What are prime brokers? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here they are prime brokers.

What kind of brokers are these?

A prime broker provides a range of services to a hedge fund or family office – a company that manages the millions or billions of a wealthy dynasty.

These services, which aim to help them execute their trading strategies, include the provision of financing, research and back-office administrative support.

Global banks control the prime brokerage sector, which they view as a way to sell other services, such as asset management, to clients.

Until recently, prime brokerage rarely made headlines. But that changed this summer as the spotlight shifted to the critical role of primes in the existence of hedge funds that manage some $4.5 trillion in assets worldwide.

Prime brokerages are hedge funds’ main source of funding — “their lifeblood,” according to George Evans of Convergence, a specialty analytics group.

Why are they in the news?

After hedge fund Odey Asset Management was engulfed in scandal this week, Goldman Sachs and other prime brokers — including Morgan Stanley and Exane — cut ties with the fund following allegations of sexual misconduct by its founder and former boss Crispin Odey.

Without support from prime brokerage, the fund would not be able to continue trading. Odey no longer has any ‘economic or personal involvement’ with the partnership.

Any other reasons?

Yes. There is an increased focus in the stocks in which prime brokers trade on behalf of clients – as this guides the direction of the stock markets.

For example, it became clear this month that some funds had failed to notice the rally in stocks in the technology companies that would benefit from the growth of ‘generative’ AI (artificial intelligence).

Prime brokers in particular scrambled to gain exposure to megatech semiconductor group Nvidia. Shares are up about 200 percent this year.

Is prime brokerage lucrative?

Yes, that’s why there’s such a fight to grab a bigger slice of the action. The three biggest names worldwide are Goldman Sachs, JP Morgan Chase and Morgan Stanley. But Barclays and Exane battle for position.

The fees received by all players in the industry total about $15 billion per year. But while prime brokerage is profitable, it is also labor intensive. Competition has become cutthroat as the number of hedge funds is dwindling.

It is also a risky business. The bankruptcy of US hedge fund Archegos Capital played a role in the demise of its prime broker Credit Suisse. The bank suffered heavy losses as a result of the relationship.

What else do prime brokers do?

If the client wants to short a stock and believes the value will fall, the prime broker will borrow the stock to execute this trade from a pension fund or other holder.

The shares are sold in the hope that they can be bought back at a lower price, earning something for all parties, including the owner of the shares.