How prime brokers can help a hedge fund

Prime brokers provide a variety of key services to hedge funds that help facilitate and coordinate complex trades in a range of financial instruments. Critically, prime brokers act as the middlemen between hedge funds and two key counterparties: commercial banks (which may also be prime brokers) that have the cash to provide loans for margin purposes, and institutional investors (such as pension funds) with large equity holdings that can be lent to hedge funds for the purpose of short-selling.

Hedge funds rely on a few prime brokers, with the largest ones each serving more than 1000 funds. Larger hedge funds tend to have relationships with prime brokerage offices located in various jurisdictions, which helps those hedge funds broaden their trading reach across markets.

Meeting new challenges

Some analysts believe the relationship between prime brokers and their hedge-fund clients has evolved significantly over the past 15–20 years as running a hedge fund has become increasingly challenging and complex Factors such as a convergence of market correlations, increasingly efficient access to information, and the increasing efficiency of markets are driving this evolution.

A generation ago, when most hedge funds were simply focused on long/short equity trades, the main role of prime brokers was the provision of stock-borrowing facilities and financing for long activities. Today, however, prime brokers are much more holistically involved in all aspects of the hedge fund.

Prime brokers have always assisted hedge funds in areas such as:

• Leverage or loans: to help hedge funds pursue their investing activities and enhance returns.

• Security management: prime brokers can provide the clearing, custody and servicing of securities.

• Regulatory advice: to help hedge funds navigate the increasingly complex and interconnected laws and regulations governing the financial world. Prime brokers often have an extensive network of connections with lawyers who are able to advise clients on potential legal changes.

• Reporting: prime brokers offer a level of performance analytics reports, either pre-set or customisable, according to their clients’ needs. Real-time portfolio reporting and specialised reports support informed investment decisions, founded on in-depth analysis and knowledge.

However, they also now help hedge funds to maximise the efficiency of resource utilisation across all the various financially constrained resources, as well as assisting in growing the talent base and advising on the use of capital.

Moreover, while prime brokers have always assisted with the raising of capital to launch hedge funds, as well as to maintain and expand their activities, prime brokers’ importance in this area is growing, given that it is increasingly difficult to raise capital as the sums needed to compete in the marketplace have become much larger.¹

Other trends affecting the relationship between hedge funds and prime brokers include the continuing rise of multi-strategy funds, which have ‘very sophisticated and specific demands which can only be met by certain service providers with scale and a broad offering covering a range of asset classes’, according to The TRADE.² A synthetic prime brokerage can help simplify the demands facing hedge funds engaged in complex strategies. It is a service offered by financial institutions to hedge funds that allows the latter to access a range of investments without actually owning them. This is achieved through the use of derivatives and other financial instruments so that exposure to these investments is created artificially or synthetically, using these derivatives, rather than through direct investment.

Why a prime broker is essential for hedge funds to operate and succeed