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Prime Brokerage

Prime Broker, as the name suggests, seems like it does broking but in practice they may or may not do broking at all. The offer services which are custodial in nature and some important additional services, which the custodians may not offer. The following are some of the services offered by prime brokers.

Services offered by Prime Brokers

1. Liquidity Financing
2. Equities Financing
3. Securities Lending and Borrowing
4. Synthetic Prime Brokerage
5. Execution Services
6. Clearing
7. Financial Engineering
8. Portfolio Margining
9. Other on-demand services

Financing
Most Hedge funds and other investment managers require access to funding to meet their trading, collateral and liquidity requirements. Custodians, usually, do not and may not (as per local regulations) be able to provide financing solutions to their clients. Prime brokers provide financing to their clients. These are highly customisable to the trading styles, strategies and requirements of their clients.

Equities Financing
It is one of the most important and sought-after service provided by all prime brokers. "Equity Financing" is not just about financing equity trades, it is a complete package of services which include, among others, execution, security lending and borrowing, clearing, custody and settlement services. Often, all these individual services related to equity trades are bundled together and offered as a package. Clients may choose to avail the "Equity Financing" package as a stand-alone and only service from the prime broker, without availing any other services that the prime broker may have to offer. Equity focussed funds might avail this service, without using other services.

In general, the products covered under this service include cash equities, equity derivatives and equity structured products. Equity derivatives and structured products include forwards, futures, options (exchange traded and OTC) and swaps (based on both risk and return). Financing services such as swaps, stock loan, repos and other synthetic finance are also included as a part of this package.

Securities Lending
Hedge funds and some cummulative investment schemes require securities lending solutions to meet their trading, liquidity and collateral needs. Prime brokers provide these services to their clients either as a stand-alone service or as a part of their package services such as "Equity Financing", "Liquidity Management" or other be-spoke or on-demand offerings.

The securities lending services include things such as short selling, portfolio financing, cash reinvestment and collateral optimization. The products that are generally covered under this service include traditional and simple securities lending and borrowing, repos and reverse repos, and other structured securities lending solutions on both liquid and illiquid securities.

Synthetic Prime Brokerage
Hedge funds and some investment schemes use leverage while trading. Prime brokers provide this leverage to their clients through margin loans, structured repos and other financing arrangements. Under this approach, the client deposits a margin amount or margin loan, which is usually a fraction of the total purchase price, and the remaining purchase price is provided by the prime broker as a loan. This is very similar to the common housing loan that we avail, where we deposit a down payment and the rest is financed by the bank. However, instead of using this traditional method, prime brokers can use OTC derivatives such as Total Return Swaps (TRS) to provide the same exposure. This method is commonly known as "Synthetic Prime Brokerage". Under this method, the prime broker undertakes to pay its client the total return (capital gains + dividends) on a single asset (equity or debt) or on a portfolio of assets (equity portfolio, debt portfolio or hybrid portfolio) and the client undertakes to pay the prime broker either a fixed or floating return. The prime broker, often, hedges its position by purchasing the reference asset. This method is used by hedge funds, PMS schemes and other private funds. The word "synthetic" is used here because the client never buys the actual reference asset but has full exposure to it under the agreement. The asset is therefore "synthentic" in nature and not a real asset. Another way of understanding is that: this service provides only economic ownership of any asset but no real or legal ownership to the client.

Note: The operational details of this service are beyond the scope of this article. I shall try to cover this aspect in a separate article in future.

Execution Services
These services are meant to provide the clients of prime broker a platform to execute their trades across various assets, locations and strategies. Global prime brokers would be able to provide these services across global markets, which means that their clients can access globaly markets and liquidity. Local prime brokers may provide services in their local market. The services may include features such as Direct Market Access (DMA), Algorithm Trading (Algos), and Program Trading. For example, some large prime brokers are able to provide execution services that provide access to more than 130 markets covering all time zones with order management and some post trade processing services.

