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Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return. The business advantage to a hedge fund of using a Prime Broker is that the Prime Broker provides a centralized securities clearing facility for the hedge fund, and the hedge fund's collateral requirements are netted across all deals handled by the Prime Broker. The Prime Broker benefits by earning fees ("spreads") on financing the client's long and short cash and security positions, and by charging, in some cases, fees for clearing and/or other services. It also earns money by hypothecating the portfolios of the hedge funds it services and charging a fee to those borrowing securities and other investments.

The following services are typically bundled into the Prime Brokerage package:

• Global custody (including clearing, custody, and asset servicing)
• Securities lending
• Financing (to facilitate leverage of client assets)
• Customized technology (provide hedge fund managers with portfolio reporting needed to effectively manage money)
• Operational support (prime brokers act as a hedge fund's primary operations contact with all other broker dealers)

In addition, certain prime brokers provide additional "value-added" services, which may include some or all of the following:

• Capital Introduction - A process whereby the prime broker attempts to introduce its hedge fund clients to qualified hedge fund investors who have an interest in exploring new opportunities to make hedge fund investments.
• Office Space Leasing and Servicing - Certain prime brokers lease commercial real estate, and then sublease blocks of space to hedge fund tenants. These prime brokers typically provide a suite of on-site services for clients who utilize their space.
• Risk Management Advisory Services - The provision of risk analytic technology, sometimes supplemented by consulting by senior risk professionals.
• Consulting Services - A range of consulting / advisory services, typically provided to "start-up" hedge funds, and focused on issues associated with regulatory establishment requirements in the jurisdiction where the hedge fund manager will be resident, as well as in the jurisdiction(s) where the fund itself will be domiciled.

Contents 1 History 2 Counterparty risks 3 Fees 4 Risks 5 Margin methodologies

[edit] History

The basic services offered by a prime broker give a money manager the ability to trade with multiple brokerage houses while maintaining, in a centralized master account at their prime broker, all of the hedge fund’s cash and securities. Additionally, the prime broker offers stock loan services, portfolio reporting, consolidated cash management and other services. Fundamentally, the advent of the prime broker freed the money manager from the more time consuming and expensive aspects of running a fund. These services worked because they also allowed the money manager to maintain relationships with multiple brokerage houses for IPO allocations, research, best execution, conference access and other products.

The concept and term "prime brokerage" is generally attributed to the U.S. broker-dealer Furman Selz in the late 1970s. However, the first hedge fund operation is attributed to Alfred Winslow Jones in 1949. In the pre-prime brokerage marketplace, portfolio management was a significant challenge; money managers had to keep track of all of their own trades, consolidate their positions and calculate their performance regardless of which brokerage firms executed those trades or maintained those positions. The concept was immediately seen to be successful, and was quickly copied by the dominant bulge bracket brokerage firms such as Morgan Stanley, Bear Stearns, Merrill Lynch, Lehman Brothers, and Goldman Sachs. At this nascent stage, hedge funds were much smaller than they are today and were mostly U.S. domestic long-short equities funds. The first non-U.S. prime brokerage business was created by Merrill Lynch's London office in the late 1980s.

Through the 1980s and 1990s, prime brokerage was largely an equities-based product, although various prime brokers did supplement their core equities capabilities with basic bond clearing and custody. In addition, prime brokers supplemented their operational function by providing portfolio reporting; initially by messenger, then by fax and today over the web. Over the years, prime brokers have expanded their product and service offerings to include some or all of the full range of fixed income and derivative products, as well as foreign exchange and futures products.

As hedge funds have proliferated globally through the 1990s and the current decade, prime brokerage has become an increasingly competitive field and an important contributor to the overall profitability of the investment banking business. As of 2006, the most successful investment banks each report over two billion dollars in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs).

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[edit] Counterparty risks

The prime brokerage landscape has dramatically changed since the collapse of Lehman brothers in September 2008. Hedge funds who received margin financing from Lehman Brothers could not withdraw their collateral when Lehman declared bankruptcy due to a lack of asset protection rules, such as 15c3 in the United States, in the United Kingdom. This was one of many factors that led to the massive deleveraging of capital markets during the Financial Crisis of 2008.

Upon Lehman's collapse, investors realized that no prime broker was too big to fail and spread their counterparty risk across several prime brokerages, especially those with strong capital reserves.

[edit] Fees

Prime brokers do not charge a fee for the bundled package of services they provide to hedge funds. Rather, revenues are typically derived from three sources: spreads on financing (including stock loan), trading commissions and fees for the settlement of transactions done away from the prime broker. The financing and lending spreads, which are charged in basis points on the value of client loans (debit balances), client deposits (credit balances), client short sales (short balances), and synthetic financing products such as swaps and CFDs (Contract for difference), make up the vast majority of prime brokerage revenue. Therefore, clients who undertake substantial short-selling or leverage represent more lucrative opportunity than clients who do relatively less short selling and/or utilize minimal leverage. Clients whose market activities are principally fixed income oriented will generally produce less prime brokerage revenue, but may still present significant economic opportunity in the repo, foreign exchange (fx), futures, and flow business areas of the investment bank.

[edit] Risks

Prime Brokers facilitate hedge fund leverage, primarily through loans secured by the long positions of their clients. In this regard, the Prime Broker is exposed to the risk of loss in the event that the value of collateral held as security declines below the loan value, and the client is unable to repay the deficit. Other forms of risk inherent in Prime Brokerage include operational risk and reputational risk.

Large prime brokerage firms today typically monitor the risk within client portfolios through house-designed "risk based" margin methodologies that consider the worst case loss of a portfolio based on liquidity, concentration, ownership, macroeconomic, investing strategies, and other risks of the portfolio. These risk scenarios usually involve a defined set of stress test scenarios, rules allowing risk offsets between the theoretical profit and losses (p&ls) of these stress test scenarios for products of a common underlier, and offsets between groups of theoretical p&ls based on correlations.

Stress testing entails running a series of what-if scenarios that identify the theoretical profits or losses for each position due to adverse market events.

Examples of stress test scenarios include:

• Flight to Quality
• 1% up or down parallel movement in 10 year treasury yield curve

[edit] Margin methodologies

• Risk/Rules-Based House Methodologies
• Portfolio Margining
• Regulation T
• Risk Based Haircuts (RBH)