The Role of a Prime Broker

A prime broker is a financial institution that facilitates and coordinates extensive, complex investment and trading activity. These institutions include large investment banks and firms like Merrill Lynch and Goldman Sachs (GS). Prime brokers like these offer prime brokerage services to large investment clients, such as hedge funds. In this article, we focus on the role of prime brokers and how large investment clients choose the right one.

Core Prime Broker Services

Prime brokers provide a variety of custodial and financial services to their clients. This includes acting as an intermediary between hedge funds and two key counterparties. These counterparties are:

• Large institutional investors, such as pension funds. This group has massive equity holdings and serves as a source of securities to lend for short-selling purposes.
• Commercial banks. These entities have adequate funds available to make large loans for margin purposes.

With the help of prime brokers, these two counterparties enable hedge funds to engage in large-scale short selling through borrowing stocks and bonds from large institutional investors. This allows them to maximize their investments through leverage by obtaining margin financing from commercial banks.

Prime brokers also clear and settle trades. While a hedge fund traditionally holds accounts at different brokerage firms, it commonly instructs these executing brokers to clear all trades through its designated prime broker. Doing so simplifies reporting and operations for the fund since the prime broker also serves as the custodian for the hedge fund's assets. This further streamlines the process of borrowing investment securities and capital since the hedge fund's assets can quickly and easily be shifted to the prime broker as collateral.

Additional Prime Broker Services

In addition to core lending, prime brokers also offer concierge services. These additional services are designed to ease and enhance the operation of a hedge fund, including risk and performance analytics. Prime brokers often partner with risk management service providers, such as RiskMetrics Group, to provide their hedge fund clients with daily risk and performance analysis services.

They may also offer capital introduction services for the hedge fund's manager. Capital introduction is essentially the process of connecting hedge fund managers to potential investors in the form of the prime broker's asset management and private banking clients. Prime brokers further serve their hedge fund clients, who frequently engage in trading derivative financial instruments, by offering them access to their derivatives trading desks along with risk management suggestions from their own derivatives trading operations.

Clients are also privy to the prime broker's private research services, thus enhancing and reducing the fund's research costs. Outsourced administration and trustee services, along with enhanced leverage enabled by offering lines of credit, are additional features offered by many prime brokerage firms.

How Hedge Funds Select a Prime Broker

Prime brokerages provide many essential services to hedge funds. These services can help ensure they operate efficiently and generate profits. That's why hedge fund managers should choose their prime brokers carefully.

Among the primary considerations in selecting a prime broker are the price of the various services offered, easy access to large holders of securities, including holders of less liquid and more difficult-to-borrow securities, and trading confidentiality.

Potential investors in a hedge fund may also be influenced by the selection of a particular prime broker—either positively or negatively. This can be an important factor in the decision, especially for a new fund that is just starting up and actively seeking major investors.

The Bottom Line

Prime brokerage is an important part of the financial sector. It creates jobs for thousands of people and makes a significant contribution to the economy. It also helps large financial institutions facilitate their businesses and outsource activities that allow them to focus on their core responsibilities. For these companies, a prime broker can be a one-stop shop that makes doing business much easier.