Clearing Services
For clients trading OTC markets and particularly for products which have clearing obligations under CFTC and EMIR regulations, the prime broker can provide clearing services. These services can also be provided for exchange traded products. Prime brokers, usually, are clearing members of clearing organisations or have tie-ups with clearing members through which these services are provided. Typically, these include clearing through CME, LCH, ICE Eurex and other important clearing organisations.

Financial Engineering
This includes creating and entering into structured products with clients. The service may also include the entire life-cycle management of the products, right from documentation to settlement and some post settlement activities.

Portfolio Margining Services
If one trades (takes long and short positions) in a single trading venue then such positions are netted and a margin equal to the net position is required to be deposited. However, many investment managers trade various asset at multiple venues. This creates an issue with regarding to margining as off-setting positions at multiple venues cannot be netted, thereby increasing the overall margin costs. The portfolio margining services of a prime broker are aimed to maximize capital efficiencies across all markets. This service includes doing margin computation, reporting, risk analysis, position drill-down, real time monitoring of margins and margin optimization.

Other On-Demand Services
These include services such as research, reporting, capital introductions and consulting.

Who use Prime Broker services?

In general, mutual funds, pension funds, private equity funds, venture capital funds and insurance companies opt for custodial services. Hedge funds and private asset managers opt for prime brokerage services. The preference is mainly due to their business and trading strategies. The following provides a summary of the reason for their preferences.

Strategy	Mutual Funds and similar Asset Managers	Hedge Funds and other private Asset Managers	Remarks
Leverage	Not permitted by law	Permitted	Hedge funds borrow money from Prime Broker. Custodians don't lend money.
Short-selling	Not permitted by law	Permitted	Hedge funds borrow securities from Prime Broker. Custodians do provide this service but Prime Brokers can provide additional services around it, including account management, margining, etc.
Use of derivatives	Limited permission to use derivatives	Used extensively	The prime broker provides execution services, middle office analytics, collateral management, reporting and other add-on services.

Main Prime Brokers (as of 2019)

The following are the top 10 prime brokers in the world in terms of AUM.

1. Goldman Sachs
2. J.P. Morgan
3. Morgan Stanley
4. Credit Suisse
5. Bank of America Merrill Lynch
6. Citi Group
7. Deutsche Bank
8. Barclays Capital
9. UBS
10. BNP Paribas

Legal Framework and Agreements

The establishment of a prime brokerage arrangement requires specific legal documentation that articulates the rights and responsibilities of the client, prime broker and executing dealers. A foreign exchange prime broker documents its relationship with the client through a prime brokerage agreement and its relationship with the executing dealer through a give-up agreement. In essence, the following are the three agreements that are commonly entered into.

1. Prime Brokerage Agreement
2. Give-Up Agreement
3. Compensation Agreement

Prime Brokerage Agreement

Under this agreement, the prime broker agrees that the client may enter into foreign exchange transactions with dealers approved by the prime broker and that the prime broker, rather than the client, will become the party to these transactions if the applicable terms specified in the prime brokerage agreement are satisfied. Generally, these terms are of two types. First, each transaction will have allowable products, such as spot, forward, or option transactions, and a tenor that does not exceed a specified maximum. Second, the transaction will have to be within specified limits, which may include settlement, open position limits, or both. These limits usually apply to the aggregate of all transactions executed by the client with an executing dealer and are typically either specified in the prime brokerage agreement or sent to the client by the prime broker so as to be known to the client at all times.

The prime brokerage agreement typically includes agreements by the client to enter into or, if the client is a manager or advisor, have funds or accounts that it manages enter into (in each case, the "relevant account"), one or more transactions that offset the transaction accepted by the prime broker. This process gives the relevant account the economic benefit of the transaction, as intended, while the prime broker assumes the credit risk of the executing dealer. In addition, the client can achieve efficient use of its collateral by consolidating much of its trading position with the prime broker. Lastly, the prime brokerage account describes the procedure by which the prime broker is notified of the transaction by the client.

