Prime Brokers

A prime broker is a large bank or brokerage that provides a bundle of services to hedge funds and other professional trading firms: lending them money and securities, holding their assets, clearing their trades and helping them operate. If a hedge fund is a racing team, the prime broker is the garage, the fuel supplier and the bank rolled into one.

What prime brokers provide#

Why funds need a prime broker#

A hedge fund may trade through dozens of executing brokers, but it wants one place where all positions are held, financed and reported. The prime broker consolidates everything, lends against the whole portfolio and nets long and short positions so margin reflects the overall risk. Large funds often use several prime brokers to diversify and negotiate better terms. See Prime Brokerage and Hedge Funds.

How prime brokers make money#

• Interest on margin loans, above their own funding cost.
• Fees for borrowing securities, especially hard to borrow stocks.
• Spreads and commissions on execution and derivatives.
• Using client collateral, within rules, to fund other activities.

The risks: leverage and opacity#

Prime brokers manage their risk with margin requirements, but leverage across many brokers can be hard to see. The collapse of Archegos Capital Management in March 2021 showed how this can go wrong. Archegos built very large, concentrated positions through total return swaps with several prime brokers, none of whom saw the full picture. When some of its stocks fell sharply, it could not meet margin calls. The banks sold its collateral in huge blocks, and several prime brokers suffered losses running into billions of dollars, with Credit Suisse among the hardest hit. See Archegos Capital.

The 2008 failure of Lehman Brothers revealed another risk, for the funds: assets held at a failing prime broker can be tied up in bankruptcy proceedings, which is why many funds now spread assets across brokers and negotiate stronger protections.

Prime brokerage for smaller traders#

Traditional prime brokerage is for institutions with large balances. Some brokers offer "prime" style services, such as portfolio margin and stock lending access, to sophisticated individual traders and smaller funds. Crypto has its own prime brokers serving funds that trade across many exchanges.

How funds choose prime brokers#

Funds weigh several things when picking prime brokers: the strength and credit rating of the bank, financing rates and margin terms, the depth of its securities lending inventory, the quality of its technology and reporting, and how its terms might change in a crisis. Many funds use at least two prime brokers so they are not dependent on one firm's balance sheet or willingness to lend when markets are stressed.

Why it matters to other traders#

Even if you never deal with a prime broker, their risk management can move markets. When prime brokers raise margin requirements or force clients to reduce leverage, the resulting selling can cause sharp, seemingly unexplained drops in crowded stocks, often called deleveraging events.

Frequently asked questions#

What does a prime broker do?#

It provides hedge funds and professional traders with financing, securities lending, custody, clearing, execution and reporting in one relationship.

Do individual traders use prime brokers?#

Traditional prime brokerage is for institutions, though some brokers offer prime style services to very active, high balance individuals.

What went wrong with Archegos?#

It held highly leveraged, concentrated positions through swaps at several prime brokers. When prices fell, it could not meet margin calls, and forced selling caused large losses for the banks involved.

Sources#

• Wikipedia, Prime brokerage