Prime brokerage is an important business for investment banks that provides services to hedge funds and other institutional investors. As a key service offering, prime brokerage generates steady revenue streams for banks through financing, securities lending, trade execution, custody and other services. With tightened regulations after the financial crisis, prime brokers are asked to provide more robust risk management and middle/back office capabilities. The prime brokerage landscape has consolidated, with top banks capturing most of the market share. However, there is still growth potential for prime brokerage as assets under management of hedge funds continue to increase globally.
Prime brokerage provides integrated solutions to hedge funds
Prime brokerage serves as the main hub for hedge funds tomanage their operations and investments. By centralizingmost activities with the prime broker, hedge funds can focus on their core competencies of investing while outsourcing non-essential functions. Prime brokers offer a one-stop solution covering trade execution, margin financing, securities lending, custody, capital introduction, risk analytics, regulatory reporting and other services. With consolidated information and robust risk management capabilities, prime brokers have a holistic view of the funds’ positions and risks.
Financing and securities lending are major revenue drivers
The main revenue streams for prime brokerage come from financing activities and securities lending. Prime brokers provide leverage to hedge funds through margin lending. They also facilitate short selling by lending out securities. These activities generates interest income and fees. Although commissions from trade execution also contribute to revenues, they have diminished in importance due to declining commission rates across the industry. Post-trade services like custody and reporting are essential components of prime brokerage, but are not significant direct revenue generators.
Regulations require prime brokers to enhance risk management
Regulations like Dodd-Frank in the US called for more stringent risk control and reporting capabilities from prime brokers. Basel III rules also necessitated higher capital levels. As a result, prime brokers have invested heavily in their risk analytics platforms to provide transparency into counterparty exposures and enable stress testing. Stringent credit checks are performed before taking on new hedge fund clients. Prime brokers also collaborate with custodians to segregate assets and minimize co-mingling risks. Ongoing investments in risk management and compliance will ensure the long-term viability of prime brokerage.
Consolidation among top banks in prime brokerage
The prime brokerage industry has consolidated after the financial crisis, with the top banks increasing their market share. Smaller niche players have exited the business due to high barriers to entry. Large global banks have competitive advantages in prime brokerage due to their balance sheet strength, global footprint and bundled product capabilities. Currently, the top prime brokers are Goldman Sachs, Morgan Stanley, JP Morgan and Credit Suisse. Although consolidation has occurred, there is still upside potential as more assets migrate to the prime brokerage model amid growth in hedge fund assets.
Prime brokerage generates steady fees and interest income for investment banks while providing an essential suite of solutions to hedge funds. With increased focus on risk management and regulations, prime brokers will continue serving hedge funds with robust capabilities backed by large balance sheets.