Give-Up Agreement

In this Agreement between the prime broker and the executing dealer, the prime broker agrees to become the counterparty to each transaction executed by the client with the executing dealer, subject to compliance with the specified terms. A give-up agreement is customarily executed as a master agreement and is supplemented by a give-up agreement notice for each prime-broker client that will execute trades with the applicable executing dealer. The give-up agreement notice identifies the client and contains the allowable products, tenors, and specific limits that apply to the trades that the prime broker will accept for that client. The terms specified in the give-up agreement notice are typically either the same as those included in the prime brokerage agreement or sent to the client by the prime broker. Because these terms are specified in the give-up agreement notice, the executing dealer is able to determine, before executing any trade with the prime broker's client, whether the prime broker is obligated to accept the give-up of the transaction. In addtion, the prime broker may be contacted and asked to accept transactions that may be outside the limits specified in the agreements.

Compensation Agreement

The Master FX Give-Up Agreement may be accompanied by a Compensation Agreement, to be executed by the prime broker's client and an executing dealer. The Compensation Agreement provides for the compensation of losses in the event that the give-up of a transaction is not accepted by the prime broker.

Best Practices for mitigating credit, operational and reputational risks associated with Prime Brokerage service

Prime Brokerage services can have credit, operational and reputational risks associated with it. The Foreign Exchange Committee (FXC) has recommeded some best practices can help mitigate some of thse risks. These practices are not binding rules but just good suggestions for reducing overall risks. These practices should be followed along with FXC's three primary documents - Guidelines for Foreign Exchange Trading Activities, Management of Operational Risk in Foreign Exchange and Foreign Exchange Transaction Processing; and Execution-to-Settlement Recommendations for Nondealer participants.

Best Practice No. 1
No trade should be finalized without confirming sufficient availability under the give-up line. Give-up line usuage information should be updated as soon as a deal is accepted by the prime broker, and the updated information should be accesible to prime brokerage service personnel, risk managers, and executing dealers.

Best Practice No. 2
Prime brokers should establish real-time credit systems to actively monitor open positions against limits and pending give-up trades. A prime broker's sales area should be able to quickly access its credit exposure to a client and its systems should automatically update a client's credit status when a trade is accepted by the prime broker.

Best Practice No. 3
Prime brokers should develop policies and procedures to address credit-limit breaches and should document the approval of limit exceptions. A prime broker should produce reports of credit line excesses and exceptions on a regular basis for review. Exception reports should identify the client and executing dealer involved in the transactons. Persistent credit limit exceptions should prompt a review and possible adjustment of a client's credit limit.

Best Practice No. 4
Executing dealers should also develop appropriate tools to monitor open positions and limits against pending trades. Use of such tools with straight-through processing features for the acceptance and processing of trades should be encouraged, given the increasing volumes observed in the foreign exchange markets. Real-time give-up line management further enhances the value realized in monitoring positions and limits.

Best Practice No. 5
The give-up agreement between the prime broker and executing dealer and the prime brokerage agreement between the prime broker and client should clearly specify the permitted transaction types, tenor, and credit limits and the procedure by which such limits and the procedure by which such limit are to be calculated. The Master FX Give-Up Agreement published by the Foreign Exchange Committee can be used by the prime broker and executing dealer for this purpose.

Best Practice No. 6
Executing dealers and clients should have internal controls designed to monitor the permitted transaction types, tenors, and credit limits so that they execute only those trades that were authorized by the prime broker. Because they are legally obligated to accept trades within the terms specified in the relevant agreements, prime brokers should have similar controls to determine whether they are obligated to accept a particular trade when it is given up to them.

Best Practice No. 7
Executing dealers, clients, and prime brokers should have the proper processes in place to send and receive notices of give ups and should provide the names and contact details of the appropriate personnel to the other parties in a give-up relationship.

Best Practice No. 8
The executing dealer and client should each notify the prime broker of the details of any trades that they execute for give up to the prime broker as soon as practicable or otherwise within the time frame specified with the relevant legal agreement.

Best Practice No. 9
Whenever feasible, executing dealers, clients, and prime brokers should use electronic trade message systems linked to the prime broker's electronic matching system. In this way, prime brokers can automate the matching and validation of executing dealer and cleint trade notifications, providing timely notice of matched and unmatched trades to all parties through directed communications or available trade blotters.

