A broker is usually a third party, who acts as an intermediary between the buyer and seller. The broker relays information between the two, to reach a sale agreement that both parties can agree.
A prime broker provides services from security firms and investment banks to hedge fund managers, to enable them to borrow cash and securities for investment purposes. Prime brokerage refers to various services offered to special clients, i.e. hedge funds and other professional investors. Prime brokerage services include, but are not limited to, securities lending, leveraged trade executions, providing margin financing and cash management, providing back office technology and reporting.
Securities lending is the act of loaning securities, which is a tradable asset of any kind such as stock, to an investor. When a security is loaned to a borrower, the title and ownership are transferred to the borrower. Since ownership is transferred temporarily to the borrower, the borrower is liable to pay any dividends to the lender. The borrower is required to pay a fee and put up collateral in exchange for the securities. The broker then tries to sell the security immediately. The aim is to buy the security back at a lower price and thus make a profit from the difference.
A leveraged trade execution is also known as trading on margin. It does not require you to pay the full amount of the investment holding. You are allowed to leverage the difference. Leverage, in this case, is referring to the degree to which borrowed money is being utilised by an investor. The risks of highly leveraged companies are that it may result in bankruptcy or difficulty in the future to find new lenders. However, leveraging also has tax advantages and can increase return on shareholder’s investment.
Margin financing is money borrowed by an investor from a broker to buy securities. Margin financing offers high reward in exchange for high risk. Margin financing also has unique risks to investors including interest payments for the use of borrowed money, whereas the cash management function relates to the strategy by which a company administers and invests its cash.
In business, the term “back office” refers to the administrative and support roles in a financial services company. Therefore, the reference to prime brokers’ service in providing back office technology and reporting refers to the technology used by administrators for functions such as settlements, clearances and accounting. Technology includes software systems, and systems and processes to create a more efficient workforce.
A prime broker’s role cannot be brought in-house and easily controlled, the selection of a prime broker has to be carefully considered. There are several factors which must be taken into consideration. Given that prime brokerage services are usually provided by large broker companies such as Goldman Sachs, Paine Webber and so on by going through a larger broker company it would be easier for hedge funds to obtain a prime broker who is suited for their businesses. For example, if it is a hedge fund specialising in foreign exchange, a prime broker specialising in the same field would be advisable. It would also be wise to attain a different prime broker for the various areas of specialisation and geographies needed.
In consideration of a prime broker, a factor to be taken in is that of capital introduction. Capital introduction is a service offered by the prime broker to introduce fund managers to potential fund investors. This introduction service is done by introducing the client to both external as well as internal potential fund investors through networking events, setting up business meetings, and conferences.
A fund manager may need to receive business consulting advice from the fund’s start-up to stimulate the growth of the business regarding human resources, fund structuring, technology and global awareness. This advice should include product development, which refers to the strategic budgeting, product enhancements, and technology requirements to employ the best strategy.
Prime brokers need to demonstrate a robust framework of internal control, which includes transparency. Hedge funds have a legitimate interest in protecting proprietary trading strategies, and a balance between the interest of investors, counterparties and hedge fund managers must be struck (Cole, Feldberg & Lynch 2007).
Ensuring the right prime broker is selected is of vital importance as there are several key risk factors associated with prime brokers, which can affect business. A risk often looked at, is the effects related to the insolvency of the prime broker. The legal entity structure of a prime broker who has become insolvent affects its client because a hedge fund would be regarded as an unsecured creditor. Thus, the hedge fund would have difficulty in assuring they will regain their initial investment from the insolvent company. To avoid insolvency risk, the investment management companies may require from their prime brokers the development of prime custody products in conjunction with custodians, to create tri-party agreements for pledged assets and keeping non-pledged assets with non-credit counterparties.
Another factor that concerns investment management companies with regards to prime brokers is the practice of hypothecation. This practice is the process of pledging securities in customer margin accounts as the collateral for a brokerage’s bank loan. Customer margin in this regard refers to the safeguarding enacted by the buyer and seller of future and option contracts to ensure the fulfilment of the contract by both parties. The practice of hypothecation means that the assets of the customer of the prime broker can be used to raise cash; this cash can be used for leveraged purposes and to support the borrowing of stock which the prime broker can lend to other funds.
Although there are several risks involved with prime brokers, they are of necessity to the hedge fund market. Hedge fund businesses usually outsource the use of a prime broker because a prime broker provides what is known as a “centralised securities clearing facility” for the hedge fund. Centralised securities clearing facilities give hedge funds the ability to trade with several brokerage houses while maintaining a central “master account” at the prime broker for the fund’s cash and securities. Prime broker services give fund managers the opportunity to maintain relationships with multiple brokerage houses for IPO (Initial Public Offerings) allocations, research, and conference access and so on, while the prime broker focuses on the more time consuming and expensive factors in managing a fund.