What Is Prime Brokerage?

I've noticed that there is a dearth of information and answers about this area of Wall Street here on WSO, so I've decided to give a basic overview of prime brokerage-what it is, how it fits in the overall picture, and what its responsibilities are. To really drive home the explanations, over the next few weeks I'll be featuring some real-life stories from the prime brokerage arena, told from the perspective of a close family member who spent about 30 years in the business.
You'll hear about the frauds he uncovered, the laughs he enjoyed, and of course, the characters he encountered.

But these stories aren't going to make a whole lot of sense unless we have a primer on Prime Brokerage.

There are many, many ways to make a buck in this industry; for those who don't mind tearing their eyes away from banking, trading, or consulting, read on for one of them…

So what is prime brokerage?

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.

Why would a client want to use a prime broker?

The most important reason for a client to use a prime broker is for netting.

Think about it: from a client's perspective, would you rather maintain accounts at a dozen different brokers (and by extension, have to keep tabs on a dozen different places for risk, fees and exposure), or maintain a presence at a single entity that consolidates all of that centrally?

With a prime broker, clients can essentially net their risk exposure by taking advantage of all the deals and special relationships the prime broker has.

How does a Prime Brokerage Unit make money?

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.

There are also fees based on how much margin is extended to a client, as well as custody and clearing fees.

Now that we have a basic, high-level overview of what prime brokerage is, beginning next week I'll start in on its importance to the Street in the prime brokerage stories...

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