Prime-ServicesHard

3 min read · 583 words

What the seat actually does

A prime broker is the bank a hedge fund keeps its positions at. It lends the fund money against those positions, borrows the shares the fund wants to sell short, clears and settles the trades, and reports the whole book back in one statement.

The product is leverage, sold as a service. A fund with a hundred of capital and a prime broker can run several times that in gross positions; how much depends entirely on what margin the broker asks for. That number is the relationship — it is negotiated, it is reviewed, and it can be changed.

• Financing — lending against long positions, usually through repo or a margin loan.
• Stock borrow — sourcing the shares a short seller has to deliver. See securities lending.
• Clearing, settlement and custody — one place where everything the fund holds actually sits.
• Synthetic access — the same exposure through a total return swap, where the bank holds the asset and the fund holds the return.

A day, and where it goes

• Margin calls. What each client owes this morning, and who has not paid. See margin and collateral.
• Borrow. What is hard to borrow today, what it costs, and which recalls are coming back.
• Exposure by client. What the bank would lose if one fund stopped answering, at today's prices and at worse ones.
• New business, which is a negotiation about margin terms far more than about fees.

What it is measured on

• Balances — financing and borrow outstanding, because that is what the revenue is charged on.
• Return against the capital and balance sheet the business consumes, which is the constraint the desk lives inside.
• Losses on client default, which should be nil and are the only number that ever really matters.
• Whether the margin held in the last stress: a model that was right on average and short on the day is not a model that worked.

What it touches on this site

• The financing — repo, securities lending and total return swaps.
• The clients — every seat under hedge funds, and especially relative value, which cannot exist without this desk.
• Where the leverage hides — the analysis, written around exactly these positions.
• When it goes wrong — 2021, where several banks financed one client and none of them could see the others.

How it goes wrong

• Concentration nobody could see. Each broker's exposure looked survivable; the client's total across all of them did not.
• Margin set on a calm market. The collateral and the position fall together, which is precisely the case the margin was for.
• A crowded short recalled at once. Borrow that was available all year is not available on the day it is needed. See 2021.
• Competing on terms. The easiest way to win a client is to ask for less margin, which is the same as taking more risk for the same fee.

Concepts to master

• Margin is the leverage limit, and it is a decision rather than a market price. See leverage.
• Gross and net are different questions. A market-neutral book can be enormous gross and still be described as neutral.
• Rehypothecation — what the broker may do with collateral it is holding, and what happens to it if the broker fails. See that question.
• A close-out is a liquidity event. Unwinding a defaulted client's book moves the very prices the recovery is measured at.