What is Prime Brokerage?

Trading securities is a very complex process arising from when a trade is placed, to when it is executed / settled and managed. Prime brokerage is a specialised set of capital market services provided by well-resourced large financial institutions like top in investment banks, to other qualifying institutions like hedge funds, pension funds, insurance firms, etc., that may elect to outsource such services rather than perform the functions in-house.

These expert services facilitate the trading operations of fund managersand other financial organisations by helping them monitor portfolios, manage risks, liquidity and grow the business.

The trades aren’t just limited to vanilla securities like stocks, shares or bonds. They also include complex derivatives like futures, options, forwards, structured notes, and more complex structured products like the following

These products have delta of 1, hence for a given variance in price of underlying asset, the price of the delta 1 derivative product will equally move by a similar variance.

Note that delta signifies the sensitivity (or change) of the price of a derivative product, to a change in the price of the underlying asset or index. Hence, Delta One implies a one-for-one or like-for-like variance. Synthetic delta one products can be created by combining other derivatives to achieve the desired constant unit delta of 1, hence providing one-for-one economic exposure to desired underlying assets. For an agreed fee, Traders can create a strategy that offers the return (income) of a given index like the FTSE 100 index without the risk of actually buying the quoted stocks. The Trading Desk can either buy the securities directly or a combination of derivatives thereof to achieve the desired return.

Another set of derivative products that lend to delta 1 are structured credits. These are pre-packaged derivative investment strategies based on single products, basket or derivatives, as the underlying assets. The organisation of the business tends to be in the form of flow trading (mainly when the Trading Desk trades with client funds, in liquid securities per instructions, often acting as market maker and hence, also trades for itself). In this instance, it will typically trade in Flow Credits, which are securities like bonds, single name CDS and index CDS traded like single names. They’ll also trade structured credits, which are products with multiple underlying credits, such as synthetic CDO, CDO tranches, index tranches, FTD and NTD baskets.

As a market maker, prime brokers can employ a swathe of strategies to broker a deal. For a relatively small fee, clients like hedge funds can enjoy the expert services or prime brokers compared to the hefty cost of setting up the infrastructure in-house.

Provide leverage to speed up trade executions. Line of credit (margin financing), which normally requires collateral, can be extended. The collateral could also be used for other investing purposes to earn additional income, subject to terms agreed with collateral owner. Also, by allowing large financial institutions like hedge fundsto borrow securities for short selling, prime broker earns financing fee (spread).

Having custody of funds (cash management) and other assets of a hedge fund speeds up trade execution and reporting.

Linking up fund seekers like hedge funds, and investors such as pension funds, commercial banks and other institutional investors like sovereign wealth funds, insurance funds, family offices, etc.

Consulting and advisory services in regulation, research, due diligence on hedge funds and technology analytics. It is important to understand that the credibility of a hedge fund, from the perspective of a prime broker, may be swayed by the size of collateral in custody, compared to detailed due diligence of the hedge fund. It therefore makes sense for investors to do their client on boarding KYC / due diligence.

This is particularly important given the complex and cloudy nature of the products and business, to ensure that appropriate internal controls are in place to bolster the structural integrity of the system for the benefit of both staff and firm. This will help prevent what happened at UBS in 2011 when Kweku Adoboli (biggest rogue trader in Britain, convicted in 2012 for losing $2.3bn, having booked fictitious hedging trades to hide his “over risk limit” trades. During the trial, it was revealed that the bank had uncovered about three other instances of unauthorised trading. His actions wiped circa $4.7bn off UBS’s market value. He claimed the bank turned a blind eye when his strategy raked in millions in profit) worked his way up and transitioned from back office to front office, mastering the systems along the way and was able to circumvent internal controls. The breach was discovered when UBS Risk Management Team conducted routine checks on outstanding trades with French Banks, rumoured to be due to other concerns about their own counter party risk. Compliance Team asked questions and things unravelled from there. I guess one can say that internal controls ultimately worked and limited the loss eventual loss. However, the operational risk had already materialised. The key point here is that investors need to be proactive and conduct independent due diligence focusing on prevention rather than belated discovery of material risk.

Package of services provided for old and new funds needing help with infrastructure, setting goals and strategies, administration functions, staff hiring and training, etc. for a fee. Some of the expert functions may depend on product type and can include monitoring, reconciliation and control of revenues and balance sheet analysis and commentary. Micro level primary responsibilities include management of the books and records including finance daily and monthly profit and loss and balance sheetsign offs, regulatory reporting, reviewing and advising on new trading structures, managing key risks and controls etc.