Hedge funds are among the most important clients of investment banks. Unlike institutional asset managers who typically hold long-only positions, hedge funds take long and short positions, use leverage, and trade across multiple asset classes. To do this, they require a specialised banking relationship: prime brokerage.
What is prime brokerage?
Prime brokerage (PB) is a bundle of services provided by a bank to a hedge fund, enabling the fund to execute its investment strategy. The core services are:
*Financing*: The prime broker lends money to the hedge fund against its long positions, allowing the fund to take larger positions than its equity would allow. A fund with billion of equity might run -5 billion of long positions financed by the prime broker through a securities financing structure.
*Securities lending*: To sell a stock short, the fund must first borrow it and sell it in the market (with the plan to buy it back cheaper later and return it). The prime broker sources borrowed securities from its securities lending pool (borrowing from pension funds, insurance companies, and asset managers who hold large long positions and are willing to earn a fee from lending them).
*Execution and clearing*: Many prime brokerage clients execute through multiple brokers for best execution but clear and settle all trades through a single prime broker (or a small number). This simplifies the fund's back-office operations — one relationship for all clearing and settlement, one consolidated net position.
*Custody*: The prime broker holds the fund's assets in custody, providing daily account statements and consolidated position reporting.
*Capital introduction*: Some prime brokers provide introductions between hedge fund clients and potential investors (family offices, pension funds, endowments) — a valuable service for smaller funds raising capital.
The economics of prime brokerage
Prime brokerage is highly profitable for the bank in aggregate, but the profitability varies significantly by client. The revenues come from: the spread on financing (lending to the fund at a higher rate than the prime broker's funding cost); the stock borrowing fee on short positions; execution commissions; and technology/reporting service fees.
The risks for the prime broker are significant: credit risk (if the fund's positions fall in value, the prime broker may not recover its loans); operational risk; and, in extreme cases, reputational risk if the prime broker is seen as facilitating a fund that causes market disruption.
Concentration and systemic risk
The 2008 GFC demonstrated the systemic risks of prime brokerage concentration. Many hedge funds had a single prime broker. When Lehman Brothers failed, hedge funds that were Lehman's prime brokerage clients found their assets frozen in the Lehman estate. In response, the industry shifted to multi-prime-broker relationships — splitting positions across two or three prime brokers to reduce single-point-of-failure risk.
The relationship between prime brokerage and the rest of the markets business
Hedge funds are also important clients of derivatives desks, structured products teams, FX sales, and fixed income trading. The prime brokerage relationship is often the gateway: once a bank has the prime brokerage mandate, it has operational and relationship leverage to offer additional services.