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Investment banks all over the world have deep relationships with hedge funds. This is because investment banks often become the source of funds for the highly leveraged investments which are made by hedge funds. These funds are often made available through an organization called a prime broker. It needs to be understood that most prime brokerages around the world are owned by investment banks. Hence, even though legally they may be different entities, the reality is that they are nothing but extensions of investment banks.
In this article, let’s have a closer look at what prime brokerage is and how it acts as a major source of revenue for investment banks all over the world. We have already studied the concept of prime brokerage in a different module. In this module, we will understand how they impact the investment banking business.
Prime brokers are different as compared to regular brokers. This is because regular brokers only help find counterparties to buy and sell transactions. Often times, brokers also help arrange for the finances via the margin funding mechanism.
Prime brokers, on the other hand, help their clients make highly leveraged bets. This is because they allow hedge funds to put only a little money upfront and buy some securities. These same securities brought with borrowed money are then once again used as collateral to borrow more. It is not uncommon for prime brokerages to facilitate a leverage ratio of 10:1 for their clients.
Hence, the main service provided by prime brokerages to their clients is that they facilitate access to an almost unlimited pool of funds for a reasonable fee. In return, investment banks earn in two ways. Firstly, they earn brokerage on the large volumes of securities which form part of a buy and sell transactions at hedge funds. Secondly, they earn by levying a premium or a spread on the funds which they help hedge funds borrow.
Prime brokerages also provide some other services to their clients. This includes settlements and reporting. Investment banks basically use their already existing technological infrastructure to generate reports for hedge funds. However, that is not the defining factor. It needs to be understood that almost all prime brokerages are investment banks, and almost all clients are hedge funds. This is because hedge funds are the only institutional class allowed to borrow without any restriction and investment banks are the only financial intermediaries that have the wherewithal to satisfy this need for borrowing.
Also, since both investment banks, as well as hedge funds, are owned by high net worth individuals, the amount of regulation is quite less. Prime brokerages do have some minimum regulation in the United States. However, for the most part, they function as unregulated organizations.
Prime brokerages are not a recent invention. In fact, they have been around for at least a couple of decades. Over time, the business of prime brokerage has evolved. Now, there are at least two types of prime brokerages operational in the market.
Standard prime brokerages facilitate the borrowing of money using traditional financial instruments such as stocks and bonds. They do not deal with structures, instruments, or derivatives. This limits the size of their operation.
Synthetic prime brokerages, on the other hand, deal with synthetic financial instruments such as structured derivatives. This could include over the counter derivatives, and exchange-traded derivatives, or a combination of the two. The size of the derivates market in the world is huge. This is the reason why these prime brokers are able to provide more liquidity to their clients.
Full-service prime brokerages, which are owned by large investment banks, generally provide both these types of services.
The prime brokers’ structure transactions in such a way that all transactions of the client are routed through them. This means that they are effectively an intermediary in all the transactions of the client. For example, if a hedge fund enters into a transaction with a broker, the transaction is actually structured as two transactions i.e., one between the hedge fund and prime broker and other between the prime broker and the other broker. Since all transactions are routed via the prime brokerage, considerable credit risk gets accumulated in prime brokerages.
It has traditionally been believed that prime brokerages are backed by investment banks, which are some of the most powerful financial organizations in the world. Hence, they are unlikely to default. However, the collapse of Lehman Brothers and other such investment banks has exposed a flaw in the prime brokerage model. It is not uncommon for both hedge funds and investment banks to hedge their bets so that their interests are protected from credit risks in the event of the failure of either of the counterparties.
Prime brokerages are often remunerated through a wide variety of ways. Some of them are paid a standard fee, which works like a retainer. However, there are some others who earn remuneration via spreads on loans, ticket charges, interest, etc. The real remuneration paid to a prime broker is often difficult to calculate since it is derived from several sources. The reality is that prime brokerage has become one of the biggest source of revenue in investment banks. Almost 50% of the revenue derived in the equities division of an investment bank is via a prime brokerage.
The bottom line is that over time the prime brokerage business has become an important part of the investment banking business. It is one of the largest contributors to the revenue of an investment bank.
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