I realized that there really isn't much information on prime brokerage on this site, even though it has been a significant source of revenue at bulge bracket banks under the S&T umbrella. I currently work in this industry (one of the big players GS/MS/JPM/DB) and am here to answer any question you have about prime brokerage. Silly or not, whatever question you have, shoot them my way.
prime brokerage services definition
Prime brokerage (PB for short) is a service provided by a registered broker-dealer that handles centralized custody, securities lending, financing, and margining, and regulatory reporting for both individual and institutional clients.
Put another way, in the client service functions of a broker-dealer, someone has to issue the margin calls, establish the clients' reporting and netting structure, resolve disputes, and keep their eyes open for regulatory issues (which include Reg T at the Federal Reserve Board level, Rule 4210 at the FINRA level, and whatever in-house custom requirements are set by your bank). That someone is your PB unit.
You can get another perspective on the role of PB below:
How Does a PB Desk Make Money?
The are several ways that a PB desk makes money. We discuss several below.
One of the ways a PB unit makes money is through "rehypothecation," a process that is done by your stock loan desk. Rehypothecation essentially lets the firm re-use client collateral for its own trading and borrowing purposes--allowing for more flexibility, and potential profit, for the firm. This can be a MAJOR source of income.
However, the most basic way to make money is financing client's positions (leverage). BBs can take the client's portfolio and raise cash from it (collateralized financing) at attractive rates, let's say some basis points over libor/fed funds/other reference rates and lend this balance out to HFs at a mark-up as HFs are less credible counterparties than investment grade rated banks. This represents part of the revenue. So PBs want large AUM clients that need massive leverage.
Finally, fees can also be collected for providing custody and clearing services.
Good Groups in Prime Brokerage and Exit Opportunities
In the Q&A below, one user inquired about what group within prime brokerage is considered to be the most analytical and to have the best exit opps.
The OP responded that origination sales gets paid really well. I think it's a great job if you have a talent for selling. You just have to get clients to sign with your PB and you own the relationships.
As a sales person you sell the products and services that the firm offers and if your client is a big contributor, you will make out well from a commission standpoint and you will build a strong network with the buy side.
The other groups that the OP recommended are trading groups (repo trading, sec lending, etc). It is market related and you get to take some risk. If you have a view that IBM will be shorted heavily by hedge funds starting 3 weeks from now, you can accumulate IBM inventories and hedge your market exposure by selling synthetic forward on IBM (long a put and short a call at same strike). This way, when every HF in the earth wants to borrow IBM in a few weeks, you have all these supplies and can lend it out at high rates and make bank.
The OP explained that product management is good if you like system design and info technology. When considering bad groups, the OP warned against client services which is the least analytical role since you will be mainly just tackling the daily problems and requests of clients.
Prime Brokerage Compensation
If you are a senior person (SVP/MD) within PB, you get paid well no matter what group you are in. However, on the junior level, your all-in compensation (base + bonus) might not be as high as your peers that are doing well on a traditional trading desk.
Bonuses depend largely on group that you sit in within PB. The trading, origination people are going to get paid on par with other areas of S&T, especially if the PB is a big market share taker. Other groups might make slightly less than the origination people as the other groups such as product management are not directly contributing to revenue.
Read More About Prime Brokerage on WSO
- What Is Prime Brokerage?
- Prime Brokerage Sales
- Prime Brokerage (Super Day)
- Prime Brokerage Stories: Expect No Favors
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In what order do prime brokers typically do their gym, tanning, and laundry?
Gym first. Being fit is important. When a prospective client asks all the major prime brokers to do a beauty contest, the more fit ones get the business. This is why the people (guys and girls) on the prime floor have better physiques than traders/salesppl on other floors (I am very serious).
After gym, laundry follows.
Prime brokers actually don't tan all that much...this is influenced by the vacation schedule. Prime brokers's vacation schedules are dependent on their clients. Most hedge funds rarely make decisions to change prime brokers toward the end of the year (Nov-Dec), so a lot of ppl take time off then, and it's hard to go somewhere with a lot of sun around those months. As a result, most are very pale.
Let me give an overview of prime brokerage. Will be a long post. Prime brokerage is really a huge bundle of services provided to hedge fund clients and these services can be very, very different from each other.
At first all it had was the most basic function, that is custody: asset servicing and clearing. It was very ops-like. You were basically earning a fee to do ops. Nowadays these services are provided free (and done by ops at BBs), as the real money comes from other, more sophisticated services. Even though the work is actually done by ops, you still need front office people (usually in product management) supervising them. for example: there are some countries you can clear securities of and countries you can't. there are some legal entities you can clear certain securities in, and some legal entities you can't. So these ppl try to constantly expand the asset servicing ability/etc. They work a lot with back office teams, technology, and legal, but generatig revenue for the firm meanwhile. (without full asset servicing capability, some HFs wont want to PB with the firm and the big sec lending revenue is gone). You gotta get your basics right before talking about more advanced stuff. Is it really finance work? related to finance yes, but doesn't match the typical "finance job" description WSO-ers aspire to.
Then PB developed a bit more and it had more functions, such as execution (latency sensitive clients such as stat arb funds needs lightening fast execution speed these days), financial reporting (that's like accouting), and capital introduction + consulting (finding institutional clients to complete fund raising efforts, finding new office space for startup funds). Cap intro is pretty self-explanatory. A very salesy role. Financial reporting is all automated these days (ops may have to manually fix it if there's a system error). Creating execution platforms is a real challenge. HFs want their futures, options, stocks and other exchange-traded product executed within a few milliseconds. Product management people work really hard along with IT to develop better and better systems to satisfy clients' needs. PB makes execution revenues from clients (especially stat arb and global macro ones).
