In the world of trading commodities and assets, big players, such as hedge funds oftentimes trade in a large number of assets. Such massive operations are next to impossible to manage or keep track of manually.
Moreover, hedge funds deal in riskier investments and even riskier strategies. That’s why they usually choose esoteric investments that other investors won’t even consider. With high risks come high gains if you manage to pull it off, and in most cases, hedge funds manage just fine.
But how do they do it? Simply put, they outsource the majority of their financial tasks to prime brokers. It’s safe to say that hedge funds wouldn’t even exist if it wasn’t for prime brokers.
However, prime brokers only facilitate large and active trading operations because that’s where their services are needed the most.
With that in mind, here’s why prime brokerage is important in the trading strategy.
What exactly is prime brokerage?
Before we delve deeper into what prime brokers do, we have to learn a bit about hedge funds.
Hedge funds are usually partnerships that pool their money together. Hedge fund managers use various risk management tactics and investment strategies in search of large returns.
They usually leverage borrowed capital, such as money or assets, to take advantage of specific market opportunities. Such operations require a delicate touch, which is where prime brokerage comes into play.
Prime brokerage is basically a bundle of services offered to hedge funds and other large investment clients to help manage and facilitate extensive and complex trading using a wide variety of financial instruments and assets.
Services offered by prime brokers
When it comes to large complex trades, it’s very important to have someone at your side who knows all the ins and outs of the market.
To put it mildly, prime brokers serve as intermediaries for all sorts of trading operations. Their importance is vital for the success of such operations, which is why prime brokers have a variety of services at their client’s disposal. Here are a few examples.
1. Borrow securities
Prime brokers allow their clients to borrow capital for their investments. That includes borrowing stocks and bonds, also known as securities borrowing, as well as borrowing cash to purchase assets, such as stock or bonds, also known as margin financing capabilities.
2. Active intermediaries
Prime brokers act as intermediaries between their clients and two major counterparties. The first party is large institutional investors, such as pension funds, for example. The other party is major banks or lenders with an adequate amount of money for margin loans. The purpose of this collaboration is usually to engage in large-scale short-selling of securities.
3. Provide the resources you may not have
One of the key factors of prime brokerage is providing their clients with resources that these institutions may not have in-house. By doing so, prime brokers offer a mechanism upon which their clients can outsource the majority of their investment activities to their brokers while shifting their focus towards investment goals and strategies.
4. Concierge services
Aside from other services, prime brokers also offer more concierge services to their clients. Such services include risk management, performance analytics, finding new investors, cash management, research, trade clearing and settlement, custody of assets and so on.
Helping you find the assets you need
As mentioned before, one of the core services offered by prime brokers is borrowed capital. To capitalize on a lucrative market opportunity, even hedge funds must have the capital to make an investment.
If not, their prime brokers can lend them the capital they need to make the investment. This is very important because it allows you to follow through with your investments even if you lack the capital yourself. However, margin terms are set and agreed upon before any lending can be conducted.
The main reason is that the prime broker has no risk on the underlying positions, only on the client’s ability to make margin payments. Therefore, having access to additional capital, whether to buy assets or obtain assets, is vital in a trading strategy.
Helping you minimize and mitigate the risks
People often wonder how large investors and hedge funds keep going even when the market is failing. The main reason is that their prime brokers have conducted proper risk assessment and management.
Prime brokers have both the means and the resources to analyze the potential trade and determine how to maximize gains while minimizing the risks. This is crucial for the success of the trade, especially when large sums of money are involved.
As you may already know, every trade has some risk involved. Considering that large investors and hedge funds deal in really risky investments and strategies, having someone who knows how to minimize and mitigate those risks is essential.
Prime brokers have access to several markets and exchanges all over the world. They provide access to these opportunities to their clients using a unified platform.
When a client wants to make a trade, their brokers will try to find the best buyer or seller. They will, therefore, evaluate various execution venues to ensure that the client gets the best offer possible.
They will also evaluate other factors, such as speed, pricing, safety, fees and others, so that the client will be able to maximize gains from the trade and ensure what’s referred to as the best execution.
The broker will also handle any processes involved in clearing and settling of the trade. That’s why it’s important to have a prime broker to facilitate trades, so you don’t have to worry too much about it.
As active custodians, prime brokers offer services of handling the receipt, delivery, recording, and safekeeping of their client’s assets. By having custody of your assets, prime brokers can ensure more seamless and faster lending services.
They will be able to guarantee that their clients can use their portfolio assets as collateral for leverage. As a result, prime brokers can offer their clients larger loans at moment’s notices. You wouldn’t be able to gain such loans with other lenders so fast.
In other words, you allow your brokers to take custody of your assets as collateral for providing you with a loan.
In return, you get larger loans whenever you need them. This can help you capitalize on trades that have the potential to yield significant gains. This is especially true when you cannot afford to waste time getting the loan approved by alternative lenders.
Prime brokers have all the services you may need to conduct your trading successfully. They are a valuable partner to have, especially when large and high-risk trades are involved. Prime brokers can basically take care of everything while you focus on finding the best market opportunities.
Even if you have difficulties finding such opportunities, prime brokers can lend a hand. That’s why it’s of the utmost importance to have a prime broker at your side if you plan to take on large investments in complex environments.
Without prime brokerage, the risk would simply be too great even to consider such trades in the first place.
Travis Dillard is a business consultant and an organizational psychologist based in Arlington, Texas. Passionate about marketing, social networks, and business in general. In his spare time, he writes a lot about new business strategies and digital marketing for DigitalStrategyOne.