The term “prime brokerage” refers to set of bundled services which typically serve the needs of hedge fund managers and their clients. Investment banks, securities firms or brokerages offer prime brokerage services to hedge funds or other professional investors, who need to be able to borrow against securities and invest cash on a leveraged basis. The prime brokerage facilitates hedge fund leverage by securing loans against the “long positions” of their investor clients. Some of the other services provided by a prime brokerage include:
The prime brokerage may also serve in other capacities, such as introducing hedge fund managers to potential hedge fund clients, and offering a wide variety of risk management and consulting services. Most large brokers who have active hedge fund clients offer prime brokerage services to their investors.
The advantage of using a prime brokerage is that the prime broker consolidates and centralizes the hedge fund’s cash and securities, while spreading its collateral requirements across all the deals that are handled by the prime brokerage. It also frees up the money manager of the hedge fund to trade with multiple brokerage houses for IPO allocations, research, and other purposes.
Prime brokerages generally derive their revenue from three sources: the financing “spread,” trading commissions, and fees charged on transactions that are settled away from the prime brokerage. The financing or lending “spread,” which is typically charged on a points basis based on the value of the client’s loans deposits and short sales, makes up the the greater part of the revenue generated by the prime brokerage. For this reason, clients that engage in substantial leveraging or short sales are a more lucrative customer for them than a client who engages in less risk-driven investment practices.