After that, PB developed into more sophisticated functions like security financing and security lending services. Financing is basically a lending business, a bank within a bank. They basically lend cash to HFs against a portfolio of assets as collaterals, therefore giving the HFs leverage. HFs have to post a margin and it is up to the PB to determine what the margin is. Margin is usually risk based, therefore a high risk/volatility strategy like activist/concentrated investing would have to post a lot more margin than a low risk/volatility strategy like stat arb. You have margin team that develops margin methodologies that capture the risk of different HF strategies. On equity side, You have collateral traders looking at the rehypothetication market for funding levels (how much does it cost to raise cash from collaterals). On fixed income side, you have traders who participate in the repo market. Sec lending is basically borrowing securities from asset mgrs (think fidelity who HAS to hold everything in an index to replicate index fund like returns) and lend it out at higher rate to HFs, making a cut in the middle. that spread depends on how hard it is to borrow the stock so sec traders spend all day looking at supply and demand of short interests. Synthetics/equity swap trading is also part of the PB business in a way: total return swaps allow a client to go long/short something without committing much cash upfront, it is basically a form of leveraged financing. Financing and sec lending is where the big bucks are and PB actually takes on risk to generate these revenue. You never want some hedge funds to blow up and blow you up in the process, that is why there is a huge emphasis on risk in PB.
Then you have the PB origination/sales people. They own the relationship with the HF clients and wine/dine/golf with them so HFs would use the PB instead of its competitors. Rather than selling financial advices, PB origination people sell the strength of the bank (big balance sheet, good counterparty to have), the range of product and services it offers, its execution ability and operational capabilities, the aggressive margin methodologies it offers, and etc.
Then you have client services reps. Client service reps get a not-so-good reputation in PB, as the work is more mundane. They usually recruit from non target schools for these positios. They are assigned to individual clients and take care of all daily requests of the clients. Clients reach out to them on every question they have (book this trade for me/how to login to some portal/why is my MBS marked so low) and client reps have to coordinate with other functions in PB to answer the requests.
Most BBs have prime brokerage as part of S&T. It is different from S&T as you are not really following a particular asset class (stocks/bonds/fx), but rather trying to offer the best products/services for the buyside. At the same time, there are roles (repo trading, sec lending, etc) that are market related.
So PB has two parts: equity and equity linked products (think convertible bonds, warrants, options) and fixed income side (rates, credit and ABS)
In the equity space, the most basic way to make money is financing client's positions (leverage). BBs can take the client's portfolio and raise cash from it (collateralized financing) at attractive rates, let's say some basis points over libor/fed funds/other reference rates and lend this balance out to HFs at a mark up as HFs are less credible counterparties than investment grade rated BBs. This represents part of the revenue. So PBs want large AUM clients that need massive leverage. (fundamental equity l/s funds like Greenlight doesn't really need much leverage and doenst turn over portfolio very often meaning no execution revenue, plus risk is high as they can be wrong in the short run, thus they aren't profitable clients).
Then stock loan plays the next part. When you short a stock, you borrow it from someone and sells it on the open market to raise cash. Then you pledge that cash to the lender as collateral. The lender puts that cash into the repo/fed funds market to earn risk free rate, and "rebate" part of that interest (let's say risk free- 30bps) to you. That 30bps is effectly the cost to borrow. It's pretty easy to borrow stocks with a lot of float out there, but when things become "hard to borrow", it is a "special" stock, like AIG a while ago coz everyone wanted to short it. The rebate rate could become risk free - 1000bps, that means you get negative rebate (you actually have to pay the sec lender almost 10% a year). The stock better go down hard for you to justify this high cost of borrowing. Obviously the PB takes a cut in this: if the sec lender (vanguard) is rebating PB risk free - 30 bps, PB is rebating the client risk free - 50 bps to make 20 bps for themselves. Sec lending guys spend all day analyzing stocks and try to source shorts for their clients (they have databases are are plugged into other banks' inventories), building relationships with the big sec lending firms (asset management companies) so they get good rates. Since you make the most money in "specials" book, traders try to forecast what stocks will be shorted heavily in the future and try to accumulate the supply beforehand. If you wait until a stock goes special, it is not great opportunities anymore as it costs you a lot of money to borrow it from asset mgmt firms. So you want to have the supply before it goes special, the easiest way is to buy it. But then you worry about it falling in value on your book, so you hedge it with the short position in synthetic forward. You can't short stocks in forward market so you use options to construct the same payoff.
Put call parity
Long stock + Long Put = Long call + PV(Strike price)
So rearrage equation
Long Put + Short call = Short stock + PV(strike price) = "synthetic forward"
This way, you own the shares, you can lend it out and you are hedged if the price goes down.
If a client longs a stock that another client wants to short, then it's golden situation. This is because 1) PB can just lend out the long position to the other guy and no need to borrow it from sec lenders (0 cost), but still rebate standard rate to the guy who wants to short. 2) PB doesn't have to raise cash to finance the long position/doesnt have to fund it, because the HF that shorts it already raised cash in the open market and pledge it to PB as collateral (meanwhile the HF still paying standard interest rate on the balance). Basically PBs can make huge spreads when this happens. This is why PBs want a lot of clients/balances/awesome long and short books, so they can monetize from these opportunities. The majority of revenue in the equity business comes from this as well as SL fees.
In the fixed income space, it is basically the same thing. Financing and lending bonds, instead of equities. But the economics is very similar. The FI market is obviously much bigger and much more liquid (like govie stuff).
A significant stream of revenue comes from execution from options/futures, too. Faster systesms are always in demand. You can make great money if you can design good systems.
I currently work in the product management/development team.