Explanation of a Prime Brokerage

Prime brokerage is an extensive list of bundled services that many brokerage houses provide to hedge funds. It includes clearing facilities, custody and asset servicing, securities lending, financing to facilitate leverage of client assets, risk management services and capital introduction. Prime brokerage services are one of the fastest growing areas of investment banking, despite the credit crisis and collapse of Bear Sterns.

Traditional Use of Prime Brokerage Services

Traditionally, the primary uses of prime brokerage were for capital introduction and financing. Because prime brokerage houses deal with hundreds of hedge funds, and have detailed information and data in the industry, Prime Brokers often provide valuable information and compatible partners to new start-up hedge funds. They also provide forums for hedge funds via capital introduction. The financing that prime brokers provide is a very important aspect of prime brokerage services because hedge funds are in the business of producing abnormal returns.

Changing Landscape for the Industry

A recent article produced by the ICFA explains that the prime brokerage industry is being re-shaped due to “convergence between hedge funds and traditional long-only investment strategies.” In other words, traditional asset managers are beginning to use prime brokers and are coaxing the industry to place more emphasis on custody, reporting, and risk management services and less on financing and capital introduction.

The increasing use of prime brokerage services by traditional asset managers supports the forecasting trends of growth of the industry. Because of these industry shifts, though, less financing for margin trading means the industry will not necessarily see increased profits. A large percentage of prime brokerage profits come from this type of lending.

Short Selling

Another important service that prime brokers provide is the lending of securities for short selling. Hedge fund objectives are usually to earn abnormal returns on client investments through arbitrage strategies. This often involves the shorting of stock. One of the key differences among prime brokerages lies in their ability to have access to and lend out “hard-to-borrow” securities.

Another competitive advantage for a prime brokerage is the ability to have access to shares of recent IPOs faster than competitors. When an IPOs is sold to the secondary market for the first time, there are technically no owners of the securities. This means the shares cannot be shorted for a period of time. This contributes to an upward bias of the stock market’s total value over time.

Prime brokerages, such as Goldman Sachs, Paine Webber, and Morgan Stanley provide crucial services to hedge funds and help these funds to minimize transaction costs. However, a shift in the industry caused by the recent changes in philosophy and structure of the financial markets is causing prime brokerages to redefine themselves as to the nature of services they provide.

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