Prime brokerage – speech by Rebecca Jackson
For those of you not familiar with Prime Brokerage I have one question: where have you been for the last 40 years? But, to catch you up, I should explain what prime brokers do, which is provide financing and related services to hedge funds, including operational support, securities lending, risk management services, and capital introductions.
The core of this business is financing. When a client wants to go long a security, almost always an equity, the prime broker lends them the money to purchase it, and then holds that security as collateral. And when a client wants to go short a security, the prime broker lends them the security, and then takes the proceeds of the short sale as collateral. Prime brokerage can be either ‘cash’ – which corresponds directly to the transactions I’ve just described – or synthetic, where total return swaps (TRS) are used to achieve the same economic effect.
It is not hard to see why prime brokerage returns are fundamentally a function of scale. Prime brokers can finance one client’s margin loan by re-using their equity, posted as collateral, and delivering it into another client’s short position in that same equity. The proceeds of the second client’s sale are effectively used to finance the first client’s margin loan. This is called internalisation, and the larger a firm is, the more scope that the firm has to do it. The benefit comes in the form of positive returns to scale, by way of significantly reduced costs, as internalised transactions don’t require costly external financing, or costly borrowing of securities from elsewhere. Internalised positions are also very efficient from a balance sheet perspective; a key factor for a business that is an increasingly large user of firms’ balance sheet capacity.
The full speech is available here.