Best Practice No. 10
A prime broker should notify the executing dealer and client as soon as practicable if it rejects a trade involving transactions or amounts that were not authorized according to the applicable agreements. Timely notifications minimizes an executing dealer's potential loss from the liquidation of a nonaccepted trade. Nonacceptance of an executed trade by the prime broker may place the executing dealer at risk of loss, especially when there is no agreement in place between the executing dealer and the client on the disposition of nonaccepted trades. Accordingly, compensation agreements between executing dealers and clients may be considered.

Best Practice No. 11
A prime broker should confirm trades if, and only if, the type of trades is permitted under the give-up agreement, the trade complies with the applicable trade type and tenor and is within the applicable limits, and the prime broker has received matching trade notifications from the executing dealer and client. Confirming trades prior to the receipt of matched notices may raise legal and market risks that should be avoided. For structured transactions, which contain unique features such as special pricing or settlment conventions that affect the valuation of the trade, matching should include all relevent terms. Mismatched trade terms may expose the prime broker to basis risk.

Best Practice No. 12
All parties should make every effort to exchange confirmations at the earliest possible opportunity. In the wholesale foreign exchange market, parties should make every effort to send confirmations or positively affirm trades within two hours after execution and in no event later than the end of the day. Standard excalation procedures should be in place to pursue and resolve all discrepancies in a timely manner.

Best Practice No. 13
The give-up agreement between the prime broker and executing dealer and the prime brokerage agreement between the prime broker and client should specify the party responsible for the determination and notification of post trade events.

Best Practice No. 14
The prime brokerage agreement between the prime broker and client should specify whether the prime broker will assume or pass through the basis risk associated with varying interpretations of post-trade events by the parties.

Best Practice No. 15
The relevant staffs of the executing dealer and prime broker should be trained to identify potential post-trade issues. All such issues should be raised immediately for timely resolution.

Best Practice No. 16
The prime broker is obligated to take on a trade only when the material terms of the trade have been agreed upon by the executing dealer and the client. If such details do not match, the prime broker should reject the trade in the manner provided in the appropriate agreements. Assuming this is done, disputes with respect to trade details must be resolved between the executing dealer and the client.

Best Practice No. 17
If a prime broker rejects a trade because the material terms of the trade submitted by the executing dealer and client do not match, the prime broker should notify the client and, if specified in the applicable give-up agreement, the executing dealer as soon as practicable so that the client can promptly contact the executing dealer and attempt to resolve the discrepancy. Executing dealers, clients, and prime brokers should have authorized personnel available throughout the business day that are able to work to resolve any discrepancies in a timely manner.

Best Practice No. 18
Except in cases of default, clients have the right to expect that their identity, orders, and strategies will be handled in a manner that protects their interest and confidentiality. At the outset of the relationship, the prime broker should determine the client's confidentiality requirements. In the absence of a formal understanding, the prime broker should assume that the client requires confidentiality of its give-up trading activity.

Best Practice No. 19
Prime brokers should establish and control access to their systems to ensure that only authorized staff are able to access or alter information regarding client give-up trades and positions.

Best Practice No. 20
Prime broker client service and operations staff should understand the confidentality requirements of each client. In addition, front-office staff should be similarly trained so that there is a common understanding between the front- and back-office staffs regarding what is and is not appropriate information exchange.

Best Practice No. 21
To mitigate reputational risk, prime brokers should perform due diligence, including an anti-money-laundering, review, with respect to their clients.

Best Practice No. 22
A prime broker should be prepared to investigate a compliant by an executing dealer that a client may have engaged in illegal or unethical trading practices. The prime broker should evaluate the reputational risk posed to it and assess whether it should modify its role or cease acting as prime broker for the client. While this best practice does not impose a legal obligation on the prime broker to the executing dealer or its client, the prime broker should ascertain whether the client's trading activity gives rise to any legal or regulatory obligation on the part of the prime broker.

END OF MY NOTES