To understand better the business of prime broking, there is a felt need to understand the business of hedge funds first, as prime brokers are in their business only because of these hedge funds!
According to Goldman Sachs & Co, the term hedge fund includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction. This is in addition to the basic requirements of a hedge fund – protection of investors, information disclosure and integrity of securities market.
Prime brokers offer a variety of services to the hedge funds to enable them to access a wide range of markets and products. In a nutshell, the prime broker acts as a conduit between hedge funds and the market place. Hedge funds normally require the following services – capital introduction, margining (including cross margining), security lending, risk management, fund administration, and start up service, consolidated reporting and structured financing.
The Prime broker earns his income from financing, stock loan fee, ticket fee, commission brokerage and underlying foreign exchange. Due to competitive pressures, the earnings are always under pressure for a prime broker; however, due to large volume of business handled year after year, they continue to post sizeable income year after year.
Some of the major risks faced by the prime brokers are credit risk, legal risk, operational risk and market risk.
The credit risk is mainly managed through appropriate Know Your Customer norms – a basic regulatory requirement and active follow up.
The legal risk is managed through well and fully documented relationship model including appropriateness of transactions undertaken by the prime broker on account of its clients.
Operational risk is managed through high degree of technology for automation purposes and robust reconciliation requirements. Actually, the latest entrant to the prime broking field is expected to have least operational risk, as he would normally go in for latest technologies and techniques. So the last mover advantage for a prime broker is greater in the technology area (as against the first mover advantage advocated in marketing products and services)
Finally the market risk is managed through constant review of margin requirements and also collaterals provided. Concepts like cross margining would really help.
The hedge funds normally look for the following features before they take up the prime brokerage offering:
Standing and track record of the prime broker – because the hedge funds have a fiduciary relationship with their investors, they have a first and foremost need to associate with a prime broker whose reputation is in tact. Other wise the hedge funds would be accused of having associated with less than an acceptable name if something were to go wrong
Credit rating – it is not that the standing and track record of the prime broker selected is good at the time of selection only but there is a requirement to follow up the same on a real time basis and this is done through watching the credit rating of the prime broker
Business knowledge and performance – the knowledge profile, hands down experience and performance of the owners/manager traders of the prime broker is the next item in the tick list of the hedge funds
Capability – of the prime broker in financing and security lending would be keenly discussed by the hedge funds in the selection. This area would provide the hedge funds with leverage benefits and ability to go in for short selling as a part of their alternative investment strategies.
Technology support – what the prime broker can offer would be one of the clinching issues in the selection, as this alone would assure the hedge funds on a real time basis solid execution, status and reporting support.
Therefore if the prime broker can focus on the following areas he can be assured of more and more business from hedge funds.
- Business understanding
- Capability on capital introduction
- Client service
- Competitive Commission, Brokerage and Fees
- Compliance and reporting
- Front office and back office capability and their integration
- Securities lending
- Trading confidentiality
The hedge funds will expect the prime broker to assist them in a variety of ways and this support enhances their performance. A proactive prime broker will not provide the basic services but also innovate and provide new products and services. An effective prime broker may assist a hedge fund in a variety of ways and, in turn, this support may affect the hedge fund’s performance. A good prime broker is more than just a service provider – it is a key resource that a hedge fund must depend on, day in and day out.
Today, a successful prime broker must consistently maintain the quality of its core services, and also innovate with new products and services to meet its clients’ changing requirements. As hedge funds continue to play a growing role in global capital markets and as institutional investors increase their allocations to hedge funds, the prime brokerage business has to position well to provide innovative solutions.
Hitherto, the hedge funds were funded by investors and operated by managers in developed countries, mainly, United States of America. However, with the newfound wealth in developing countries in the Asian continent, many hedge funds are rushing in to these countries with their offer and also for making investments for better returns. If local prime brokers could position themselves aggressively in this space, they would be taking on the international prime broking players easily as they have their local market knowledge and understanding better.