on a single prime broker. In an illustrative market shock, the broker raised its margin requirements across all clients, which demanded $15,000,000 of extra collateral within a day.
The fund had to sell some of its most liquid holdings at depressed prices to meet the call. Prices fell further as other funds did the same, which hurt the fictional fund's returns well beyond the original market move.
Afterwards the chief operating officer arranged accounts with two more prime brokers and negotiated longer notice periods for margin changes. The case shows that convenience from one provider has to be balanced against the risk of depending on it.
Watch out
Common mistakes.
- Using a single prime broker for everything, which concentrates the risk of that broker failing or tightening credit.
- Ignoring the terms on re-use of assets, which can leave the fund as an unsecured creditor for part of its holdings.
- Overlooking financing costs, which can quietly reduce returns on leveraged strategies.
Questions
People also ask.
Who uses prime brokerage?
Mainly hedge funds and other professional investors, though some large asset managers and proprietary trading firms use it too.
How does a prime broker make money?
It earns interest on financing, fees for lending securities, commissions on trades and charges for other services.
What is a margin call?
It is a demand from the broker for extra cash or collateral when the value of the fund's positions falls below the required level.
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