How prime brokerage supports hedge funds and large traders

Hedge funds need much more than a normal trading account. They borrow money, short sell shares and trade across many markets. Prime brokerage is the service that makes this possible. This page explains what it is and how it works.

Quick answer

Prime brokerage is a package of services offered by large banks and brokers to hedge funds and other big, active investors. It usually includes financing (lending money for leveraged trades), securities lending for short selling, custody of assets, clearing and settlement of trades, and reporting. The prime broker acts as a central hub for the client's trading activity.

Key takeaways

• Prime brokerage bundles financing, lending, custody and clearing.
• Its main clients are hedge funds and large active traders.
• Prime brokers lend money and securities against collateral.
• Failures of large clients can cause big losses for prime brokers.
• In India, these services are split across custodians, brokers and clearing members.

What is prime brokerage?

It is a full-service relationship between a large financial firm and an active investor, usually a hedge fund. Instead of using separate firms for each task, the fund works mainly with one or a few prime brokers for most of its needs.

The service grew in the US from the 1980s, as hedge funds became larger and more complex. Today, a small number of global banks handle most of this business.

What services does a prime broker offer?

Many prime brokers also help new funds meet potential investors, a service called capital introduction, and provide office space or technology to smaller funds.

How do prime brokers earn money?

They charge interest on money lent to clients and fees on shares lent for short selling. They also earn from trading commissions and other services. Client assets held as collateral support the loans.

Because they lend against collateral, prime brokers set margin rules. If a client's positions fall in value, the client must add funds, or the prime broker may sell the assets.

What are the risks?

The main risk for a prime broker is a client failing to meet margin calls during sharp price moves. In 2021, the collapse of US family office Archegos Capital led to losses of several billion US dollars for some global banks that acted as its prime brokers. This showed how leverage and concentrated positions can spread risk.

For clients, relying on one prime broker creates counterparty risk. If the prime broker itself gets into trouble, the client's assets or financing may be affected, which is why many funds use more than one.

Is there prime brokerage in India?

India does not have prime brokerage in the full US form for most investors. Similar functions are handled by separate entities: custodians hold assets, trading and clearing members execute and clear trades, and the securities lending and borrowing scheme on exchanges lets shares be lent and borrowed.

Alternative investment funds, especially Category III AIFs that use complex strategies, work with these service providers under SEBI rules. Understanding prime brokerage helps you follow news about global hedge funds and market stress.

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